Regulatory treatment of accounting provisions - EY

Regulatory treatment of accounting provisions An update on global and European developments

Contents What you need to know

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Overview 2 Background to the capital impact under IFRS 9 — standardised and internal ratings-based approaches

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►► Standardised approach ►► Internal ratings-based approach

BCBS interim approach

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►► Immediate impact for general and specific credit risk adjustments ►► 'Transitional' model

BCBS approaches to transitional arrangements 6 Key EY contacts

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What you need to know ►► On 29 March 2017, the Basel Committee on Banking Supervision (BCBS) issued the final standard 1 for the Regulatory treatment of accounting provisions — interim approach and transitional arrangements for expected credit loss (ECL) models. This follows the consultative document (CD) 2 and discussion paper (DP) 3 issued by BCBS in October 2016. ►► The BCBS standard provides a relatively broad transitional framework, within which each jurisdiction can implement its own approach over a period of up to five years. This makes the creation of a consistent and comparable industry-wide transitional approach less likely, as it passes the design to national jurisdictions. The standard risks a further departure from global harmonisation when considered in light of International Financial Reporting Standard (IFRS) and US Generally Accepted Accounting Principles (GAAP) differences for ECL. ►► Two examples of transitional approaches are presented in an annex to the standard: ►► Static approach — a fixed Common Equity Tier 1 (CET1) Day 1 impact adjustment phased out evenly over the transitional period. ►► Dynamic approach — a variable CET1 impact adjustment based on 'new' Stage 1 and 2 provisions at each reporting date, phased out evenly over the transitional period. This approach may require Stage 1 and 2 provisions that would have been present under International Accounting Standard (IAS) 39 Financial Instruments: Recognition and Measurement to be identified at each reporting date during the transitional period (for example, incurred but not reported (IBNR) losses).

►► For European banks, the European Council (EC) published a press release on 16 June 2017. This clarified its position and stated that relevant provisions should be fast-tracked to provide a five-year transitional period, with the addback progressively decreasing to zero. This reflects the European Banking Authority (EBA) opinion4, published on 6 March 2017, which presented the viewpoint that a static approach achieves a better balance between addressing the rationale of the transitional arrangements whilst at the same time being a prudent and simple approach. ►► The static approach predominantly addresses concerns over the impact on CET1 ratios in a future benign economic environment. However, the dynamic approach has a more complex design to allow it to address concerns over impairment volatility during the transitional period, as well as the phasing of potential Pillar 2 impacts driven by the results of stress testing under IFRS 9 Financial Instruments. ►► The standard retains the regulatory distinction between the standardised approach (SA) and the internal ratings-based approach (IRB), and for the SA, the distinction between general and specific credit risk adjustments for an interim period. In line with this, the EBA published opinion 5 maintains the view that general credit risk adjustments (GCRAs) will not exist under IFRS accounting rules as IFRS 9 provisions do not meet the criteria to be classified as GCRAs in that they are not freely and fully available. ►► The standard does not address the long-term regulatory treatment of provisions — the subject of the DP issued in October 2016. BCBS notes that further analysis is required and that the impact of ECL accounting on regulatory capital may be significantly more material than expected.

“Publications,” Bank for International Settlements website, https://www.bis.org/bcbs/publ/d401.pdf. “Publications,” Bank for International Settlements website, http://www.eba.europa.eu/documents/10180/359972/EBA-RTS-2013-04-draft_ RTS_ on_ Credit_ Risk_Adjustments.pdf, October 2016. 3 “Publications,” Bank for International Settlements website, http: //www.bis.org/bcbs/publ/d385.pdf, October 2016. 4 “Press release,” European Council website, http://www.consilium.europa.eu/en/press/press-releases/2017/06/16-banking-creditor-hierarchy-ifrs9-proposals/ 5 https://www.eba.europa.eu/documents/10180/1772789/EBA+Opinion+on+transitional+arrangements+and+credit+risk+adjustments+due+to+the+introduction+of+IFRS+9+(EBAOp-2017-02).pdf. 1 2

Regulatory treatment of accounting provisions — an update on global and European developments

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Overview

The current regulatory treatment of accounting provisions will be retained for an interim period, with the ultimate decision on transitional recognition of IFRS 9 impairment in capital ratios left to individual jurisdictions.

