The impact of IFRS 9 on EU banks and the challenges ahead

largest impact appeared to be driven by ECL's estimate for expected losses over the life of the loans, i.e. for a level/stage 2 of exposures. Small banks estimated a larger impact on regulatory capital ratios than larger banks. 

As such, banks should not underestimate the challenges inherent in implementing IFRS 9. In the future, a cross-sectional review of the implementation of quantitative ECL models in banks, throughbenchmarking exercises, may be useful to ensure the quality of IFRS 9 implementation and regular monitoring of the key elements of the ECL models. Additionally, the possible impact of IFRS 9 on banks' lending behaviour to the real economy needs to be assessed.

Benefits and future challenges

The benefits of the new IFRS 9 accounting regime are numerous. To begin with, incentives to improve credit assessment processes, the monitoring of under performing exposures and credit impairments , as well as strategic planning and regulatory capital levels have been enhanced. Transparency is also reinforced and market disclosures for the various agents are promoted. An important aspect to bear in mind regarding the benefits of this new regime is the need for a high quality of the IFRS 9 implementation process.

The variation in provisions across banks will be influenced not only by the underlying risks of the assets, but also by the assumptions of the quantitative models of estimated loss calculations. Banking supervisors, and other market participants, should be able to discern the above factors. The main concern is to ensure proper interaction between the regulatory capital structure and the use of quantitative models of ECL calculations in accounting.

5-year transition

In May 2017, the European Union adopted a five-year transition period to mitigate the impact on regulatory capital levels of the implementation of IFRS 9. Thus, the necessary conditions were created for a progressive introduction of the impact of IFRS 9 impairment requirements on regulatory capital andleverage ratios. The proportion of "excess" provisions through ECL (impact of IFRS 9), included in CET1 capital (as an offsetting effect), will progressively decrease over time, with full implementation expected by the end of 2022.

Table: Evolution of "excess" provisions included in CET1 capital between 2018 and 2022

Source: EU (European Parliament and Council)

Banks which decide to apply the IFRS 9 transition period are required to disclose the effects of this measure on their regulatory capital and leverage ratios. The improvement in the information accessible to market agents ensures consistency and comparability, further fostering market discipline.

Impact Assessment

In 2017, the estimated impact for the European Union of IFRS 9 on the CET1 ratio was a reduction of 45 basis points (bp), without taking into account the transition period [2]. In 2018, the immediate negative impact on CET1 regulatory capital (51 bp on average) and the increase in provisions (9% on average) confirmed the accuracy of the previous year's estimates. Regarding the use of the transition period (which mitigates the impact of IFRS9 on CET1 capital), the average impact on CET1 that results from the recovery of provisions for all banks corresponds to 118 bp [3].

Figure: Impact on CET1 ratio without transition period (reference date: 1 January 2018)

The estimated total impact of IFRS 9 on banks' funds is mainly driven by impairment requirements, namely ECL's estimate for expected lifetime losses, i.e. level/stage 2 exposures (instruments where a significant increase in credit risk is considered to have occurred since initial recognition, but for which there is no objective evidence of impairment yet with interest being recognised; in this case, impairment will reflect expected credit losses resulting from default events that may occur over the expected residual life of the instrument).

The main instruments and credit portfolios to assess the impact are loans and advances to households and non-financial corporations. The impacts are different between large systemic banks (G-SIBs) and smaller banks (e.g. banks with total financial assets below €100 billion and that tend to use the Standard Approach-SA to measure credit risk). Smaller banks expect a greater impact on their ratios and regulatory capital than larger banks, namely banks that more often use the internal models (IRB-InternalRatings-Based) approach for risk measurement.

Regarding the change in asset classification and valuation requirements, the impact should be limited for most banks. However, the operationalisation of the new classification and valuation requirements imply the use of additional resources. In this case, banks should not underestimate the challenges that will arise from the implementation of these requirements. Additionally, several banks anticipated that the impairment requirements of IFRS 9 would increase profit and loss volatility. This prediction is mainly due to the expected cliff effect arising from moving exposures from level/stage 1 to level/stage 2 (i.e. a transition from an ECL with expected loss estimation for the next 12 months to an ECL with expected loss estimation over the life of the loans) and the practical use of forward-looking information. In principle, this will reduce surprises and delays in the timely recognition of estimated losses.

Robust Validation Process and Governance Structure for ECL Measurement

During the implementation of IFRS 9, banks (some for the first time) need to use new processes, data, systems and quantitative calculation models in order to obtain robust estimates for ELC. Factors such as data quality, accessibility to historical data and assessing the "significant increase in credit risk" (as required by IFRS 9) are the most important challenges. Therefore, a robust validation process for estimating ECL is essential and this needs to be very well defined and implemented to ensure regular monitoring of the key elements of the quantitative models for ECL calculations.

