Deloitte has released a new paper, which helps banks take the first step towards understanding the impact of IFRS 9 accounting rules on their regulatory capital position. This blog post summarises the paper’s key findings.
What is IFRS 9?
IFRS 9 is a key component of the International Accounting Standards Board (IASB)’s reform package that followed the global financial crisis. It determines how banks should classify and measure financial assets and liabilities for accounting purposes. Crucially, the rules mark a fundamental shift in credit impairment rules.
The standards, which take effect in January 2018, require banks to recognise impairment sooner and estimate lifetime expected losses against a wider spectrum of assets. Impairment is one of the key obstacles to financial sector profitability, with four-fifths of EU banks expecting their stock of impairment to rise under IFRS 9.
Why will impairment rise for many banks?
We anticipate three main drivers of higher impairment. First, banks will provide for the lifetime expected credit loss of exposures that have declined in creditworthiness but not yet incurred a loss.
Second, IFRS 9 requires banks to recognise future losses on undrawn commitments, reflecting the tendency for customers to draw down on credit lines and the bank’s ability to manage problem accounts.
Third, banks are expected to develop probability-weighted loss estimates against a range of macroeconomic scenarios. This is likely to result in a more conservative view of impairment in many cases.
What is the regulatory capital impact?
Regulatory capital resources are driven by shareholder distributions and profits, the latter of which incorporates credit impairment charges. So impairment acts as a drag on capital adequacy.
A rise in impairment inevitably depletes the capital adequacy of banks that use the Standardised Approach to credit risk. The result is less clear-cut for Internal Ratings Based (IRB) banks, reflecting the relationship between impairment and outcomes of the IRB capital formula. Nevertheless, most banks are expected to suffer material capital depletion.
The “day one” and ongoing impact depend on the bank’s risk profile, regulatory permissions and accounting policies, as well as prevailing economic conditions. On average, Standardised banks are expected to suffer twice the capital depletion of IRB peers, albeit with significant variation across the industry.
What does this mean for investors?
Capital buffers are being ramped up for many lenders, particularly those with high systemic importance. Banks that fail to meet certain requirements will face automatic restrictions on the payment of dividends, certain debt coupons, staff bonuses and discretionary pension benefits. IFRS 9 is likely to make it harder for some banks to maintain adequate buffers and make discretionary payments.
Will regulatory rules change in response to IFRS 9?
As of November 2016, regulators are yet to address the issue of IFRS 9 in full. In particular, time horizons used for accounting and capital requirement purposes are misaligned, whilst the mapping between IFRS 9 impairment and regulatory capital components (i.e. specific and general credit risk adjustments) remains unclear.
The Basel Committee on Banking Standards (BCBS) recently issued consultation and discussion papers, which describe some potential options. These include the possible phasing of IFRS 9 impacts on capital, which would provide relief to some banks. However, the introduction of Regulatory Expected Loss rules that could further deplete the resources of some Standardised banks are also mooted.
How should banks be preparing for the capital impact of IFRS 9?
We make two recommendations in this paper. First and foremost, banks should prepare a fair and open assessment of potential IFRS 9 consequence, transposing this into a regulatory capital impact where appropriate. Second, banks should devote resource to integrating IFRS 9 modelling into stress testing, also potentially looking to exploit synergies with IRB capital requirement modelling.
This is a potential silver lining for lenders: as loss modelling becomes the norm for banks of all shapes and sizes, they will realise greater synergies between impairment, capital and stress testing analyses. Meanwhile, some regulators have suggested a desire to widen the IRB scope, potentially easing capital requirements and helping banks develop a fuller understanding of their risk profile.
How is Deloitte making an impact in this area?
As a core proposition of its Audit and Risk Advisory functions, Deloitte is supporting a wide range of clients with their IFRS 9 transition, from specialised next-generation lenders to global, systemically important banks. The impact on regulatory capital and stress testing are core focus areas for our clients in the current environment.