European IFRS banking conference Amsterdam 9 June 2016
European IFRS banking conference summary EY’s European IFRS banking conference on 9 June 2016 in Amsterdam drew more than 146 representatives from 60 different banks in 18 countries, as well as standard-setters and industry bodies. The discussion covered the ongoing challenges arising from the changes to accounting and regulatory rules affecting the banking industry. The focus of the event was the impairment requirements of IFRS 9 Financial Instruments, including the main points arising from the IFRS Transition Resource Group for Impairment of Financial Instruments (ITG) meetings and, in particular, the use of multiple scenarios. Complexities arising from the classification and measurement requirements of IFRS 9 were also discussed, as well as some of the wider implications. An independent market perspective was provided as well as that of the European Central Bank (ECB). There was also a session discussing Prudential developments as they impact fair value, capital and regulatory reporting. This document provides a high-level summary of insights from discussions with leading specialists and peers across the European financial services industry, as well as the findings of real-time polls taken during the conference.
Update from the International Accounting Standards Board Sue Lloyd, International Accounting Standards Board (IASB) member, provided an update on the Board’s activities to date and future work plan.
IFRS ITG The ITG was established to help standard setters, adopters and auditors share experiences on implementation of the standard. Although the ITG has not been disbanded, it currently has no unanswered questions or scheduled meetings. Sue chairs the ITG and shared some of her takeaways from the meetings and summarized the key issues for implementation, which we’ve outlined below. Forward-looking information ►► An important change from International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement is that, under an expected loss model, entities are required to use forward looking information. This can be challenging when faced with novel circumstances, such as the UK European Union referendum. The ITG agreed that Information should be not be excluded simply because: ►► The event has a low or remote likelihood of occurring Or ►► The effect of that event on the credit risk or the amount of expected credit losses (ECLs) is uncertain. However the information has to be “… reasonable and supportable.” Determining whether there is such information will be a matter of judgement and in some instances the ITG acknowledged it will not be available. In these cases, the ITG emphasized the importance of disclosure. Multiple scenarios IFRS 9 states that ECLs take into account “… a range of possible outcomes”1. In December 2015, the ITG agreed that “… where there is a non-linear relationship between different forward-looking scenarios and their associated credit losses … more than one forward-looking scenario would need to be incorporated into the measurement”.2 Sue Lloyd stressed that the ITG did not say that an entity: ►► Must use PDs. ►► Must use three scenarios. ►► Must always use multiple scenarios. What it did say was that an entity should consider nonlinearity and a representative sample of the complete distribution of possible losses, subject to what is reasonable and supportable and available without undue cost or effort.
IFRS 9 Paragraph 5.5.17 (a). ITG December 2015 paragraph 49.
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Sue Lloyd reiterated that disclosures are as important as the measurement requirements and that there are clear disclosure objectives that need to be satisfied: users need to be able to understand how ECL is calculated, how credit risk is managed and the absolute credit risk as at the reporting date. This should not be viewed as a compliance exercise but, rather, a communication exercise. It is hoped that the European Union endorsement of IFRS 9 will be announced by the end of October 2016.
IFRS 9 for insurers The IASB expects to finalize the development of a new insurance contract Standard in 2016, although it won’t be effective before 2020. The Board is intending to permit most insurers to defer the application of IFRS 9, but this deferral will generally not be available in the consolidated accounts of banks with insurance subsidiaries. However, they will be allowed to adjust the reported revaluation profit or loss on assets backing their insurance businesses so that it reflects IAS 39 rather than IFRS 9 (with the counterbalancing entry being to other comprehensive income).
Other projects ►► Financial Instruments with Characteristics of Equity (FICE) will be one of the IASB’s main projects over the next five years. The project will use IAS 32 Financial Instruments: Presentation as a starting point to draw the line between debt and equity, looking at ways to supplement this through other presentation and disclosure requirements. ►► Accounting for dynamic risk management will stay on the active research agenda. The IASB is participating in research conducted by the European Financial Reporting Advisory Group (EFRAG) to reach a clearer understanding of the key drivers in banks’ core demand deposit modelling. ►► The disclosure initiative continues to explore ways to improve presentation and disclosure in financial statements and aims to be informative, relevant and entity-specific. The Principles of Disclosure discussion paper is expected in the second half of 2016. The final Materiality Practice Statement is planned for early 2017.