On 29 March 2017, the BCBS issued the final standard for the regulatory treatment of accounting provisions, which sets out the committee’s decision to retain the current regulatory treatment of accounting provisions for an interim period. It also sets out principles for the transitional recognition of the capital impacts of IFRS 9 to take effect from 1 January 2018 and the corresponding Pillar 3 disclosure requirements. The standard provides individual jurisdictions with the option of whether, and how, to implement the transitional arrangements.6 This follows the CD and DP issued by BCBS in October 2016. This standard addresses both IFRS 9 Financial Instruments and the US GAAP current ECL equivalent. However, this EY publication will focus only on the IFRS 9-related issues. BCBS continues to support the use of ECL approaches. BCBS 'encourages their application in a manner that will achieve earlier recognition of credit losses than incurred loss models while also providing incentives for banks to follow sound credit risk management practices.' This is in line with its earlier Guidance on credit risk and accounting for expected credit losses (G-CRAECL) publication.7 BCBS recognises that the IFRS 9 ECL model will likely lead to higher provisions than the Basel expected loss (EL) capital requirement for IRB portfolios. This is because the Basel requirement is based on expected losses estimated on a time horizon limited to 12 months for all exposures, whereas IFRS 9 requires a 12 months ECL only for Stage 1 exposures and lifetime ECLs for Stages 2 and 3 exposures. Yet the calculation parameters (PD, LGD and EAD) of the Basel IRB EL should generally be more prudent, hence Basel IRB EL will generally be higher than IFRS 9 ECL for the same Stage 1 exposures.

Technically, a new paragraph (§96A) is inserted in the Basel III document on capital (Basel III: a global regulatory framework for more resilient banks and banking systems (BCBS 189, June 2011). Guidance on credit risk and accounting for expected credit losses, “Publications,” Bank for International Settlements website, http: //www.bis.org/bcbs/publ/d350.pdf, December 2015. 8 “Press room,” EBA website, https://www.eba.europa.eu/documents/10180/1772789/EBA+Opinion+on+transitional+arrangements+and+credit+risk+adjustments+due+to+the+introd uction+of+IFRS+9+(EBA-Op-2017-02).pdf. 6

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Background to the capital impact under IFRS 9 — standardised and internal ratings-based approaches The IFRS 9 Day 1 increase in provisions is likely to affect the CET1 ratios of standardised banks more than those banks applying an internal ratings-based approach.

Before addressing the standard directly, it is important to understand the ways in which the Day 1 implementation of IFRS 9 will impact upon a bank’s capital position, with the key differences driven by whether the bank employs either an SA or an IRB approach to the measurement of credit risk capital requirements.

Standardised approach The CET1 ratios of banks applying the SA are likely to be affected more than IRB banks on Day 1 IFRS 9 implementation, due to the adverse impact of impairment provisions on accounting reserves flowing directly to CET1 capital resources. This can be partially offset via a decrease in risk-weighted assets (RWAs), where additional impairment provisions recognised on Day 1 are classed as specific credit risk adjustments (SCRAs) and netted off against accounting exposures prior to risk-weighting. The value of the offset is likely to be less than 10% of the impact on CET1 capital resources. Additionally, the EBA has clarified in its opinion paper that no GCRAs will exist under IFRS 9, which will mean no benefit is derived from the add-back of GCRAs to Tier 2 capital resources. The EBA’s opinion on GCRAs is worth highlighting since Tier 2 and total capital resources will become increasingly important for banks when deciding the volume of additional capital instruments required to meet the gone concern resolution requirements of total loss absorbing capacity (TLAC) and minimum requirements for own funds and eligible liabilities (MREL).

