Brisilda Bala, CFA
Manager of Risk Management Department, TIRANA BANK
Chairwoman of Risk Management Committee, AAB
This year started for many of us with intensified discussions related to the required actions for transition from IAS 39 financial reporting standard to IFRS 9, and especially with the need to understand its meaning and the impact this new standard entering to force on 1 January 2018 will bring.
Experts of financial reporting standards relate the development of the new standard with the need to address the issues its precedor IAS 39 showed. Especially, IAS 39 showed deficiencies in addressing on time problems with the assets quality, leading therefore to their poor and late provisioning, but what does it mean for banks?
The key driver, which ensures continuity of the banks’ operations under normal conditions is their capital, while the main investment activity is lending. For every Lek invested in lending, banks are obliged to set aside in a “reserve bag” funds which cover possible losses of the investment. These reserves are a small part of the investment done when the later has a good quality, and increase considerably with the downgrading of its credit quality, until it reaches the extreme of its 100% when it is considered as lost. They decrease the capital available for investment in other new loans, and when increased considerably, consume it to the point that the continuity of the business is endangered. However, the logic behind creating loss reserves funds lies with the readiness to face possible investment loss events, therefore this process should be proactive rather than reactive. IAS 39 works based on the logic of creating reserves based on the Incurred Loss Model, which showed that banks were faced with the loss and not prepared for it. IFRS 9 transforms therefore the perception for credit risk management deriving from these assets, increasing the ability of banks to face potential loss events through a more visionary model of provisioning based on Expected Losses.
What is the key news the new standard introduces?
- Classification and measuring of financial assets – designed with higher logic consistency. Financial assets will be classified under three categories (FVPL, FVTOCI, Amortized Cost), classification which is based on the typology of the contractual cash flows and the business model.
- Expected Credit Loss Model - represents the most important change of the standard, related with creating of credit loss reserves for possible losses, moving away from the Incurred Loss Model. It is this change that is expected to change the banks’ approach to the management of credit risk from financial instruments, leading them towards being more proactive.
- Hedge Accounting – is now better related with risk management practices and is more flexible. As a tool to reduce volatility in the company’s result, the standard emphasizes the economic relation between the hedging instrument and the exposure being hedged, and eliminates the band of 80-125% of hedging effectiveness ratio.
The logic introduced by the standards seems to better address problems, so why there is so much anxiety in the process of transition to it?
Certainly, it is related to the limited knowledge on the standard as well as the short remaining time to its final adoption, with the increased requirements for complete and consistent data and especially, related to its financial impact. The latest is expected to be in any case associated with increase of credit loss reserves at considerable levels (researches on its impact show for a possible increase of credit loss reserves up to 30%) and as a consequence, reduction of the financial result and capital, the efficient usage of which will have an important focus. It is worth mentioning however that despite the expected increase of loan loss reserves, they are not generally expected to increase to their level as per the local standards (of the regulatory framework of Bank of Albania) and neither to affect the capital calculated as per these standards.
The new standard presents the increased need for better coordination between risk management structures, finance and business lines. It is accompanied by the need to reassess and improve processes, especially those related to credit risk management.
The material requirements it presents for historical data create an inevitable need for important investments in IT applications for the administration of these data.
- Regarding the loans portfolio, as the main item on the banks’ balance sheet, so that to estimate the need for loan loss provisions as per IFRS 9, banks should be able to classify loans into three categories, strongly related with the credit quality. While changes for loans classified as in default are minimal, changes are significant for the performing loans, but which show significant deterioration of their credit quality since initial recognition. Certainly, the first challenge is the establishment of what the significant credit deterioration criteria will be. Loans classified under this category should be provisioned based on a lifetime probability of default and this is as well a big challenge. PDs estimated based on past default events should be simulated to produce lifetime PDs. To achieve that, it is necessary to correlate them to the economic developments and for the latest, accessible information is limited. Therefore, banks are faced today with the big challenge to overcome problems related to lack of macroeconomic data, deficiencies which should be overcome through workaround solutions with direct financial impact.
Increase of loan loss reserves means that cost of credit risk will increase as result of increase of cost of credit risk (Risk Adjusted Pricing). Furthermore, transferring of loans from category 1 (1 year PD) to category 2 (lifetime PD), which means higher PD, will increase sensitivity of banks towards credit risk management and its addressing at the early stages, avoiding downgrading of loans classification. Surely, this is one of the positive aspects of transition to IFRS 9 however, it can be associated with further tightening of lending criteria and reduced risk appetite.
- Another important item on the balance sheet of banks is as of today investment in securities portfolio of the Albanian government. The results of the standard towards possible increase of provisions for this category of investments means for sure re-consideration of the investment strategy and the required return for these investments.
As a conclusion, implementation of improved concepts of the standard is a big challenge, but its real value towards transformation of processes and increasing of banking system stability is what should remain in our focus.