Technical updates related to IFRS 9 Dr. Jana Währisch and George Prieksaitis, both from EY, presented on the technical topics that are particularly challenging in implementing staging, multiple scenarios, transition and disclosures.
Staging One of the biggest challengers in IFRS 9 is the identification of whether a loan is in Stage 1 or Stage 2. There are three pillars to assess staging: ►► Quantitative: a sophisticated approach to the quantitative assessment would be to assess the change in lifetime PD, guided by credit scores, ratings and risk categories, and (for retail banks’ exposures) by a collective assessment of the effects of forward-looking information. As discussed by the ITG in September 2015, while changes in 12 month PDs may sometimes be used instead, there needs to be a good correlation with changes in the lifetime PD and the entity will need to be able to demonstrate that the correlation continues over time.
►► Qualitative: this includes ratings and watch lists for commercial loans. For retail loans, qualitative information may include credit scores and behaviors. The advantages of using these qualitative indicators, such as a watch list, is that they are closely aligned with actual credit risk management and are sensitive to new information. But their use comes with challenges, particularly watch lists, since different banks have different thresholds for putting loans on watch lists and may have different levels of heightened monitoring. Hence, their use has to be adapted to comply with the standard. ►► Backstop assessment: examples would include when a loan is 30 days past its due date and covenant breaches. Corporates: What do you intend to use as the primary driver for assessing the stage for commercial loans? 60%
54%
50% 36%
40% 30%
Retail: What do you intend to use as the primary driver for assessing the stage for retail loans? 60% 50%
20% 0
50%
10%
10% Forward lifetime PDs
Scores
Other
38%
40% 30% 20%
12%
10% 0
Forward lifetime PDs
Scores
Other
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Multiple scenarios: George and Jana discussed three approaches to measuring the effect of non-linear loss distributions that we are seeing in practice: ►► Alternative 1: Monte Carlo simulation3 avoids having to specify and justify scenarios or probabilities. However, it can be inconsistent with what is done for risk management, and requires a large amount of data. Sue Lloyd said that firms are not required to make the solution overly engineered.
►► A lternative 3: Overlay approach based on a central base scenario uses sensitivity analysis, expert judgement and internal rating processes. It is easier to explain and is consistent with credit risk management. One possibility is to use a stressed scenario to help understand the extent that losses could exceed those used in the base scenario. However, an appropriate weighting still needs to be assigned to the stress scenario.
►► Alternative 2: Multiple scenario approach requires weightings to be allocated to a number of separate macro-economic scenarios and their associated losses.
How is your entity planning to reflect the nonlinearity of outcomes in calculating PDs? 50% 43%
45% 40% 35% 30% 25%
26% 19%
20% 15% 10% 5% 0
Run a number of macroeconomic scenarios
Run the base case and apply an overlay for stress scenarios
2%
2%
Monte Carlo simulation
We do not intend to calculate the effect of nonlinearity
Transition and disclosures ►► On transition, there are challenges in obtaining forward looking origination PDs to use for the staging analysis. The standard only requires an entity to “approximate” the PDs at origination, therefore banks are exploring various proxies. Also, IFRS 9. IG. Example 6 suggests that comparison to a maximum initial credit risk may be appropriate if the range of internal credit risk ratings was narrow. ►► Analysts and regulators are already asking for numbers. The Enhanced Disclosure Task Force (EDTF) has recommended disclosures related to IFRS 9 implementation to increase over time with the expectation that, in the 2017 accounts, more disclosures of the effects of IFRS 9 should be provided.