Internal ratings-based approach For IRB banks, the existing CET1 deduction of the excess of regulatory expected losses over accounting provisions, when made, should absorb at least a portion of the Day 1 IFRS 9 increase in provisions before affecting CET1 capital levels. Where provisions, and other allowable value adjustments, exceed the regulatory expected losses, they may be added back to Tier 2 capital, subject to a 0.6% cap of credit risk RWA calculated under the IRB. The split between GCRAs and SCRAs will be important for IRB banks where certain of their portfolios follow the SA (absent Basel parameters for the EL calculation). It should also be noted that IRB banks may be required to perform full SA RWA calculations if an IRB capital floor is introduced, as has been previously proposed. This highlights the broader context of capital regulation, as the accounting domain and regulatory domain are diverging — the former towards a more modelled approach, the latter towards a more standardised approach.


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BCBS interim approach Regulators will need to provide guidance on categorising ECL provisions as general or specific credit risk adjustments for regulatory purposes — with the EBA’s opinion being that all IFRS 9 provisions will be specific in nature.

The committee has decided that given the diversity of accounting and supervisory policies in respect of provisioning and capital across jurisdictions, and the uncertainty about the capital effects of the change to an ECL accounting model, it will retain the current treatment of provisions under both the SA and IRB frameworks for an interim period.

Immediate impact for general and specific credit risk adjustments The standard encourages jurisdictions to extend their existing approaches to categorising provisions as either GCRAs or SCRAs. Following the transition period, the distinction of accounting provisions as either GCRAs or SCRAs will remain the remit of regulatory authorities, with BCBS recommending they provide guidance on this categorisation as appropriate. The significance of this is that under the SA, SCRAs are netted against exposures prior to risk-weighting, whereas GCRAs are added back to Tier 2 capital, up to a maximum of 1.25% of SA RWA. For European-based banks, the EBA published an opinion in early March 2017 on transitional arrangements and credit risk adjustments due to the introduction of IFRS 9.8 This confirmed that, in the EBA’s opinion, no GCRAs are created under IFRS 9 accounting and the existing treatment is anticipated to continue, i.e., all accounting impairment provisions under IFRS 9 will be classified as SCRAs. One of the main reasons given for this is that provisions under IFRS 9 will not be freely and fully available to meet losses that subsequently materialise, as these provisions are ascribed to particular assets, whether individual or grouped.

'Transitional' model The standard provides jurisdictions with the option to choose whether to apply a transitional arrangement over a period of no more than five years and, if elected, the design of the approach is the jurisdiction’s responsibility — subject to a number of rules laid out by BCBS. Jurisdictions should choose between a static approach in which the transitional adjustment is calculated just once, at the point of transition (approach A), or a dynamic approach in which the evolution of 'new' ECL provisions during the transition period are also taken into account (approach B). The standard also clarifies that the portion of the ECL accounting provisions not deducted from CET1 capital due to the transitional arrangement will not be subject to other regulatory adjustments. It will not be treated as GCRAs or SCRAs for Tier 2 add-back or risk-weighting purposes. It will also not reduce the total exposure measure in the leverage ratio. Further, any deferred tax asset associated with such a non-deducted allowance should not be subject to deduction from CET1 capital or risk-weighting.

https://www.eba.europa.eu/documents/10180/1772789/EBA+Opinion+on+transitional+arrangements+and+credit+risk+adjustments+due+to+the+introduction+of+IFRS+9+(EBAOp-2017-02).pdf.

