Banks: Invest in IFRS 9 now…or live to regret it

In my previous blog, I revisited the types of valuations required by the European Banking Authority’s (EBA) valuation Regulatory Technical Standard (RTS), which is due to be finalised in the next few months. In this blog I will explore how those requirements might overlap with IFRS 9, the new loan provisioning standard that is coming into force in 2018.

IFRS 9 introduces the requirement to provide for the present value of all future credit losses projected for the lifetime of loans that have shown a significant increase in credit risk. Broadly speaking, there are two ways you can go about estimating this:

  1. Lifetime probability of default (PD) and loss given default (LGD) approach - The high-level way is to adjust the PD assumption to reflect a full lifetime equivalent. This involves applying a lifetime scaler to existing PD assumptions. Obviously this approach is less flexible and does not explicitly recognise changes in PD or LGD over time. In recent months, I have heard that banks are moving away from this approach as it is simply too high-level.
  2. Expected cash flow approach – The more detailed way is to take an expected cash flow approach. This would estimate cash flows (and therefore implied losses) over time.

There is potential for IFRS 9 projects to help develop capabilities to perform the asset and liabilities valuations (which I covered in my previous blog). In theory, either of these two approaches arguably could be used as a starting point. To estimate hold value, lifetime losses would need to be estimated for all loans i.e. not just loans that have shown a significant increase in credit risk, but performing loans too. However, when it comes to estimating exit value, interest rate risk will need to be reflected for the fixed rate portion of the book – this presents a problem for those following the lifetime PD approach as that approach does not have cash flows.

It’s important to bear in mind that the RTS explicitly states that the valuations should estimate cash flows, and there is good reason for this. Crucially, the expected cash flows approach provides a view on the timing of future losses. This is critical in assessing the viability of the restructured bank post-resolution as it impacts how quickly capital levels will be depleted by impairments as the bank ramps up its profitable activities.

In recent months, my IFRS 9 colleagues tell me that they have seen a move away from lifetime scaler approach, with banks focussing on modelling losses over time and under varying macroeconomic scenarios.

The gold standard, in my view, would be for banks to develop valuation models that are capable of adjusting key assumptions – such as PD and LGD – to quantify the difference between hold and exit value. This is what would be required to support scenario analysis of alternative resolution options. In addition, the expected cash flows that the models calculate could be used in further analysis, such as an asset separation into a good bank and a bad bank. Speaking from experience, you need to model cash flows over time.

 

Invest in IFRS 9 now….or live to regret it

The conclusion that I draw from this is that banks should think carefully now about the projects they are launching or running. Investing a little more in IFRS 9 now could save money in the long-run when resolution valuations need to be embedded. Banks should plan for the future in their current projects lest they live to regret it.

Find out how to save time and money through resolution valuations here.

 

Do get in touch if you'd like to discuss any of the points I've raised here.

Attul Karir | Valuations Partner
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