“Expected credit loss” provisioning

By: Josephine Adrienne A. Abarca and Daniel Jan E. Del Mundo

First Published in Business World (10/16/2012)

In recent years, we have seen how risk management regulations and financial reporting standards for the banking industry have started to synchronize in response to the lessons learned from the global financial crisis. This move has been very pronounced, particularly in the area of credit risk management and provisioning, as International Financial Reporting Standards (IFRS) start to converge with Basel regulations toward the use of more forward-looking estimates.
By 2015, a radical shift in credit loss provisioning standards is anticipated as IFRS moves to an “expected loss” impairment model. This change is part of the proposed Phase II of the IFRS 9 Financial Instruments project, the new standard which will replace the current International Accounting Standard (IAS) 39 Financial Instruments – Recognition and Measurement. The shift is seen as a positive move, as it attempts to mitigate the systemic risk implications inherent in the current IAS 39 framework with a provisioning approach that softens the fall during crisis conditions.
Under IAS 39, companies can only recognize impairment provisions when clear and objective evidence of default or non-performance surfaces. This, however, has resulted in the perception that IAS 39 does “too little too late” – that is, it only activates when conditions are already bad.
The current model recognizes few credit losses in good economic times. However, in times of crisis, many industries fall short of their growth targets, with some even registering negative results. As the economy stalls, non-performing loans and default rates increase as obligors are hit, causing banks to recognize more impairment losses from their loan book, on top of losses from their trading activities. This prompts banks to further limit lending, freezing the credit markets crucial to economic recovery.
Because of this, many stakeholders, including the Basel Committee on Banking Supervision, have clamored for the International Accounting Standards Board (IASB) to replace the current IAS 39 “incurred loss” impairment regime in favor of “expected loss” impairment. Working closely with the US Financial Accounting Standards Board (FASB), the IASB has developed the mechanics of the new “expected loss” model. This new model aims to recognize more credit loss provisions ahead of bad times to cushion the adverse effects of economic crises.
The general principles of the new approach are as follows:
• Expected loss provision estimation. A company must estimate impairment losses as the present value of expected contractual cash shortfalls over the entire tenor of the financial asset. This expected value is adjusted by the likelihood of default either occurring within 12 months or the remaining tenor of the financial asset, depending on its credit quality. A company should estimate the loss allowance based on relevant, reasonable and supportable data, including historical, current and forward-looking information.
• Initial expected loss allowance. Most financial assets at amortized cost will have an impairment allowance, which is the expected loss estimate covering all cash shortfalls over the asset’s life given the chance of default occurring within 12 months.
• Triggered increase in provisioning. When a company judges that there has been a more than insignificant deterioration in credit quality since initial recognition, and that default is judged as at least reasonably possible given current conditions, then the expected loss allowance increases to cover all cash shortfalls over the asset’s life based on the chance of default occurring over the remaining tenor of the asset.
• Symmetrical treatment for recovery. When a company determines that the deterioration in credit quality since initial recognition is no longer more than insignificant, or when default is judged as less than at least reasonably possible, then the expected loss allowance falls back to the estimate based on a 12-month default likelihood.
• Disclosure requirements. A company needs to meet certain disclosure requirements on its expected loss estimation approach and the trigger to increase provisions.
The principles applied above are applicable to most products in a bank’s loan books, including commercial and retail loan products, and hold-to-collect debt investments. Modified principles apply to purchased or originated loans considered impaired at initial recognition date, trade and lease receivables, and off-balance sheet committed credit exposures such as irrevocable credit facilities and financial guarantees. However, the same underlying “expected loss” underpinnings apply for these variations.
These principles are currently only tentative, and the IASB has yet to release an exposure draft for public comment. However, any future changes are expected to dwell on operational issues, and the core “expected loss” principles will hold.
With this in mind, what can Philippine banks do to prepare for the new impairment model?
The “expected loss” framework significantly aligns credit loss provisioning for financial reporting under IFRS 9 with the regulatory capital requirements under Basel. In this regard, banks may view the upcoming IFRS 9 requirements as a take-off point to adopt internal credit risk models consistent with Basel’s Internal Ratings Based (IRB) approach to credit risk capital allocation.
Philippine banks are using the Standardized Approach to determine the required regulatory capital for credit risk. This framework applies standard credit risk weights to a bank’s credit exposures, based on available external credit ratings, rather than on a bank’s internal credit risk rating system. In contrast, the IRB Approach allows the use of internally-developed credit risk parameters benchmarked on a bank’s internal rating system to compute for credit risk capital.
Moving from the Standardized Approach to IRB has potential business benefits for banks. For one, they can realize potential savings in credit risk capital. Adopting IRB also provides banks the opportunity to enhance their credit risk management processes and systems, since robust credit risk management systems are required to obtain regulatory approval.
Under IRB, banks will have estimates for probability of default (PD), loss given default (LGD) and exposure at default (EAD). These parameters can also be used for IFRS 9 provisioning after adjusting for some differences in estimation specifications. As such, estimates for IRB and IFRS 9 will likely be developed from the same credit risk data pool.
Philippine banks, therefore, are in a favorable position to hit two birds with one stone in the area of credit risk. Indeed, they will find it beneficial to align efforts to develop provisioning models for both Basel IRB and the upcoming IFRS 9 requirements. Doing so will enable them to prepare for the unfolding changes in impairment accounting and reap the business benefits of internal credit risk models, while saving on the potential costs of two disjointed initiatives. Banks only have to aim and throw.

Josephine Adrienne A. Abarca is a Partner of SGV & Co. Daniel Jan Del Mundo is a Senior Associate of SGV & Co.’s Financial Services Risk Management Group.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.