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For European-based banks, the transitional approach is included within the draft CRR. The article will be subject to a 'fast track' process

For European-based banks, the transitional approach is included within the draft Capital Requirements Regulation (CRR) published in November 2016, within Article 473(a) As confirmed by the EC press release in mid-June 2017, this article will be subject to a 'fast-track' process to ensure it can be applied as at the initial date of IFRS 9 application within the EU. The draft regulation10 proposes a five-year transitional period and is a static approach, with a transitional adjustment calculated only at the point of transition. The applicable factors are weighted towards the later years of the transitional period, commencing with a factor of 95% in year one and ending with a factor of 25% in year five. Furthermore, additional relief is provided where an institution's newly incurred ECL provisions exceed a certain threshold — the EC notes the inclusion of this clause is due to the potential volatility of the future macroeconimic environment. Several European authorities have publically commented on the CRR draft proposal, including the EBA11. The authority provides the viewpoint that a static approach achieves a better balance between addressing the rationale of the transitional arrangements whilst at the same time being a prudent and simple approach. The following examples illustrate the two main approaches outlined by the BCBS. As the standard does not prescribe a set transitional period, the examples have used a four-year transitional period, with the transitional adjustment falling to zero in the fifth accounting period following Day 1, in line with the EBA recommendation.

"Publications," European Council website, http://data.consilium.europa.eu/doc/document/ST-9480-2017-INIT/en/pdf "Publications," EBA website, https://www.eba.europa.eu/documents/10180/1772789/EBA+Opinion+on+transitional+arrangements+and+credit+risk+adjustments+due+to+the+intro duction+of+IFRS+9+(EBA-Op-2017-02).pdf.

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BCBS approaches to transitional arrangements For European-based banks, the EBA believes that a static approach achieves a better balance between addressing the rationale of the transitional arrangements and at the same time being a prudent and simple approach.

►► Approach A: Day 1 impact on CET1 capital spread over a specified number of years. The bank calculates the change in fully-loaded CET1 capital resources resulting from Day 1 IFRS 9 implementation and phases this in over a specified number of years for regulatory purposes. Below is an example of an IRB bank adopting Approach A. For simplicity, in each example we have ignored tax and deferred tax. The examples assume that the stock of IAS 39 provisions as at 31 December 2017 is 1,000 and the stock of IFRS 9 provisions as at the reporting dates is 1,350 as at 1 January 2018, increasing to 1,500, 1,800, 2,000 and 2,150 over the next four years. It also assumes an 'EL — prov' deficit of 50.

Approach A CET1 capital CET1 capital as at 31 December 2017

50,300

Impact from adoption of ECL model

(350)

Assumed IRB provisioning shortfall as at 31 December 2017

50

CET1 capital impact

(300)

CET1 capital as at 1 January 2018

50,000

Provisions as at 31 December 2017 (under incurred loss)

1,000

Assumed ECL provisions as at 1 January 2018

(1,350)

Increase in provisions

(350)

Stock of ECL provisions at reporting date

CET1 capital with full impact of ECL provisions*

Transitional relief over four years

Transitional adjustment amount to be added back to CET1 capital

CET1 capital after transition adjustments relief

1 January 2018

1,350

50,000

300 x 4/5

240

50,240

1 January 2019

1,500

49,850

300 x 3/5

180

50,030

1 January 2020

1,800

49,550

300 x 2/5

120

49,670

1 January 2021

2,000

49,350

300 x 1/5

60

49,410

1 January 2022

2,150

49,200

0

0

49,200

* It is assumed that the impact on capital is due to the pre-tax increase in provisions.

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A dynamic approach will add more complexity, requiring firms to implement ongoing operational processes.

►► Approach B: phased prudential recognition of IFRS 9 Stage 1 and 2 provisions. The standard proposes that banks phase in the recognition of Stage 1 and Stage 2 provisions (net of tax effects) to regulatory capital calculations over a specific number of years. This is based on the BCBS assumption that Stage 3 provisions under the IFRS 9 ECL model are roughly equivalent to IAS 39 incurred loss provisions. BCBS recognises that this allows for fluctuations over time and also appreciates that some of the provisions maintained today for IBNR losses will be allocated to IFRS 9 Stages 1 and 2, so the assumption that all Stages 1 and 2 provisions are 'new' may not be justified. As a simplification, the BCBS example for Approach B 'freezes' the portion of Stages 1 and 2 provisions that are deemed to exist under IAS 39, based on the amounts as at the date of transition. This is the approach used in the below example, where CU 50 of ECLs that were allocated to Stages 1 and 2 on transition are deemed also to have arisen under IAS 39. This amount is then deducted from the transition amount throughout the period. However, in practice, banks would need to be able to continue to calculate IAS 39 provisions for Stages 1 and 2 throughout the transition period. It is worth noting that this approach would not be possible for CECL reporters, due to the absence of staging within the US GAAP accounting standard. Below is an example of an IRB bank adopting Approach B.

