In the wake of the 2008 financial crisis, the International Accounting Standards Board (IASB) in cooperation with the Financial Accounting Standards Board (FASB) launched a project to address the weaknesses of both International Accounting Standard (IAS) 39 and the US generally accepted accounting principles (GAAP), which had been the international standards for determining financial assets and liabilities accounting in financial statements since 2001.
By July 2014, the IASB finalized and published its new International Financial Reporting Standard (IFRS) 9 methodology, to be implemented by January 1, 2018 (with the standard available for early adoption). IFRS 9 will cover financial organizations across Europe, the Middle East, Asia, Africa, Oceana, and the Americas (excluding the US). For financial assets that fall within the scope of the IFRS 9 impairment approach, the impairment accounting expresses a financial asset’s expected credit loss as the projected present value of the estimated cash shortfalls over the expected life of the asset. Expected losses may be considered on either a 12-month or lifetime basis, depending on the level of credit risk associated with the asset, and should be reassessed at each reporting date. The projected value is then recognized in the profit and loss (P&L) statement.
Most banks subject to IFRS 9 are also subject to Basel III Accord capital requirements and, to calculate credit risk-weighted assets, use either standardized or internal ratings-based approaches. The new IFRS 9 provisions will impact the P&L that in turn needs to be reflected in the calculation for impairment provisions for regulatory capital. The infrastructure to calculate and report on expected loss drivers of capital adequacy is already in place. The data, models, and processes used today in the Basel framework can in some instances be used for IFRS 9 provision modeling, albeit with significant adjustments. Not surprisingly, a Moody’s Analytics survey conducted with 28 banks found that more than 40% of respondents planned to integrate IFRS 9 requirements into their Basel infrastructure.
Arguably the biggest change brought by IFRS 9 is incorporation of credit risk data into an accounting and therefore financial reporting process. Essentially, a new kind of interaction between finance and risk functions at the organization level is needed, and these functions will in turn impact data management processes. The implementation of the IFRS 9 impairment model challenges the way risk and finance data analytics are defined, used, and governed throughout an institution. IFRS 9 is not the only driver of this change.
Basel Committee recommendations, European Banking Authority (EBA) guidelines and consultation papers, and specific supervisory exercises, such as stress testing and Internal Capital Adequacy Assessment Process (ICAAP), are forcing firms to consider a more data-driven and forward-looking approach in risk management and financial reporting.
Accounting and Risk Management: An Organization and Cultural Perspective
The implementation of IFRS 9 processes that touch on both finance and risk functions creates the need to take into account differences in culture, as well as often different understandings of the concept of loss in the two functions.
- The finance function is focused on product (i.e., internal reporting based on internal data) and is driven by accounting standards.
- The risk function, however, is focused on the counterparty (i.e., probability of default) and is driven by a different set of regulations and guidelines.
This difference in focus leads the two functions to adopt these differing approaches when dealing with impairment:
- The risk function uses a stochastic approach to model losses, and a database to store data and run the calculations.
- Finance uses arithmetical operations to report the expected/ incurred losses on the P&L, and uses decentralized data to populate reporting templates.
In other words, finance is driven by economics, and risk by statistical analysis. Thus, the concept of loss differs between teams or groups: A finance team views it as part of a process and analyzes loss in isolation from other variables, while the risk team sees loss as absolute and objectively observable with an aggregated view.
IFRS 9 requires a cross-functional approach, highlighting the need to reconcile risk and finance methodologies.
The data from finance in combination with the credit risk models from risk should drive the process.
- The risk function runs the impairment calculation, whilst providing objective, independent, and challenger views (risk has no P&L or bonus-driven incentive) to the business assumptions.
- Finance supports the process by providing data and qualitative overlay.
Credit Risk Modeling and IFRS 9 Impairment Model
Considering concurrent requirements across a range of regulatory guidelines, such as stress testing, and reporting requirements, such as common reporting (COREP) and financial reporting (FINREP), the challenge around the IFRS 9 impairment model is two-fold:
- Models: How to harness the current Basel-prescribed credit risk models to make them compliant with the IFRS 9 impairment model.
- Data: How (and whether) the data captured for Basel capital calculation can be used to model expected credit losses under IFRS 9.