The International Financial Reporting Standards (IFRS) issued by the IFRS Foundation and International Accounting Standards Board (IASB) create a global framework for the preparation of financial statements of corporate entities.
IFRS 9 has drastically altered how entities treat their assets, liabilities and profit and loss items. Banks and therefore borrowers will be affected, to an extent that has not been understood by the business community. This column discusses its broad implications and how borrowers will be touched by it.
The most significant difference between the old IAS 39 standards and IFRS 9 is that the latter is forward-looking as opposed to being “past based”. What is at the core of IFRS 9 that will affect borrowers?
Fact vs. forecast
What is germane is that banks will now use a concept called “expected credit loss” (ECL), for every account, using numerous parameters, including qualitative judgements. And will make provisions (for doubtful loans) on a forward-looking, ECL-basis, rather than when loans actually go bad.
It is incontestable that a forward-looking model is fraught with uncertainty as plenty of judgement is required. The historic one is based on fact.
IFRS 9 calls for three stages of the performance of any credit. Banks will need to take increasing provisions on their loans, over these. Movement from Stage 1 (ECL from an account over the next 12 months from evaluation or origination point) to Stages 2 and 3 (3 means a loan is “credit impaired”) reflects progressive deterioration in credit quality.
The ECL is determined by a formula, an essential component of which is the “probability of default” (“PD”, determined by historical data etc.). The complexity of this is not relevant.
No time cushion
Suffice it to say that PD will sharply rise with a default, causing ECL to disproportionately surge. Therefore, when even a small default occurs (e.g., a 30-day delay of a small repayment) the bank has to take a provision on the account. Under the old regime, banks could live with delays and latitude in sweeping defaults under the carpet.
No longer. Provisions balloon in stage 2 and are a disaster in stage 3.
There are additional complications. There are a few characteristics of a transaction or credit facility that significantly increase ECL and therefore provision requirements.
First is the transaction structure, comprising several elements. One is the transaction duration — the longer it is, the bigger the impact on ECL in the event of a default. The ECL (therefore provisions) is far higher in case of a two-year loan than a 90-day one.
Second and tied to this is the frequency of repayments of a loan — the higher the frequency, the lower the ECL implication and vice versa. Another is the importance of the sector being lent to. Banks now have to discriminate between sectors and risk-rate each, based on how durable and predictable each is.
Will banks view sectors differently?
The second characteristic is collateral against each credit. Banks now have to be more discerning about various types of collateral and have to rate its quality as well, based on several parameters. Therefore, the scramble for real estate security over the past 3 years is likely to hit a wall, if it hasn’t already.
Third, banks now have to calculate ECL on undrawn but committed credit lines as well, where banks are obligated to keep lines open for a specified time; and not merely on amounts already borrowed. The average borrower need not worry — almost all lines here are uncommitted.
And now, for the icing on the cake.
The UAE Central Bank has set out its own regulations, overlaying IFRS 9, like other regulators elsewhere, resulting in more stringency, and therefore higher provisions (even on current portfolios) for banks. Some examples are: from now on the account classification (at the central bank) of a borrower decided by one lender will affect other lenders.
A downgrade will force others to rework their ECLs. Reports of the Etihad Credit Bureau will now be taken cognisance of.
Multiple boxes to tick
The net widens to include unavailability or inadequacy of financial statements of borrowers; qualified accounts; significant contingent liabilities (most auditors do not even report these!); pending, potentially damaging litigation; key staff leaving the borrower; non-cooperation of a customer in providing information etc, — any of these can spike the ECL.
The canvas is clear, and stark. Lenders will now tightly structure transactions, keep borrowers on tight leashes, monitor all aspects of businesses and use a dizzying array of judgemental tools to evaluate potential risk.
Provisioning will rise and therefore the cost of credit. Credit will be even more judiciously granted, pricing will rise.
For corporates, this is going to be a whole new world, requiring less accounting jugglery, more honesty and transparency, discipline etc. As such, the ECL, not relationships, will drive relationships!
Borrowers will need to rework banking and financing strategies and transform, quickly. The new reality is here. A word of advice to owners and management — wake up and change. If you don’t know how, seek help, you will need it …
Vikram Venkataraman is Managing Director at Vianta Advisors.