While the financial industry worldwide will adopt the new standard (IFRS 9) in 2018, Indonesia will start to adopt this standard in 2020. There are significant details and changes in IFRS 9 as the new Financial Reporting Standard compared to the last standard (IAS 39 or PSAK 55 in Indonesia), but the most fundamental change is that banks will now be required to take a provision on all loans in their banking book, as opposed to the current standard which requires objective evidence that the loan has become impaired before a reserve is established. So as new loans are originated an expected credit loss is calculated, based on a 12 month time horizon (i.e. considering the probability that the loan will default within one year – often a pretty low number). Banks will have to do a second analysis, because in each reporting period, they will have to assess each loan for a “significant increase in credit risk”, and when that occurs they will have to increase the provision to a Lifetime expected credit loss, where the probability of default time horizon extends from 12 months to the full term of the loan (and therefore more similar to a provision taken today against a defaulted credit). So one can see how loan loss provisions will increase and become more volatile under the new standard.
IFRS 9 will also impact the increase of Bank’s credit risk systems and models’ complexity. Just as regulators are considering a fundamental overhaul and limitation on the use of credit risk models and parameters for capital management purposes, such models will become a key component in the new loan loss accounting standard. The expected loss model requires banks to build a new set of credit models (for the larger banks we observe mostly as extensions of their capital and stress-testing models; for smaller banks and credit unions who are not on the advanced Basel capital approach, this is a bigger challenge) and exercise significant judgement to determine loan losses at each reporting period. This new standard implementation will also introduces operational risks, as complex models need to be built, vetted and maintained, and then coupled with significant estimations and judgement, in order to calculate the new allowance and loan loss numbers. Actually, even the Expected Credit Loss (ECL) models may be built as extensions of the Basel capital models at some banks, the standards and requirements are different from the capital standards and therefore another set of books needs to be maintained.
IFRS 9 will have significant impacts on the banks capital levels. As higher and more volatile provisions are recognized through the income statement, they will flow through to and reduce retained earnings and thereby the capital ratios. There is a significant pro-cyclicality involved here, as a downturn in the economic/credit cycle will cause retained earnings to fall just as risk weighted assets are increasing (i.e. the capital rules also require risk weighted assets models to increase with a turn in the credit cycle, albeit more slowly); banks will therefore be pressured to curtail lending to protect their capital ratios, leading to a self-fulfilling cycle. Also, there is an asymmetric treatment of credit allowance reserves in the capital standards, where under provisioning (i.e. allowance reserve less capital model expected losses) leads to a haircut for the crucial Tier 1 Common Ratio, whereas an over provisioning (which could well occur under IFRS 9) does not provide a similar benefit (the benefit is recognized in the Total Capital Ratio, which is less of a binding constraint.)
The conclusion of this matter is that with this IFRS 9 implementation, banks and their shareholders will still have some significant challenges ahead of them. Questions such as who will own the models and processes, who will reconcile the various sets of books, and manage the asymmetry between capital, stress test, and accounting treatment, who will maintain the talent and systems to operate these complex systems going forward, how will the significant estimates and judgements be governed, and who will educate the user community regarding the significant change in financial disclosure, are waiting to be answered in order to overcome the challenges in this implementation.
Anabatic Technologies together with Wolters Kluwer Financial Services will hold the “Finance, Risk, & Reporting Summit 2018: Countdown to IFRS 9” seminar and forum discussion at Hotel Ayana Midplaza Sudirman, Jakarta on April 19th 2018. The event will cover key finance and reporting issues affecting financial institutions in Indonesia as they countdown to IFRS 9.
For more info regarding this event, click the following link Read More >