Another week, another constraint

Let us suppose that one wanted to make banks and insurance companies take a more predictive approach to estimating the credit risks within their portfolios, wishing to address the not unreasonable criticism that what happened during the Financial Crisis post-2007 made it clear that loss estimates (and, therefore, credit provisions and reserves) were often reactive and inadequate. What would one do?

Well, if you were the International Accounting Standards Board (IASB), you would spend 5 years, revising and refining IAS 39 and create IFRS 9, the final version of which was published earlier this week, to come into mandatory effect for all those entities subject to IFRS accounting rules  on 1st January, 2018. Of course, if you were the US’s Financial Accounting Standards Board (FASB), you would try and fail to create a joint standard with the IASB; and still be working on your own version of IFRS 9.

Why should anyone care about this new accounting standard? Perhaps because at least some global banks think it may require them to increase and disclose loan loss provisions up to 50% above current levels- and (re)insurance companies cannot ignore IFRS 9, because it also impacts their own investment portfolios, which tend to consist largely of bonds, loans and other forms of credit extension.

The reason for this potentially significant change is that IFRS 9 focusses on an entity’s business model for managing its financial assets and the contractual cashflow characteristics of those financial assets; and requires an entity to recognize expected credit losses at all times and to update the amount of expected credit losses recognized at each reporting date to reflect changes in their credit risk. In other words, one must not just take an initial reserve for an “expected” level of credit loss, but must constantly look forward and regularly re-assess and revise the calculation, using available information and judgement. This is very different from IAS 39, which did not permit any forward assessment. Disclosure requirements are also toughened: affected entities will have to publish how they calculate their credit losses and assess changes in risk.

In reality, any prudently run financial institution should be and is already doing the work described in IFRS 9; although it will have to consider whether its approach and methodology are supportable and will stand public scrutiny- no doubt the consultants will have a field day, even though there is no magic to any of this, just basic, prudent risk management.

Of course, the implementation of IFRS 9 may also have an impact on how entities invest and take credit risk. That remains to be seen, but bears watching as we come closer to 1st January, 2018. The leadtime means that there can be no excuse for being caught out. You have been warned!

-The Awbury Team

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