Compliance Matters undertakes a rare foray into the world of banking solvency with a discussion of one of the International Accounting Standards Board's new rules. The size and complexity of the multi-year introduction of IFRS 9 will have a major effect on products, systems and controls, governance, data and other things that often concern compliance directors.

In the light of recent news headlines suggesting that new accounting rules could force Europe’s top banks to recognise an extra €61.5 billion in loan losses, experts have warned that the bank accounting system is currently not fit for purpose.

It’s the final countdown!

It is no secret that the countdown for the implementation of the new global accounting standard, International Financial Reporting Standard 9 (IFRS9), has begun. The standard must be in force, with all banks complying, by January 2018.

Recent discussion has cast doubt on whether the new accounting rules are fit for the purpose for which they were made. Nevertheless, they represent a 'step change' in the industry in terms of the way people think about risk and also the way in which such risk affects pricing and losses over the life of an asset. Some of the paragraphs seem to have been written with commercial portfolios in mind and therefore require some lateral thinking on the part of anyone who wants to apply them to high-net-worth portfolios. However, given an appropriate amount of time, the right external support and pragmatism on the part of auditors and regulators, these problems are not insurmountable.

Amongst other things, IFRS9 sets out how to recognise and account for credit losses (impairment). Banks are going to have to co-operate with each other, invest money and think seriously, not only when they are trying to obey the standard but also in their attempts to reach the end-goals for which is has been designed.

The new standard is a distinct departure from the current International Accounting Standard 39 (IAS39, entitled “Financial Instruments: Recognition and Measurement”) in that it focuses on accounting for expected credit losses as opposed to incurred losses.

Criticisms levelled at the current standard

The criticisms levelled at the current standard include the following.

• It has been slow to respond to the recognition of credit losses, only recognising lifetime expected credit losses on exposures where there has been objective evidence of impairment and an additional allowance (incurred but not reported) for exposures that the bank expects to become impaired imminently.
• It has relied too heavily on backward-looking information, particularly delinquency data and historical loss rates.
• It only considers drawn loans, not commitments to lend. As a result, many credit-card and current-account providers are not recognising sufficient loss allowances.
• The information provided to users of financial statements is not transparent enough to be useful.
• It is too complicated to implement and maintain as this-or-that bank can take more than one approach to it, depending on the asset involved.

The financial crisis of 2007/2008 intensified people's attempts to overhaul this standard and avoid a repeat of the fall-out that followed. The spectacle of banks having to be bailed out by public money and countries such as Greece failing to repay their sovereign debts spurred the reformers on.

Although there have been some negative comments about the new standard, I do not believe that IFRS9 is fundamentally flawed. I do believe, however, that all large-scale change attracts criticism as it can never be a perfect fit for all organisations in view of the differences between their various products and business models. I also think that the people directly responsible for managing and reporting the profit-and-loss (P&L) account should work together to understand the changes in view of the very obvious crossover between accountancy and risk.

What IFRS9 aims to achieve

The new standard attempts to solve the problems of the old in a number of ways.

• IAS39 was slow to respond by design. It was a response to some organisations applying balance-sheet management under UK GAAP (Generally Accepted Accounting Practice, the body of regulation that governs the way company accounts must be prepared in the United Kingdom) to recognise losses that would not be incurred in good times so that they could be released to prop up the P&L in bad times. IFRS9 tackles this by recognising lifetime expected credit losses for all exposures for which there is objective evidence of impairment, all exposures that have become significantly riskier since initial recognition and exposures that are expected to default in the next 12 months.
• The new standard demands that forward-looking information should be used and losses should be accounted for on the basis of what the bank believes will happen in the macro-economic environment in the future and the specific effect that that has on its different portfolios.
• Under IFRS9, the date of recognition is the date at which the commitment to lend is made. This means that for pipeline business and 'revolving credit' products, losses must be recognised according to the expectation of draw-down over the behavioural life of the exposure.
• The disclosure requirements are more granular, requiring split by risk grade, LTV (loan-to-value ratio), drawn and undrawn.
• There is a single impairment model for assets measured under amortised cost and those measured under Fair Value Other Comprehensive Income (FVOCI).

Could we really have prevented the global financial crisis?

It is fair to ask whether IFRS9 would have prevented the global financial crisis (and the distressed restructuring of Greek debt, among other things) if it had been in place in 2007/2008.

To answer this we need to think about the reasons for the crisis and the debt. There are various opinions on the subject but five things stand out.

• Poor fiscal management by the Greek government of public finances.
• Endemic tax evasion by the Greek public.
• Heavy investment in Greek bonds at an unsustainable rate following the fall of the US sub-prime mortgage market due to perceived low risk of government bonds in Euroland.
• Financial institutions being slow to 'react to recognise' losses and not allowing for them.
• Illiquidity in financial markets.

IFRS9 will not address the first three at all as the changes are focused on financial institutions and losses resulting from providing credit, not the mismanagement of public funds, the level and availability of those funds or the ways in which financial institutions obtain funds to provide credit.

IFRS9 cannot solve problems in isolation

The standard will be able to deal with the last two, but not in isolation. IFRS9 provides the principles to allow accountants to recognise losses early and account for them. If more money is set aside in ‘good times’ to account for future losses, there should not be as much of a squeeze when things start to go wrong. This will generally ensure that there is more access to credit when required and fewer issues with liquidity. There is a risk, however, that a poorly administered model will lead to more volatility and a further risk that credit will not be available when required.

If the model the bank in question develops to do this is shown to be a good predictor of the HNW individuals' or portfolios' inherent risk, that is the first step. To be compliant and to allow it to be useful for internal planning, the bank must also be able to use that information and its view of the macroeconomic outlook to determine the way in which that risk will change over time, according to the movement in the unemployment rate, changes to interest rates, changes to price indices etc.

A burden or an opportunity?

So how do you know if your view of the world agrees with everyone else’s? How do you know if your models are performing well, in view of the fact that they have never before had to predict the future? How do you know that you are making your disclosures on the same basis as your peers?

It is incumbent on you to use the right methods to develop the right processes and present the results in the appropriate way. This will require knowledge of the industry, knowledge of how others have interpreted the standard and experience of doing things that (a) work for you, (b) meet the expectations of the regulators and (c) gain the approval of the financial services industry. The way to do this is through benchmarking.

IFRS9 is generating column inches at the moment and it shows that the industry is really starting to take this new standard seriously and think about the implications that it has for business. It is only natural to focus on the problems that IFRS9 poses rather than the benefits it might provide as those benefits have not yet appeared.

No Western government will ever go back to the techniques that the governments of the 1940s, 1950s, 1960s and 1970s used to prevent crises such as the one of 2007/8, but but this is certainly one legislative safeguard that will require banks to hold more capital than they have in the past. Rather than see this as a burden, the industry might see it as an opportunity. If it is administered correctly, it will lead to good financial planning, a better pricing of assets, more information in the hands of investors, more stability in the industry and a safer world for all banks.

* Damien Burke is the head of the regulatory practice at 4most Europe, a specialist credit risk analytics consultancy with offices in London and Edinburgh. He can be reached at damien.burke@4-most.co.uk