Approach B CET1 capital as at 31 December 2017

50,300


(350)

Assumed IRB provisioning shortfall as at 31 December 2017

50

CET1 capital impact

(300)

CET1 capital as at 1 January 2018

50,000

Provisions as at 31 December 2017 (under incurred loss)

1,000

Assumed ECL provisions as at 1 January 2018

(1,350)


(350)

Stage 1 and 2 ECL Stock of ECL provisions net of provisions at reporting date IAS 39 provision of CU 50

Transitional CET1 capital with full impact relief over four years of ECL provisions*

Transitional adjustment amount to be added back to CET1 capital

CET1 capital after transition adjustments relief

1 January 2018

1,350

300

50,000

300 x 4/5

240

50,240

1 January 2019

1,500

400

49,850

400 x 3/5

240

50,090

1 January 2020

1,800

550

49,550

550x 2/5

220

49,770

1 January 2021

2,000

700

49,350

700x 1/5

140

49,490

1 January 2022

2,150

825

49,200

0

0

49,200

* It is assumed that the impact to the capital is due to the pre-tax increase in provisions.

Banks will be required to disclose publicly (through their Pillar 3 disclosures) whether a transitional arrangement is applied and what the regulatory capital and leverage ratios are in comparison to the 'fully loaded' ratios had the transitional arrangement not been applied.


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How we see it ►► It is important for regulators to provide clarity regarding the transitional arrangements, as given the proximity to Day 1 there remains a short lead time for these arrangements to be implemented. Firms will need to monitor developments and understand the impact of potential arrangements. ►► Regulators will also be required to provide guidance on distinguishing between general and specific credit risk adjustments under IFRS 9 as soon as possible. This determination could be a challenging and complex area for banks to address, with sufficient time for implementation being critical. ►► The static transitional approach is the most simple to implement, but does not provide enhanced protection to capital ratios resulting from potential volatility during the transitional period. With economic uncertainty arising from global events combined with significant regulatory changes within the near future, certain firms may be vulnerable to the impact of IFRS 9 on their capital levels.

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►► The dynamic transitional approach would flex with movements in provisions during the transitional period, and also allow the phasing in of any incremental Pillar 2 requirements arising due to stress-testing assessments. However, it may require the identification of Stages 1 and 2 provisions which would have been recognised under IAS 39 at each reporting date (i.e., some element of the sum of Stages 1 and 2 may be equivalent to IAS 39 provisions, such as IBNR). This presents a significant operational challenge. ►► Banks should continue to review their capital plans and stress-tests, with reference to the proposed transitional arrangements, to ensure they maintain robust capital ratios through IFRS 9 implementation. This may have wider impacts on strategic decision making and choices as to the markets in which they operate and the products they offer. ►► We expect that stakeholders, such as analysts and investors, will focus predominantly on the fully loaded capital position, even if transition adjustments are made. The disclosure requirements will provide this transparency for the market.


Key EY contacts Tony Clifford

Tara Kengla

T: +44 20 7951 2250 E: [email protected]


Tom Huertas

Michiel van der Lof



Jana Währisch

Yolaine Kermarrec



Celine Molinari

Catriona Early

T: +33 1 46 93 46 44 E: [email protected]


Taryn Bles

Natalia Dembek-Slusarczynska


T: +41 58 286 44 21 E: [email protected]


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Regulatory treatment of accounting provisions - EY

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