Financial Instruments:

Expected Credit Losses

www.pwc.ie/banking
Impairment briefing
December, 2013
PwC
Agenda
1. Accounting Implications
2. Practical Implications and next steps
Slide 2
PwC
Accounting Implications Timeline
Nov 2009
IASB issues
ED on
impairment
Jan 2011
FASB and IASB issue
supplementary
document on
impairment
2017
Effective date
not before
Slide 3
March 2013
IASB re-exposes
impairment
H1 2014
Final Standard
PwC
a) Financial assets at amortised cost
b) Financial assets (debt instruments) at FVOCI;
c) Some loan commitments;
d) Some financial guarantee contracts; and
e) Lease receivables.
Accounting Implications - Scope
Slide 4
PwC
Expected loss model.
Responsive to changes in information that impact credit
expectations.
It is inappropriate to recognise full lifetime losses on initial
recognition of financial instruments priced at market.
Significant increase in the credit risk leads to recognition of lifetime
losses.
Slide 5
Accounting Implications - General model
PwC
Accounting Implications - General model (cont)
Slide 6
Effective interest on
gross carrying amount
Lifetime expected
credit losses
12 month expected
credit losses
Recognition of expected credit losses
Interest revenue
Change in credit quality since initial recognition
Stage 1 Stage 2 Stage 3
Initial recognition*
Assets with significant
increase in credit risk
since initial recognition*
Credit impaired assets
*except for purchased or originated credit impaired assets
Lifetime expected
credit losses
Effective interest on
gross carrying amount
Effective interest on
amortised cost carrying
amount (i.e. net of credit
allowance)
PwC
12-month
expected credit
losses
The expected credit losses that result from those default
events that are possible within the 12 months after the
reporting date.
Lifetime
expected credit
losses
The expected credit losses that result from all possible
default events over the life of the financial instrument.
Credit Loss The present value of the difference between all principal
and interest cash flows that are due to an entity in
accordance with the contract and all the cash flows the
entity expects to receive.
Expected Credit
Losses
The weighted average of credit losses with the respective
probabilities of default as weights.
Slide 7
Accounting Implications - General model (cont)
PwC
Accounting Implications - General model (cont)
Basis for an estimate of expected credit losses:
An entitys estimate of expected credit losses shall reflect:
a) the best available information;
b) an unbiased and probability-weighted estimate of cash
flows associated with a range of possible outcomes
(including at least the possibility that a credit loss
occurs and the possibility that no credit loss occurs);
and
c) the time value of money.
Various approaches can be used.
Slide 8
PwC
Accounting Implications - General model (cont)
Assessment whether credit risk has increased significantly:
An entity shall base this assessment on change in probability of a
default rather than the change in expected credit losses.
An entity shall compare the probability of a default occurring over
the remaining life of a financial instrument as at the reporting date
with the probability of a default occurring on the financial
instrument over its remaining life as at initial recognition.
A simple comparison of the absolute probabilities of a default
occurring is not sufficient.
Slide 9
PwC
Information to be considered when determining whether
the recognition of lifetime expected losses is required:
Changes in external market indicators of credit risk;
Changes in credit ratings (external or internal);
Changes in internal price indicators of credit risk;
Existing or forecast changes in the business, financial or economic
conditions;
Changes in operating results of the borrower.
Delinquencies (rebuttable presumption: the criteria for recognition
lifetime expected losses is met when contractual payments are more
than 30 days past due);
Other qualitative inputs.
Slide 10
Accounting Implications - General model (cont)
PwC
Discount rate for calculating the expected credit losses:
Exposure draft provided a choice of discount rate - any rate
between, and including, the risk-free rate and the effective interest
rate.
Board now agreed that effective interest rate must be used.
Slide 11
Accounting Implications - General model (cont)
PwC
Exception to the general model:
The criterion for lifetime expected credit losses is not met
(irrespective of the change in the credit risk) if, at the reporting date,
the financial asset has a low credit risk (investment grade).
Slide 12
Accounting Implications - General model (cont)
PwC
Some loan commitments and financial guarantee contracts are in
scope.
Consider the maximum contractual period when estimating expected
credit losses.
The usage behaviour shall be factored into the calculation of expected
credit losses.
Discount rate: should reflect the current market assessment of the
time value of money and the risks that are specific to the cash flow.
Board now agreed EIR must be used for drawn and undrawn
portions of rollovers.
Slide 13
Accounting Implications - Loan commitments
and financial guarantees
PwC
Robust disclosure requirements.
Overall principle: an entity should disclose information that
identifies and explains:
- The amounts in the financial statements that arise from expected
credit losses; and
- The effect of deterioration and improvement in the credit risk of
financial instruments that are within the scope of the ED.
Slide 14
Accounting Implications - Disclosures
PwC
The Board have yet to decide on the effective date, but have
confirmed it will not be before 1 January 2017.
Retrospective application by using the credit risk at initial
recognition is required except:
If on transition such application requires undue cost or effort, then
loss provision shall be determined only on the basis of whether the
credit risk is low at each reporting period.