6% 1% I do not know
Other
Further discussion of the implementation of IFRS 9 impairment can be found in our publications: ►► Applying IFRS: impairment of financial instruments under IFRS 9. ►► Applying IFRS: ITG discussed IFRS 9 impairment issues at December 2015 ITG meeting. ►► The Basel Committee Guidance on credit risk and accounting for expected credit losses January 2016.
Monte Carlo simulation is a technique used to model the probability of different outcomes in order to understand the impact of risk and uncertainty in financial or other risk management models.
3
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Not applicable
When do you plan to disclose the quantitative impact of IFRS 9 impairment? 35%
32%
30%
26%
25%
20%
20%
18%
15% 10% 5% 0
4% During 2016
First half 2017
Second half 2017
Panel session Tony Clifford, EY, moderated a panel session of industry representatives to discuss implementation issues relating to the impairment requirements of IFRS 9. The panel included: ►► Sébastien Rérolle, BNP Paribas ►► Barry Spain, HSBC ►► Menno ten Hacken, ING ►► Urs Blüemli, UBS
Progress Panellists were asked where they were on the project and their main achievements and challenges: ►► One panellist remarked, “We have left basecamp at 5,545 meters and we are trying to climb up to 8,848 metres, so there is a long way to go”. IT infrastructure is a big challenge. ►► All panellists agreed that it had been important to get risk and finance working together on sensible solutions. As one (Finance) panellist said, “Risk people are starting to understand us and we are starting to understand Risk”. ►► All the represented banks are in the process of building their new solution while certain aspects are still yet to be finalized. One panellist stressed the importance of maintaining flexibility in development.
Multiple scenarios Multiple scenarios have been a major focus in the past six months. ►► Capturing multiple scenarios is seen as the challenge that forces banks to think end-to end and what that means in terms of processes to be rolled out globally.
During 2018
Undecided
►► The represented banks have accepted multiple scenarios in principle but are still exploring how to reflect non-linearity in their ECL calculations. Three banks are planning to use multiple scenarios and one bank is still considering the options. The objective is to introduce a mechanism that is operable and pragmatic. ►► For two of the banks this is likely to mean constructing scenarios they do not already use for risk management purposes. ►► One bank is considering the use of stress test scenarios as part of its solution, the others thought this may be difficult as stress tests are prescribed by the regulator. ►► All panellists agreed that the results will be overlaid by management judgement, to fully capture non-linearity. ►► One bank thought that the challenges of non-linearity were “overblown”. The significance of non-linearities is likely to vary with the macroeconomic environment. ►► One bank plans to look at the ranges of issues they usually consider and then assess how to assign weightings. An example is to model both mild and severe recession scenarios regardless of the trigger (e.g., Brexit) rather than all kinds of scenarios that may lead to a recession. In this example, judgements have to be applied as to the level of severity of recession and the likely timing of the event. The overall assessment will be challenged by the matters of judgement associated with those portfolios, especially around sensitivities for which there is no statistical historical information. ►► It is critical to establish a strong and effective governance model, and decide at a senior level on the future scenarios that have to be approved by the Board.
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Applying the staging assessment ►► Staging is seen as a complicated judgement and will be affected by non-linearity. ►► Assessing staging will be especially difficult for retail portfolios, as delinquency may sometimes be the only obligor-specific information that is available. ►► The credit committee’s role will be to look beyond 12 months when assessing staging. ►► The watch list can be considered as an indicator of a significant increase in credit risk, although it is understood that it cannot necessarily be used in isolation. ►► There will be a lot of focus on movements between Stage 1 and Stage 2. The assessment as to whether an asset is in Stage 1 or Stage 2 is creating greater alignment between risk management and finance, as it is not just an accounting exercise.
Other ►► It is expected that IFRS 9 will have an impact on the way the business is run. Depending in part on whether regulators add additional capital buffers for accounting volatility, it may increase loan pricing. ►► The IFRS 9 impairment changes are likely to be pushed down to the lending business for management reporting purposes. ►► IFRS 9 will hopefully provide information that can be used to support the business better. Banks appreciate they have shared interest with their auditors in working together and coming up with something that is auditable.
