The new accounting regulation IFRS 9 aims to buttress financial stability against future crises. It obliges financial institutions to more faithfully reflect credit risk and calculate provisions for insolvencies following an expected loss model (versus the previous “incurred loss” model). For a majority of financial institutions, this has resulted in an increase in provisions and the subsequent impact on capital.
The International Financial Reporting Standard 9 (IFRS 9) came into effect across Europe on January 1, 2018. The new norm is part of a G20 initiative, which seeks to strengthen financial stability as a way to avoid future crises in the sector.
As BBVA Research points out in its report, Banking Outlook – released on May 25th – the new norm implies significant changes, among which are the classification and measurement of financial instruments and the new expected loss model to calculate provisions for insolvencies.
One of the key priorities of IFRS 9 is to prompt institutions to more accurately reflect the credit risk on their balance sheets. To achieve this, loans are now classified into three stages, depending on risk level: those in Stage 1 are considered to have a low risk of non-payment. When a loan’s creditworthiness is judged to have significantly worsened (but without generating losses), the credit is reclassified as Stage 2. Stage 3 is used to classify loans that deteriorate to the point of becoming non-performing.
There are also changes to the mechanism of provisioning for potential losses arising from loans. Now, provisions will be forward-looking, based on expected losses. In the previous “incurred loss” model these were recognized when the loan was already classified as doubtful.
Taking this into account, the expected loss for loans classified at Stage 1 will be calculated over a 12-month timeframe. For those loans that are classified as Stage 2 or Stage 3, expected losses will be recognized over the total duration of the loan.
IFRS 9 (introduced in Spain via Circular 4/2017) replaces the circular on banking provisions 4/2016 in which, although it classified loans according to risk (using the category “normal under special surveillance”), provisions were still calculated on the basis of already incurred losses.
The change to expected loss could result in an increase in provisions, impacting regulatory capital. In IFRS 9's first implementation, additional provisions were written off against reserves rather than accounted for in the profit and loss account, which has a negative impact on the CET1 fully-loaded ratio for most European financial institutions.
It is also worth pointing out that the European Banking Authority (EBA) has included mandatory compliance with the new standard in stress tests to be carried out this year.