No requirement to restate comparatives.
Slide 15
Accounting Implications - Effective date and
transition
PwC
2. Practical Implications
Slide 16
PwC
Practical Implications
The three Stages - Decision tree
Absolute credit quality
Does the financial asset meet
the definition of investment grade at the
reporting date?
Relative credit quality
Has the credit risk increased
significantly since initial recognition?
Specific examples:
If more than 30 days
overdue -> yes (rebuttable
presumption)
Financial asset is below investment
grade -> likely yes but significance of
increase has to be determined
Credit-impaired
Does the financial asset meet the credit-impaired definition
(same definition as in IAS 39)?
Performing
>12-Months-EL
(interest revenue on gross basis)
Deterioration of credit quality
> EL over Lifetime
(interest revenue on gross basis)
Credit-impaired
> EL over Lifetime
(interest revenue on net basis)
1 2 3
no
yes
Slide 17
yes
yes
no
PwC
Deterioration Criteria
The IASB proposed some methods and information to assess the deterioration criteria:
Probability of Default Models
Using the 1 year PD as a proxy for lifetime PD to assess the transfer
criterion
Prices for credit
Credit spread that would result if a proxy instrument were newly
originated or issued at the reporting date
External/internal credit rating
and scores
If internal, should be mapped to external or supported by default
studies
Delinquencies
Rebuttable presumption that the credit risk on a financial asset has
increased when contractual payments are 30 DPD
Qualitative Assessment
Qualitative factors (e.g., business, technological, economic, and
political factors) that may affect loss rates or other loss
measurements
Rates or terms of existing
instruments
Significantly different if issued at reporting date (e.g. More
stringent covenants, increased collateral, or higher income
coverage)
Operating results of the
borrower
Significant changes including declining revenues or margins,
increasing operating risks, and increased balance sheet
Value of collateral or reduction
of financial support
Expected to reduce the borrowers economic incentive to make
scheduled contractual payment
Expected performance and
behaviour of the borrower
e.g. An increase in the expected number of credit card borrowers
who are expected to approach or exceed their credit limit
Slide 18
PwC
Challenges Considerations
Gaining an understanding of new standard
Training programme
Gaining insights from IASB
Impact on profit and capital
Initial assessment using simulation tool
Understand what the results are sensitive to
Impact on both back book and front book volumes
with knock-on impact on lending and restructuring
policies
Pricing implications
Definitions default/significant
Judgmental considerations
May consider what your peers are doing
Policy will be required
Using existing suite of models
Key adjustment required
Forward looking assumptions e.g. future collateral
values
Dealing with data gaps.
Fit for purpose assessment
Financial results and disclosure impact
Extensive disclosure requirements
Organisational impact
Appropriate skills
Ownership of models
Interaction between finance, risk and credit
Key stakeholder (both internal and external)
messaging
Need to manage message to stakeholders
Changes to key MIS
Forecasting results
Challenges
Slide 19
PwC
Stakeholder communication
The newprovisioning model will:
Likely increase provisions and will recognise losses earlier
Impacts will differ between types of portfolio
Impacts will differ between lenders
Need to:
Understand and model the impact of the proposed rules
Communicate the impact and reasons internally
Assess potential changes of business model, product types, average contractual terms, etc.
Understand data and assurance implications
Understand the impact of key drivers of change:
Policy for triggers
Segmentation policy
Restructuring/forbearance policy
Method used to build static loss curves
Survivor curves
Forecasting inputs to be applied to build
forward PD curves.
Assumptions around future collateral valuation
Assumptions about loss resolution periods
Slide 20
PwC
Project Outline
Roadmap for IFRS 9
Assessment phase
Undertaking the new or
proposed accounting
standards.
Establish steering committee
and governance
Communicate to the key
stakeholders (consider both
internal and external
Consider using a simulator
to assess potential
quantative impact and
understand the key factors.
Use simulator to assess data
requirements.
Consider resourcing impacts.
Detailed assessment
Agree key definitions for
default /significant.
Consider detailed model
(both IAS39 and Basel)
inventory and assess which
models to leverage
Assess the financial
reporting implications.
Agree model point in time
adjustments.
Consider estimated
potential impact.
Communicate with key.
stakeholders and consider
impact on credit policy and
pricing. Consider other key
projects.
Implementation and
transition phase
Model and data validation.
Implement technology
changes.
Finalise control design
including key
reconciliations.
Perform validation on
results.
Training and handover
from steering to business
as usual.
Slide 21
PwC
Contacts
John McDonnell Partner Ronan Doyle Partner
john.mcdonnell@ie.pwc.com ronan.doyle@ie.pwc.com
+353 1 792 8559 +353 1 792 6559
Oonagh Carroll Director Robert Lacey Senior manager
oonagh.carroll@ie.pwc.com robert.lacey@ie.pwc.com
+353 1 792 8163 +353 1 792 8131
Fidelma Boyce Senior manager
fidelma.boyce@ie.pwc.com
+353 1 792 8938
Slide 22
PwC Slide 23
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