On January 1, 2018 International Financial Reporting Standard 9 (IFRS 9), the new accounting standard issued by the International Accounting Standards Board (IASB) came into effect globally. IFRS 9 governs the reporting of various types of financial instruments and investments and applies to commercial banks, finance companies, insurance companies, mutual funds and credit unions. The new standard replaces IAS 39 Financial Instruments: Recognition and Measurement and seeks to address many of the shortcomings identified worldwide by financial regulators and the investment community following the 2008/09 financial crisis.
The key change introduced by IFRS 9 is the move away from an incurred loss model towards a forward looking expected credit loss model (ECL). Under the new ECL model, financial institutions are required to hold loss provisions against all exposures with inherent credit risk, rather than against only those assets that have actually defaulted. This new approach requires financial institutions to make provisions for loan or investment assets from the date of origination. Additionally, the impairment provisions against these assets may evolve over time, dependent on the past, current and expected future conditions of the borrower, which also may consider the impact of relationships with other factors such as macroeconomic variables. IFRS 9 utilises three distinct credit stages to categorise exposures. This categorization also determines the level of provisions required and details are as follows:
The transition from stage 1 to stage 2 assets and the associated change in provisioning methodology for such assets is driven by whether or not the exposure has experienced a significant increase in credit risk. However, IFRS 9 does not explicitly define what can be considered a significant increase in credit risk. This leaves such determination to each financial institution and creates the possibility for nuanced approaches. Generally, financial institutions worldwide have indicated intentions of using various factors such as changes in borrower probability of defaults, changes in internal risk grades or in applicable cases changes in external credit ratings.
The requirement for financial institutions to move from 12-month to lifetime credit loss provisions is hinged on when the exposure was first originated by the financial institution and the credit risk of the exposure at that time. The ECL model requires financial institutions to have a comprehensive understanding of their exposures and to be rigorous in their analyses when seeking to determine if a significant increase in credit risk has occurred. The outcome of these analyses will influence required credit loss provisions, in turn affecting profitability, shareholder equity and ultimately capital adequacy and solvency ratios.
Transitioning to the ECL model and the potential increased reliance on data to support estimation of forward looking credit provisions will be challenging for many domestic financial institutions. Taking into consideration the requirements of the IFRS 9 standard, potential challenges which Barbados institutions may encounter include:
The new ECL methodology outlined above is likely to result in financial institutions experiencing an increase in provisioning. Notably, on initial adoption of the new standard, institutions are required to make a one time adjusting entry to retained earnings in order to account for the increase in credit provisions. In the case of the banking and credit union sectors, this reduction in retained earnings, is likely to result in lower levels of capital. In addition, international accounting and consulting firms have estimated that globally, banks who utilize the Basel II standardized approach are likely to face a capital impact on adoption of IFRS 9 that is twice as large as their internal ratings-based (IRB) approach counterparts. This estimation is based on the fact that IRB banks already incorporate some of the same credit risk measures and forward looking approaches such as probabilities of default and loss given default that are now required under IFRS 9.
Domestically, implementation of IFRS 9 continues to be a major priority for the financial sector. The Bank and the FSC have engaged financial institutions in order to understand this potential impact. In the case of the banking sector, the Bank has sought to understand the nature of preparations for IFRS 9 implementation at domestic banks and, where available, obtain projections of the quantitative impact on adoption of the standard. Based on some preliminary analysis performed internally by the Bank all domestic institutions remained in excess of the minimum CAR, even in severe scenarios such as a 70% increase in provisions. This resilience in the capital base is primarily attributable to the generally highly capitalized nature of the domestic banking sector, primarily with Tier 1 capital instruments. The Bank recognizes that the new ECL model employed under IFRS 9 requires the exercise of significant judgement in certain areas and has committed to issuing industry guidance during 2018 to support licensees through the implementation process, where possible.