05 July 2013

EBF: Comment letter on the IASB ED Financial Instruments (Expected Credit Losses)

The EBF believes that the IASB approach is a step in the right direction and regrets that the FASB has decided to develop its own expected loss model. In the EBF´s view, the FASB does not meet the objectives of financial reporting as it would obscure information about credit deterioration and risk management, resulting in financial reporting which does not faithfully portray the economics of transactions.

It is crucial that the new provisioning system recognizes impairment allowances that are meaningful for different portfolios in different jurisdictions on a timely manner, permits banks to draw from their risk management systems incorporates a broader range of credit information and is operational and applicable to open portfolios.

12 months measurement

The EBF acknowledges that the loss allowance at an amount equal to 12 month expected credit losses would result in a credit loss at initial recognition even when a financial asset is priced on market terms. Whilst there is no conceptual justification for this, the EBF sees the recognition of 12 months expected credit losses as a proxy for adjustments in yield and a compromise that would achieve an appropriate balance between the benefits of faithful representation of expected credit losses and operational cost and complexity. The 12 month allowance, which can be based on existing practices, is seen as not being operationally burdensome and from an economic perspective as more than sufficient to cover the associated risk and result in a more forward looking assessment compared to IAS 39.

The EBF would strongly object to any model leading to recognition of losses for stage 1 beyond 12 months. Determining expected losses for any longer period of time, particularly an undefined period, would result in costs and complexity as well as a loss of comparability that cannot be justified.

Explicit link to the credit risk management

The EBF believes that a clear and explicit reference to the use of the entity’s current credit risk management processes should be included in the body of the final standard for assessing transfer to lifetime expected loss measurement.

In order to evaluate the transfer criterion entities should use the qualitative and/or quantitative information that is relevant and used for evaluating credit deterioration in the credit management processes. Such information is either an integral part of statistical models used to calculate the movements in PDs or, if not integrated or not updated at each reporting period, is used as an indicator of significant deterioration from a credit management perspective. Those relevant indicators would imply, in themselves, a significant deterioration since initial recognition. While adverse changes in macroeconomic factors should not be ignored, these should not imply a direct transfer to lifetime measurements if they are not expected to change the credit risk management. None of the factors mentioned in paragraph B20 (f) should therefore be considered in isolation when evaluating the transfer. Using macro-economic factors in isolation to trigger the transfer may not only be in conflict with entities’ risk management but also result in inconsistent application among entities (i.e. different interpretation of the same data, heterogeneity of forecasts of different organizations).

Clarification

While the EBF supports the IASB model, it is believed some clarification would achieve a better balance between the faithful representation of the underlying economics and the implementation costs. Clarification would enhance understanding and therefore increase the likelihood of the model being accepted at global level.

The standard should also be principles based and the text of the standard should not prevent implementation that would otherwise be compliant with the principles of the standards as long as it results in outcomes that remain consistent with the objectives of the proposal. There are several methods to achieve compliant outcomes.

The EBF does not believe that paragraph 8 is necessarily reflective of what the IASB is seeking to achieve. As currently drafted, the wording implies that the tracking of PDs would provide the only means by which credit deterioration could be assessed, whereas in practice this would constitute only one of a number of methods that could be used to achieve much the same result. The EBF would therefore firmly recommend that the paragraph be redrafted to focus more upon the principle that migration from Bucket 1 to Bucket 2 be based upon a significant deterioration in credit quality since initial recognition. While other aspects of the paragraph are important to explaining the principles, it needs to be appreciated that these are expanding upon the concept and not setting prescriptive rules. It needs to be clear, for example, that the objective is to consider changes in probability of default as opposed to changes in expected losses, and that the principle is to consider changes in credit quality over the remaining life of the financial instruments.

A further issue would be the criteria for determining that a significant deterioration had taken place. The ED correctly avoids suggesting bright lines. While B15 articulates important guidance to assist with applying the principle, the EBF is concerned that in this regard the current wording of the example in paragraph 6 could be read in conjunction with B15 as implying that a movement below investment grade credit quality could be interpreted as a bright line.

The EBF would also suggest clarification to the wording of paragraph B 11 to read: “However an entity may use the 12-months probability of a default occurring to determine whether credit risk has increased significantly since initial recognition if there is no objective evidence that the outcome would differ".

As acknowledged in the ED, many entities manage credit risk on the basis of information about past due status and have limited ability to assess credit quality on an instrument by instrument basis in more detail. The EBF believes the text of paragraph 9 should be clarified to allow the use of the 30 days past due rebuttable presumption together with other more forward-looking information that may be available.

Finally, the EBF believes that it will be necessary to adopt practical approaches, including the use of proxies, to achieve a timely and effective transition, in recognition of the difficulty that many entities will experience in obtaining relevant data in respect of existing business. The EBF would welcome explicit reference to practical approaches to obtaining relevant data approximating original credit quality, including, for example, use of suitable statistical approaches. In addition it should be clarified that it is possible to use the 30 days past due rebuttable presumption status for retail portfolios on transition to assist preparers with these challenges.

Comment letter

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