|
|
Overall the losses themselves do not change in total over the life of the loans; only the timing of their recording by the bank will be different. The new approach is seen as more timely and it reflects the underlying economics more closely since expected future losses are already priced in the interest rate charged on the loans.
Prior to and during the financial crisis, loan loss provisions were based on an “incurred loss model” which only permitted banks to recognise losses once loss events became observable. For example if borrowers lost their jobs and/or stopped loan repayments. This model was heavily criticised in the wake of the financial crisis because it was perceived to provide for losses “too little, too late” and was “pro-cyclical”, i.e. it allowed excess profits to build up in the good times, causing much higher losses to have to be recorded in the bad times. The pro-cyclicality allowed a credit bubble to develop based on underestimated credit losses which led to an over-optimistic assessment of bank’s reported profits.
Banks have, for many years, been required to assess their expected losses for banking regulatory purposes. Currently these rules require them to calculate their expected losses for the next 12 months from the reporting date. In many cases the banking regulatory requirements are more prudent than the IFRS 9 ones and it is very unlikely that the expected loss estimates would be the same; this is not surprising as they have different objectives.
When applying IFRS 9 principles, there are three different stages of measuring impairment. Most exposures will initially be in Stage 1. The bank recognises only the credit loss associated with the probability of default within the next 12 months as a provision against the asset. However, as soon as the exposure has suffered a significant increase in credit risk (‘Stage 2’), the bank recognises an allowance equal to expected credit losses over the lifetime of the loan. IFRS 9 does not specify what constitutes a significant increase in credit risk. Preparers have to define it for themselves. Transfers between Stages 1 and 2 are based on relative movement in credit risk since origination rather than based on absolute level of risk. The expected loss over the lifetime of a loan is likely to be significantly higher than the expected loss for the next 12 months.
Stage 3 includes financial assets that have objective evidence of impairment at the reporting date. For these assets lifetime expected loss is calculated for accounting purposes on the same basis as exposures in Stage 2; so the movement between the Stages 2 and 3 in itself, will not change the provision made.