EBF: Basic features of an alternative to IASB expected cash flow model
21 June 2010
EBF does not fully support the IASB model and proposed the “Expected Loss over the Life of the Portfolio” model. The model is built around the key principles which include alternative application of the concept of expected loss for impairment.
The European Banking Federation (EBF) is evaluating the IASB’s Exposure Draft (“ED”) “Financial Instruments: Amortised Cost and Impairment”. The Federation believes that the ED is an important step in the right direction as the industry conceptually supports the development of an impairment model that is based on “expected loss”, rather than the current “incurred loss” model in IAS 39. However, the EBF believes that the “expected cash flow” model in the ED has a number of significant and important drawbacks, including:
• Conceptual issues: for example, as proposed in the ED, the initial expected cash flow estimate is recognised over the life of the related assets, whereas the present value of (positive and negative) changes in the expected cash flow estimate must be recognised immediately. This results in significant additional subjectivity, volatility and procyclicality.
• Practical issues, as the proposals in the ED are extremely complex, making the proposals difficult to be:
- understood by users, e.g. due to the proposed combination of credit losses with interest margins;
- implemented by preparers, e.g. due to the need to completely revise the methodology for effective interest rates and the need to define expected cash flows by time period whereas entities manage expected losses and
- made reliable and relevant enough in practice given insufficient modelling capabilities.
For these reasons, the industry has been working to identify a number of sources of complexity as well as the conceptual issues. To address these shortcomings, the EBF has developed an alternative application of the concept of expected loss for impairment that it believes is conceptually superior, in line with the general objective of financial statements and consistent with the lending activity and credit risk management of financial institutions.
The model proposed by the industry is “Expected Loss over the Life of the Portfolio” (“ELLP”) model and is built around the following key principles:
1) The new impairment model should not change the current definition of amortised cost or the EIR calculation
2) Expected losses in the context of the new impairment model should be determined on a portfolio level
3) The methodology is based on the “expected loss over the life of each portfolio”
4) Impairment allowances are built up to be used, and therefore they are not just buffers.
5) Impaired loans are treated as in the current IAS 39.
6) Impairment allowances must be properly considered in the capital framework
© EBF
