The institute’s technical team says that the application of IFRS 9 will substantially increase the amount banks set aside for bad loans, and will also make their results more unpredictable as economic predictions are made. The key challenges banks will face include difficulties predicting the future, complexities of calculations, and defining ‘significant’ changes in credit risk.

Zsuzsanna Schiff, manager, auditing and reporting at ICAEW, said: ‘One of the major outcomes of the financial crisis was a fundamental review of how banks account for loan losses. The model used prior to the crisis was heavily criticised for providing “too little too late”, and ultimately allowing a credit bubble to develop and an over-optimistic assessment of bank’s reported profits.

‘IFRS 9 is a more forward-looking approach. It will mean banks will be forced to estimate credit losses from the date the loan is taken out, and over the course of its lifetime. However, this model is complex and means that banks must look into the future and estimate the impact of possible economic events - and it is just that, an estimate.’

Complexity

The expected loss model in IFRS 9 is complex, ICAEW points out, and it requires banks to look into the future and to estimate the range of possible economic scenarios that might occur. Banks will have to decide what they think is going to happen to their customers and when. Although this will be done on a portfolio rather than individual borrowing level, they have to consider different circumstances, wider economic events and extreme conditions.

While ICAEW agrees this treatment is more prudent, it points out there are some real challenges. Measurement is highly subjective because it relies on an estimate. This element of forecasting will potentially lead to volatile results. When recession is predicted losses will accelerate, even if current economic circumstances are benign. Comparison between banks will be difficult since their view of the future could be radically different. Analysts looking at bank financial statements may find this problematic.

One of the greatest judgments in calculating an expected credit loss is when a borrower’s credit risk has ‘significantly increased’. The interpretation of 'significant' will vary considerably between banks; qualitative and subjective information will have to be taken into consideration and sometimes this will be difficult to obtain.

Furthermore, an exposure that is in stage 2 of the three stages of measuring impairment might improve to the point that it is in the same or better credit condition than when the loan was taken out. In this case, an exposure must move back into the stage 1 assessment and the expected loss moves from a lifetime expected credit loss to a 12 month expected credit loss.

Schiff cautions that the element of forecasting involved in reporting under IFRS 9 could potentially lead to unpredictable results, as estimates are highly subjective.

‘Providing enough information on year-on-year changes, assumptions and projections will be vital to allow users to compare banks,’ Schiff said.

 The ICAEW briefing states: ‘The size of the impact of changes in assumptions and the different expectations of the future will make the explanation for the variation in expected losses from one year to the next extremely important for investors and other users of bank financial statements. ‘Disclosures of changes made from one year to another will be important but also providing enough information on the assumptions and projections will be vital to allow users to compare one bank with another. The quality of disclosure will therefore be a key issue as banks start reporting their results under the new standard.’

The ICAEW briefing is here.