The art of loan loss provisioning is tough and just got rougher

Paul Lichtenstein, Partner, National Credit Risk Advisory
Paul Lichtenstein, Partner, National Credit Risk Advisory

Sending out official announcements just before Christmas can often result in limited pick-up. Particularly so when they concern the arcane subject of accounting standards.

But a media release from ASIC, the corporate regulator, on how banks and other financial institutions should disclose provisions in their accounts for bad debts on loans has caused considerable interest in the market.

This is because ASIC has effectively brought forward by a year the timescale that institutions thought they had to deal with a long-running issue. All of a sudden, the next set of financial statements will be expected to include the impact of the new requirements. And they are significant.

The relevant standard IFRS9 has been long in the gestation. In 2014, the International Accounting Standards Board issued the fourth and final version of the new standard. It completed a project that was launched in 2008 in response to the global financial crisis.

Internationally, the standard is likely to have a significant impact on how banks account for credit losses on their loan portfolios. Provisions for bad debts will be bigger and are likely to be more volatile.

The good news for Australia, is that, given the GFC wreaked less havoc here than overseas, the impact is likely to be less severe. But impairment provisions are always one of the thorniest issues in accounting. And now the clock is ticking more loudly.

The standard aims to address concerns about “too little, too late” provisions for loan losses which plagued banks in the GFC, and accelerates the recognition of losses by requiring provisions to cover credit losses expected in the future rather than merely already incurred losses.

So rather than just looking back and booking losses once they have happened banks will have to look forward over the lifetime of a loan, as they are writing it – which could be 20 years or more – and assess the likelihood of a loan going bad.

The impairment provisioning requirements of IFRS 9 represents a significant change in the way financial institutions will calculate loan loss provisions.  Estimating impairment is an art rather than a science and involves difficult judgements about whether loans will be received as due, and if not, how much will be received and when.

The move from ‘incurred losses’ to ‘expected losses’ regime involves building or changing predictive credit models to align with the accounting standards.  This is a significant undertaking with a range of data and systems challenges.

Most financial institutions had projects underway to meet the requirements of IFRS 9 by the implementation deadline of financial years commencing after 1 January 2018.

But the project plans did not anticipate ASIC’s pre-Christmas announcement which indicated that they expect entities to make some disclosures about the impact of these standards in their 2017 financial statements.  ASIC noted that “it is reasonable for the market to expect that quantitative information will be available and disclosed for the reporting date that coincides with the start of the first comparative period that will be affected in a future financial report.  Information that there will be no material impact may also be important information for the market.”

The ASIC media release now brings forward the deadline by a year which will be extremely challenging for some organisations and simply not feasible for others.

The standard is principles-based, not rules-based, which enables organisations to interpret and adopt the requirements in a way that suits the business model and technology infrastructure capabilities.  As a result, alternative interpretations are not only possible but necessary.

Many organisations are assessing the alternatives through impact analysis and sensitivity exercises to ensure that the outcomes are reflective of the risk of their loan portfolios.  The ASIC media release implies that these alternative quantitative impacts should be disclosed – which will be confusing and potentially counterproductive to the intention of increasing transparency.

Furthermore, industry debate continues and a number of interpretation issues have not yet reached consensus.  Therefore, individual organisations’ quantitative information about the impact of IFRS 9 might change between the initial disclosure and the final implementation.  This might be seen as misleading the market when the intention is merely to achieve an outcome that complies with the requirements and is comparable across the industry.

Credit risk is at the heart of a bank’s business, and is an important element of an insurer’s business.  Accordingly, the standard is likely to have a significant impact on the KPI’s of banks, insurers, credit unions and similar entities.

There are several other accounting standards changes due in 2018 and 2019. As the IFRS9 announcement has shown, companies would be advised to pay them full attention.

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