Market perspective on IFRS 9 Adrian Docherty, Head of Bank Advisory, BNP Paribas, provided a stimulating discussion from an investor perspective. IFRS 9 is one of several major and simultaneous drivers of change in the banking industry. As such, Adrian pointed to the big picture and highlighted some of the challenges: ►► ”We work in an industry that is certain not to exist in its current form in 20 years.” ►► Various initiatives are driving an increase in capital requirements, such as risk-weighted floors, cancellation of advanced Internal Ratings Based (IRB) approaches, Fundamental Review of the Trading Book (FRTB), new operational risk rules, etc. ►► Adrian listed some of the negative consequences of IFRS 9, such as the increase in provisions, the increase in earnings volatility, the impact on own funds (an estimated 10-20% reduction in CET1 is expected upon first time application), the increased use of judgement and estimates, administrative costs, complexity, etc. ►► IFRS 9 is more volatile and pro-cyclical by design. In Adrian’s view, judgements that are best made by the Prudential
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supervisor who has the interest in managing stability are being left to banks to model and auditors to validate. What are investors saying? ►► “It’s good news. It will force banks to carry loans at more realistic values.” ►► “With numbers swinging around, the cost of equity is going to be higher.” ►► “Given these changes, I will not be able to invest in bank equity any longer.” ►► “There will be a lot of competition with the auditors, consultants and regulators — as well as the banks themselves — to hire people who understand the risk models.” Banks are exploring ways to mitigate some of the harmful effects of IFRS 9, such as increasing use of fair value approaches and risk transfer structures.
Classification and measurement (C&M) insights, and the wider implications of IFRS 9 Nick Stewart, EY, shared practical insights on C&M, and discussed criteria for success when approaching IFRS 9 projects and looked at some of the wider implications. One of the challenges for banks and auditors is that the solely payments of principal and interest (SPPI) test for assessing C&M under IFRS 9 involves judgement. A successful IFRS 9 programme needs: ►► Upfront engagement from front office and product control in identifying high risk areas before moving in to the business model assessment (BMA). Finance directors and business owners involvement is also key in order to help them understand the potential changes from an C&M accounting standpoint. As well as greater profit and loss volatility, the classification outcome also may have impacts on the regulatory capital treatment e.g., for trading book do you need a daily mark-to-market (MTM)? ►► Upfront assessment of the wider front-to-back changes affecting banks and decisions around bank’s processes and systems. Banks that have started early with their C&M programmes have mainly been driven to do so by the significant changes to their IT processes (a time consuming task). ►► Banks should get upfront auditor engagement. ►► For ‘bottom-up’ (i.e., detailed SPPI testing), a sampling approach designed to give sufficient confidence for auditors.
What stage in the C&M process are you in?
What approach have you been taking to identify the classification of financial instruments?
60%
70% 49%
50%
60% 50%
40%
40%
30% 20%
30%
21%
18% 13%
10% 0
59%
20% 10%
Detailed Impact Mobilization Documentation business model SPPI testing assessment on operating model assessment
0
13%
13%
15%
Bottom up Both Top down Not started Top down approach — and Bottom up, testing yet approach — depending on detailed no contract business contract review view
Nick gave examples of potential problem areas:
Market insights and practical challenges
►► Equity release mortgages (ERM) — for ERMs, besides recovering a stated principle and interest, the lender bank also participates in the change in the value of the house, which is not likely to meet the SPPI criteria.
►► There are some practical challenges around the business model assessment for liquidity portfolios. Separate business models may need to be developed for assets held in order to collect contractual cash flows from those which may also be sold for liquidity purposes.
►► Product bundling and profit margin — for instance, mortgage products bundled with insurance products. These may pass the SPPI test, as long as the profit margin component of the interest rate is “reasonable compensation” for the time value of money and credit risk.4 ►► Variable rate loans and interest rate resets for instance, a 12-month loan with an interest rate that resets every quarter based on a different underlying LIBOR. IFRS 9 sets a benchmark test, which some instruments will fail. ►► Break clauses and high penalties — two-way break clauses are partly driven by regulatory requirements. Today, banks are motivated in some non-core divisions to unwind certain positions with clients to help them pay some of the benefit of fixed rate loan movements. From an IFRS 9 perspective, if compensation is paid to the borrower that is potentially problematic.