A particular concern for banking supervisors is the expected reduction in parallel calculations of IFRS 9 and IAS 39 (previous accounting approach) decided by banks during the implementation phase of IFRS 9 and, in some cases, the complete absence of such parallel calculations. From the perspective of banking supervisors, parallel calculations allow for better benchmarking and testing of IFRS 9 implementation processes and procedures in banks. Furthermore, the governance structure in banks is crucial, especially after the major global financial crisis. The main governance bodies of a bank, such as the board of directors and the audit committees, need to be involved in the implementation of IFRS 9.

Implications for financial stability

There is a long-standing debate between the use of fair value or historical cost calculations for valuing financial assets and the usefulness of these methods for different types of assets in banks. In particular, it can be expected that a stable and rigorous implementation of IFRS 9 will increase transparency and facilitate early and comprehensive recognition of impairment losses, which in turn will be reflected in positive effects on the financial stability of the banking sector. There are two key challenges for banks, micro-supervisors and banking macro-supervisors: the risk of using quantitative models for estimating losses and the possible implications of procyclicality (reinforcement of business cycles).

On the risks of using quantitative models for loss estimation purposes in IFRS 9 the issue resembles discussions on the implementation of internal regulatory capital calculation models (IRBs). As they were areas for potential uncertainties in future improvements a stronger banking supervisory role was required in the formal validation of these internal quantitative models. For this reason, the importance for authorities and banks of developing cross-bank benchmarking exercises [4], conducted by supervisory bodies (EBA, BIS and national authorities) for the internal models (IRBs) used in capital requirements should be underlined. Benchmarking exercises mean that banks' internal models are compared with banking industry benchmarks . For internal IRB models, these exercises have become mandatory at European level and are useful for the assessment of internal models and for the credibility of the calculation of risk-weighted active capital requirements (RWA). These benchmarking exercises can also be useful for ensuring the quality of IFRS 9 implementation and regular monitoring of the key elements of the ECL calculation models. Adequate disclosure of such benchmarks will also be useful, as can be seen from the IRB procedures, from the perspective of market participants.

The possible pro-cyclical implications of the ECL approach are also an important aspect to consider. Timely and forward-looking recognition of credit losses responds to the criticism of the previous accounting approach based on accruals only for incurred losses being 'too little, too late'; thus, by accelerating the recognition of losses, IFRS 9 may improve the financial stability of the banking sector by reducing the accumulation of losses from recognition too late (i.e. a lower or zero level of business cycle strengthening, i.e. less pro-cyclical, compared to the previous accounting approach). Assuming that the slowdown, or its implications are identifiable early enough, then it is possible to reduce the severity of pro-cyclicality and the contraction of the level of credit granted in the event of a negative business cycle. It is expected that market players will get used to the new approach to calculating ECL based on previous experience and recognition of losses. If losses are recognised in a timely manner, the sensitivity to business cycles of the risk parameters of the quantitative models used in the estimation of ECLs and of the transitions between exposure levels will not reinforce the business cycle, quite the contrary.

Conclusion and areas for future development

Banking regulators in the European Union are contributing to a stable implementation of IFRS 9. In parallel, it is expected that banks will continue to improve the elements of IFRS 9 implementation after its initial introduction in 2018. In an economic analysis it is important to understand how differences in IFRS 9 implementation may affect ECL estimations. In this regard, comparisons and benchmarks will be a very useful and feasible banking supervision tool.

Finally, the possible impact on lending behaviour to the real economy needs to be assessed and there are several aspects that should be considered in an economic analysis. There are still several topics that need to be assessed:

- How will IFRS 9 continue to influence banks' capital ratios?

- How will banks respond to the changes in regulatory capital requirements brought about by IFRS 9?

- Will banks change their capital structure, levels of credit granted, type of assets and balance sheet evolution?

The combined impact of all these aspects is difficult to establish in advance, taking into account micro-prudential and macro-prudential concerns. Consequently, these and other issues should be considered in a further post-implementation review of IFRS 9, to which academic studies will contribute.

This article is based on Chapter 6 " The Impact of IFRS 9 On Banks Across The EU And Implementation Challenges" by Professor Samuel Da-Rocha-Lopesas part of the book Institutions and Accounting Practices after the Financial Crisis: International Perspective

Notes

[1] The views expressed are those of the author alone and cannot be attributed to the European Banking Authority, (EBA), Nova School of Business and Economics (Nova SBE) or Aarhus University.

[2] EBA Report on Results from the Second EBA Impact Assessment of IFRS 9, July 2017. Charts are based on banks' estimates with reference to 31 December 2016.

[3] EBA Report on First Observations on the Impact and Implementation of IFRS 9 by EU Institutions. The banks' preliminary observations are mostly based on the second quarter of 2018.

[4] Paolo Bisio, Samuel Da-Rocha-Lopes, and Aurore Schilte. Europe's New Supervisory Toolkit (2015: Risk Books).