The introduction of IFRS 9 from 1 January 2018 will have a significant effect on regulatory capital across the banking industry, with four-fifths of EU banks expecting their stock of impairments to rise under the new rules according to a Deloitte survey. The European Banking Authority’s (EBA) estimates for the increase of impairment stock (provisions), compared to the current levels under IAS 39, is 18% on average and up to 30% for some firms. This led to an estimated decrease in Common Equity Tier 1 (CET1) and total capital ratios by an average of 59 bps and 45 bps, respectively. As a result, finding a mechanism to smooth any unwanted impacts following the IFRS 9 adoption, by avoiding a capital cliff-effect on day one, has rapidly become a priority for prudential regulators.
In October 2016, the Basel Committee on Banking Supervision (BCBS) published a consultative document discussing the impact that the introduction of IFRS 9’s Expected Credit Losses (ECL) approach could have on the capital adequacy of banks, suggesting that prudential regulators may consider using transitional measures to smooth the adoption of the new rules. Just over a month later, the European Commission, recognising the same concern, included a transitional phase-in arrangement for IFRS 9 in its proposal to review the EU Capital Requirements Regulation (CRR2).
The Commission proposed to allow banks to temporarily include a reducing proportion of ECL provisions for performing loans in their CET1 capital requirements over a five year period after CRR2’s entry into force (starting at a 100% allowance and decreasing by 20% per year). With IFRS 9 coming into force at the end of 2017, however, there is a growing view among industry practitioners and policymakers that a quicker solution is needed.
The EU legislative process is complex and often slow moving, with CRR2 (a broad and controversial package of prudential rules for banks) expected to take at least two years of negotiations before a final law can enter into force. This would see its IFRS 9 phase-in allowances being applied in Q1 2019 at the earliest, already more than a year after banks will have to start applying the new ECL accounting standard.
Getting there in time
The Commission has acknowledged that its IFRS 9 phase-in proposal is a “candidate for fast-tracking” but has not yet committed to any next steps. But what does “fast-tracking” EU legislation mean? The CRR2 package cannot itself be fast-tracked in its entirety. It is simply too far-reaching and complex. To be accelerated, the IFRS 9 proposal would have to be split out of CRR2 and would likely then be re-proposed by the Commission as a standalone law.
The new standalone IFRS 9 proposal would then have to go through the same EU legislative process as any other proposal. The speed of an agreement would entirely depend on the willingness of EU Member States and the European Parliament to see the IFRS 9 phase-in proposal as non-controversial and wave it through the process. There is precedent for such an approach: it was done for the recent delays of the EU’s MiFID II and PRIIPs rules, but the legal and legislative procedures involved mean that this could still take several months at best. What’s more, legislators may seek improvements to the Commission’s proposal, including those set out in the opinion issued by the EBA last week, calling for a simpler one-off transitional allowance to be calculated (without the 100% allowance in year one) instead of the Commission’s five-year dynamic approach.
One important question is how soon a transitional phase-in for IFRS 9 needs to be ready to be of meaningful assistance to banks. Having transitional rules ready before the end of the year is a start. In practice though, banks and their supervisors arguably need more time to prepare for IFRS 9 implementation from a capital management and prudential point of view, in order to better understand and anticipate its effect on different kinds of asset classes, exposures and business models.
In order to maximise the usefulness of a phase-in period, these rules would ideally be in place before supervisors make their bank-by-bank Pillar 2 capital adequacy decisions as part of the Supervisory Review and Evaluation Process (for the ECB, this is usually finalised in September). This would allow supervisors to understand the amount of additional capital banks will be required to hold from 1 January 2018, and to make Pillar 2 capital requirement decisions that ensure regulatory capital adequately reflects the risks prudential regulators have identified in each bank.
That does not leave much time for a standalone phase-in arrangement to be negotiated and finalised, if a new proposal even ends up being made.
What if a phase-in arrangement isn’t ready in time?
Broad support for a transitional phase-in of IFRS 9 appears to exist among supervisors, national governments, the Commission and the European Parliament. However, the challenges around rushing through a fast-track proposal at the EU level or the expected slow pace of CRR2 negotiations leave the very real possibility of a phase-in arrangement not being ready in time.
If so, supervisors may be able to use the discretion they have in setting Pillar 2 capital requirements to smooth the impact of IFRS 9 adoption. The UK Prudential Regulation Authority’s (PRA) consultation on its Pillar 2A framework last month raised the impact of IFRS 9 on capital adequacy. This signalled that the PRA will seek to even out the disproportionately large impact that ECL provisions are expected to have on banks using standardised approaches for risk measurement relative to those using internal ratings-based (IRB) models.
This could address some concerns around IFRS 9 adoption, although without a clear EU-wide phase-in arrangement, ad hoc supervisory approaches could be inconsistent with each other (e.g. between the UK and Eurozone) and not the comprehensive solution many banks and prudential regulators would like to see. For example, supervisory approaches similar to that being outlined by the PRA, may not offer relief to banks using IRB models, even though IFRS 9’s effect on them is less clear-cut.
In the face of this uncertainty between now and the end of the year, banks should engage closely with their supervisors to understand their expectations of them and the approach they will likely take either with our without an EU-level phase-in arrangement on the books.
To learn more about the impact of IFRS 9 on banking sector regulatory capital, please see the report (A drain on resources?) published by Deloitte last year.