►► There will be wider interplays between the classification of assets under IFRS 9 and some regulatory requirements. For example, the IFRS 9 business model assessment considers the intent and therefore is informed by certain criteria also considered for FRTB classification (e.g., trading intent). These need to be assessed prior to first time application. ►► IFRS 9 will drive banks to improve how they communicate with their investors and improve investor market relations overall. ►► Tax implications and consequences due to IFRS 9 transitional adjustments may prove a challenge and should be considered in the implementation programme.
EY expects to issue a further publication on C&M in 2016. Further guidance can be found in our previous publication Applying IFRS: Classification of financial instruments under IFRS 9.
4
IFRS 9.B4.1.7A
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Prudential developments
Securitization
Doug Vick, EY, presented on Prudential developments.
►► The revised Basel III securitization framework represents a significant improvement to the Basel II framework in terms of reducing the complexity of the hierarchy and the number of approaches.
Capital impact of IFRS 9 ►► Greater day 1 impact is expected on the capital ratios of banks using the standardized approach5 to calculating risk weighted assets (RWA), than those using an IRB approach. ►► General credit risk adjustments (GCRA) which would be added back to Tier 2 capital, up to 1.25% of RWA, cannot exist under current IFRS impairment accounting rules — including incurred but not reported (IBNR) impairments. GCRAs may exist in IFRS 9 Stage 1 and Stage 2 impairments — which could require Stage 2 impairments to be split between specific and GCRAs.
RWA and IRB capital floors
►► One of the stated aims is to provide a robust framework for what is a key source of funding within the EU. The European Commission securitization initiative, adopted on 30 September 2015, is a package of two legislative proposals: ►► Regulation that will apply to all securitizations, covering: due diligence, risk retention and transparency rules, together with the criteria for simple, transparent and standardized (STS) securitizations.
►► All of the RWA calculation methodologies for standardized approaches are being revised (implementation dates are currently unknown, but expected to be after 1 January 2018).
►► A proposal to amend the capital requirements regulation (CRR) to make the capital treatment of securitizations more risksensitive and able to reflect properly the specific features of STS securitizations.
►► The introduction of IRB capital floors is likely to require all banks to produce robust, potentially disclosable RWA calculations, under standardized rules. The IRB will not be abandoned but used for internal measurement.
Does your organization employ a return on capital framework?
►► This is expected to affect finance functions most significantly, given the dependence of standardized RWA calculations on finance data (balance sheet values, rather than risk metric data, drive IRB).
Liquidity supervision Vivek Kavdikar, EY presented on liquidity supervision. Liquidity supervision has been enhanced since the banking crisis through BASEL III and the capital requirements directive (CRD) IV within the EU, with three pillars: ►► Minimum requirements: short-term liquidity requirements (Liquidity Coverage Ratio “LCR”) and longer-term liquidity requirements (Net Stable Funding Ratio “NSFR”). LCR requirements are being introduced in a phased manner: globally at 70% in the EU, 80% in the UK, and 90% in the US in 2016, targeting 100% in 2018.
60% 50%
50% 40% 30%
30% 20%
17%
10% 0
3% No
We are currently in the process of developing one
Yes — its deployment and use is inconsistent across the organization
Yes — it is consistently embedded across all areas of business
►► Granular and more frequent reporting: additional liquidity monitoring metric (ALMM), which is monthly reporting and intraday reporting has become applicable from Q1 2016. The purpose of this is to make new, more detailed disclosures about banks’ liquidity sources and uses and so identify possible sources of funding pressures. ►► Governance and framework: the internal liquidity adequacy assessment process (ILAAP) for identification, measurement and monitoring of liquidity should be in place by 31 October 2016.
