Do investors care about IFRS 9?
01 March 2017
IFRS 9, in particular the expected credit loss (ECL) model, is the standard setter’s response to the financial crisis. Banks’ lending too much money to people who could not repay was one of the factors that fuelled the global financial crisis. Accounting, in particular the incurred loss model, was criticised for contributing to the crisis.
Incurred loss means you don’t book the loss until it happens. Expected credit loss means that that when each loan is made, the possibility the loan will default in future economic conditions is given effect. ECL accelerates the recognition of bad loan losses. It will impact banks profitability but do investors care about IFRS 9? I sincerely hope they will.
Investors may be tempted to focus more on regulatory measures such as capital and liquidity rather than accounting numbers. Capital is designed as a buffer to protect depositors (and the tax payer) in a financial crisis. Capital measures might help an investor predict how the bank would fare in a crisis, but are not primarily designed for investors.
Why should investors care about IFRS 9?
1) It is forward looking
IFRS 9 takes a ‘best estimate’ view’ based on ‘point in time’ assumptions – i.e. where we are in the cycle today and what’s expected to happen in the foreseeable future. Capital is based on ‘prudent’ (read conservative) assumptions that smooth out the effect of economic cycles.
2) It provides useful information
IFRS 9 is designed to give useful information for investment decisions. It provides granular information relevant to assessing credit risk and forecasting profitability. An example is information about changes in credit risk over time; highly relevant to assessing the profitability of a loan. A bank expects some borrowers to default so it will include a credit spread in the interest rate charged. In a perfect world, the credit spread would cover the risk of default. The ‘excess’ interest paid by borrowers who don’t default, in theory, would cover the losses from those who do for a portfolio of loans. A significant increase in a loan’s credit risk increases the risk that the expected losses on that loan are not covered by the borrower’s interest rate. IFRS 9 reflects this by increasing the credit loss (from a 12 month expected loss to a lifetime loss) and requiring more disclosures. Investors told the IASB during the development of IFRS 9 that they think such information is useful.
3) It encourages good banking behaviour
The impact of IFRS 9 goes beyond accounting. A bank that does a thorough implementation of IFRS 9 will need to generate new data and new models for measuring credit risk. And the old adage ‘what gets measured gets managed’ kicks in. This new information, if used to manage credit risk, is likely to influence how a bank behaves. The bank may take credit risk management actions earlier or may adjust the pricing or other terms of some loans or may even cease to sell some products.
Still focused on capital and not so interested in IFRS 9? Here’s my parting thought. Capital is an unaudited number and there is no assurance to its accuracy. IFRS 9 was introduced to help investors understand the risks a bank faces. Time for investors to pay attention.
This week's guest blogger is Sandra Thompson, IFRS Financial Instruments Leader. Connect with her on LinkedIn.