Over the past 2 or 3 years the body of work for most credit risk professionals has been predominantly consumed by the new accounting standard, IFRS 9. Since the International Accounting Standards Board (IASB) released its publication of IFRS 9 in 2014, much of the focus has been around preparing for implementation and the parallel run phase. With IFRS 9 set to go-live officially on 1st January 2018, many financial institutions are currently going through their parallel runs to ensure a smooth transition. Whilst many institutions have come to terms over the past couple of years with what IFRS 9 actually is and many of the standards methodological challenges, there are more practical nuances that banks are finding particularly testing as we enter the parallel run phase. It is therefore paramount that organisations prepare meticulously for the new regulatory standard.
With the Center for Financial Professionals’ upcoming 6th Annual Banking Risk and Regulation Summit taking place on 9-10 May, we undertook extensive research to explore the risk and regulatory challenges facing banking risk professionals over the coming year. The findings of this research will be illustrated at the Summit, which brings together 50+ speakers from institutions across EMEA, discussing some of the broader risk and regulatory themes, as well as more refined topics. There are three workstreams dedicated to: The Fundamental Review of the Trading Book (FRTB), Capital Management and Credit Risk, the final of which has a particular focus on IFRS 9.
Whilst the first piece in the series focused on the keynote plenary sessions and the broader themes within the industry, including the pace and change of the regulatory landscape and Brexit, this piece will focus on Credit Risk and more specifically IFRS 9, as well as its interaction with the updated Basel IRB framework.
There has been much literature written on IFRS 9 and the industry is preparing for official implementation in under a year in January 2018. Therefore the end goal or overall challenge for financial institutions is the practical implementation of the standard. Over the past year there has been a lot of industry discussion on how different institutions are dealing with or interpreting the IFRS 9 rules, which are principle based and inevitably have varying ambiguous definitions. For example phrases such as ‘significant increase in credit risk’ are given, but the words ‘significant increase’ are subjective and can be interpreted differently across institutions. Therefore how you actually apply these principles in practice can be open to a wide variety of interpretations and approaches. This has meant a lot of it has been left to banks to decide how to approach IFRS 9. As many banks are currently going through the parallel run phase, establishing some sort of standard or consistency across the industry in terms of IFRS 9 interpretation and implementation will be a challenge. If there is a more consistent approach to interpreting IFRS 9 this would put those teams working on the standards’ minds more at ease, as well as give a benchmark of comparison.
2017 should be the year banks prepare everything in terms of modelling behind the new rules and implementation of the systems that banks have to develop to meet these new demands. IFRS 9 implementation requires a substantial effort and many banks are currently, or about to be, at least in the draft or parallel run phase. It will be interesting to discover the initial impact that IFRS 9 will have as the first figures start to come in. It is expected that numbers will fluctuate more than they used to and banks will have to cope with the impact the standard has on P&L month to month. The on-going monitoring and reporting of IFRS 9 provisions will therefore be a challenge over the coming year. IFRS 9 requires forward looking information and estimations of lifetime losses, so much of it is about having expert judgements and adjusting day-to-day. This adjusting as we move through the parallel run phase is something that IFRS 9 teams will inevitably find difficult during the year. Much of 2017 will be focused on the parallel run phase and as figures come in banks will have to cope with higher volatility than in the past in the preparation for go-live in 2018.
A further area that came out of the research quite prominently was the interaction of IFRS 9 combined with the Basel changes on IRB models. The Basel Committee on Banking Supervision has been consulting on changes to the IRB approaches, which allow banks to use internal models in determining their regulatory capital requirements for credit risk. For credit risk professionals much of the challenge focuses around IFRS 9 steering one way and Basel steering in the other direction, and the similarities and differences between IFRS 9 and the updated Basel IRB framework.
For both frameworks one of the main challenges is not only the definition of loss given default (LGD), where there have been various new guidelines recently that are now being transposed by banks, but more specifically the measurement of LGD. Basel and the IASB diverge in different directions with the measurement of LGD in low default portfolios. This will require banks to use two different models where they would get completely different results where they estimate their losses, something that could prove to be a big test in terms of comparability. Another particular area of debate is around the modelling of LGD within a credit cycle, where the frameworks again seemingly diverge in different directions. On the one hand IFRS 9 requires banks to make their LGD measurements cycle sensitive, whereas on the other the Basel framework wants to make them less sensitive. This is another area that could prove to be a sticking point over the coming months and it seems that the interaction between IFRS 9 and the Basel changes on IRB models will certainly be an area of focus over the coming year.
These are only a snapshot of some of the challenges that the banking industry faces over the coming months within credit risk, as banks moves towards official 2018 implementation of IFRS 9 and the industry uncovers the interaction, similarities and differences between IFRS 9 and the updated Basel IRB framework. In particular, with IFRS 9 parallel runs currently taking place this year for many institutions it is perhaps no surprise that credit risk professionals will be kept very busy over the next 12 months.
To hear industry discussion on Credit risk and particularly IFRS 9 and the Basel IRB framework, join us at The Center for Financial Professionals’ 6th Annual Banking Risk and Regulation Summit, taking place in London 9-10 May 2017. The credit risk stream will focus on these areas and more. For full information visit www.risk-mea.com.