5” The Basel Committee has developed two approaches for calculating regulatory capital for credit risk, the so-called “standardized approach” and “internal ratings based approach” (hereafter IRB). The standardized approach uses external ratings such as those provided by “external credit assessment institutions” (hereafter ECAIs) to determine risk-weights for capital charges, whereas the IRB allows banks to develop their own internal ratings for risk-weighting purposes subject to the meeting of specific criteria and supervisory approval.” (http://www.bis.org/bcbs/publ/d347.htm).
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The European Central Bank’s perspective on IFRS 9
►► Strong involvement from governance bodies will be needed in the IFRS 9 projects across banks. It is crucial that there is a strong link between different functions, especially between finance and risk, and ultimately consistency with the overall risk appetite framework.
Patrick Amis, Deputy Director General of Micro Prudential Supervision 1, European Central Bank (ECB), gave his perspective on IFRS 9. The move towards an expected loss (EL) model is considered progress and the emphasis on forward looking is valued. It will help deal with the “too-little-too-late” syndrome and is better aligned with the prudential approach and economic perspective. However, there are challenges: ►► Patrick is concerned about the inconsistency between IFRS 9 and the US standard, and the risk of mistrust on balance sheets of European banks. ►► IFRS 9 might be more pro-cyclical than IAS 39, therefore timely recognition of Stage 2 will be key. ►► Patrick is also concerned about the interplay with the regulatory framework. For example, there may be differences with regulatory definitions for PD, loss given default (LGDs) etc., and it is not clear how banks will implement. ►► IFRS 9 might be even more judgement-based than IAS 39. ►► There might be inconsistencies in the implementation approaches taken by banks in terms of the governance, clarity of key features and reporting and transparency: ►► Smaller portfolios in the standardised approach may cause operational challenges.
►► IT systems, management information systems and disclosures will also be a focus of attention. Patrick highlighted supervisory initiatives linked to IFRS 9, and that the ECB will be considering ways to incorporate the impact of IFRS 9 into discussions around these initiatives. ►► The ECB thematic review is the major planned work for 2016 and 2017. It aims to undertake an assessment of the expected impact of IFRS 9 on banks, based on the work of the European Banking Authority (EBA), with specific regard to classification and impairment and to foster a consistent implementation and application across Eurozone banks. ►► Other supervisory initiatives where the planned implementation of IFRS 9 might come into play are the target review of internal models (TRIM), stress testing, Basel Committee on Banking Supervision (BCBS) 239, Capital planning and Pillar 2, non-performing loan (NPL) task force and regulatory reporting (potential interactions with financial reporting (FINREP) or common reporting (COREP)). Patrick noted that the capital regime has been designed for an incurred loss model from an accounting perspective and noted that the introduction of IFRS 9 might trigger the need for some adaptation.
►► As regards the approach to multiple scenarios, it is not clear whether complex methodologies (Monte Carlo simulation for instance) would be necessary and what benefit they would bring. In any case, banks will be expected to ensure auditability of their methodologies.
Contacts Tony Clifford Partner, EY UK LLP T: + 44 20 7951 2250 E:
[email protected]
Tara Kengla Partner, EY UK LLP T: + 44 20 7951 3054 E:
[email protected]
Nick Stewart Executive Director, EY UK LLP T: + 44 20 7951 3042 E:
[email protected]
Laure Guégan Partner, EY France GIE LLP T: + 33 1 46 93 63 58 E:
[email protected]
Michiel van der Lof Partner, EY Netherlands LLP T: + 31 88 40 71030 E:
[email protected]
Vivek Kavdikar Director, EY UK LLP T: + 44 20 7951 3617 E:
[email protected]
George Prieksaitis Partner, EY Canada LLP T: + 14 1694 32542 E:
[email protected]
Dr. Jana Währisch Executive Director, EY Germany LLP T: + 49 6196 996 23072 E:
[email protected]
Doug Vick Senior Manager, EY UK LLP T: + 44 131 777 2329 E:
[email protected]
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