The Use of IFRS for Prudential and Regulatory Purposes Revision of IAS 39. REPARIS IFRS Seminar Vienna, May

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1 The Use of IFRS for Prudential and Regulatory Purposes Revision of IAS 39 REPARIS IFRS Seminar Vienna, May

2 Summary» Introduction» Provisioning according to IAS 39 (Loans & Receivables)» Loan loss provisioning according to ED/2009/12 (Amortised Cost and Impairment)» Basel Committee Proposal for expected Loss (EL) Provisioning» European Banking Federation Proposal Expected Loss over the Life of the Portfolio (ELLP)» Comparison of the various approaches 1

3 Introduction» The financial crisis has shown limitations of the current incurred loss accounting model used in IAS 39: Overstatement of interest income in the periods preceding the occurrence of a loss event Insufficient amount of accumulated provisions to absorb actual losses that emerged during the crisis Inherent pro-cyclical impact on the income statement 2

4 Introduction (continued)» Pressure on IASB: Acceleration of IAS 39 replacement project (IFRS 9: Financial Instruments), conducted in three phases: - Phase 1-Classification and Measurement (completed in Nov. 2009) - Phase 2-Impairment Methodology : ED 2009/12 Amortised Cost and Impairment, based on expected cash flow model, published in Nov. 2009, comments due June 2010, final standard expected end Phase 3-Hedge Accounting (ED expected in first half of 2010) 3

5 Introduction (continued)» Reactions to ED 2009/12 show support for the more forward looking approach of the proposed expected cash flow model, resulting from the removal of the trigger event constraint» However, concerns regarding complexity, subjectivity, volatility and (remaining) pro-cyclicality» Particular interest of banking supervisors in phase 2 and ED, as lending is an essential feature of the banking industry. Building on supervisory objectives*, the Basel Committee on Banking Supervision has developed a modified proposal for Expected Loss Provisioning (unpublished as of now) and has entered into talks with IASB» Also proposal by European Banking Federation ( Expected Loss over the life of the portfolio ). *as pronounced in guidance of Central Bank Governors and Heads of Supervision of January 2010 and Basel Committee s August 2009 Guiding Principles for the replacement of IAS 39 4

6 Provisioning according to IAS 39 (Loans & Receivables)» Basis: IAS 39.58ff Impairment and uncollectibility, IAS for loans and receivables (and HTM investments carried at amortised cost)» Incurred loss model; requires objective evidence (trigger event)» Amount of loss measured as difference between asset s carrying amount and present value of estimated future cash flows (excluding future losses not incurred), discounted at original effective interest rate» Collective loan assessment possible for insignificant loans.» Assessment on portfolio basis for non-impaired loans ( GLLP ), considering the loss identification period (account for losses incurred but not reported )» Country risk considered within collective assessment or separately on portfolio basis» Reversals of write-downs up to amortised cost 5

7 Provisioning according to ED 2009/12 (Amortised Cost and Impairment)» Expected loss/expected cash flow approach for assets carried at amortised cost; on collective basis or individual basis.» Allowance for expected future losses is gradually built over the lifetime of an asset by deducting a margin for future credit losses from gross interest revenue (=> effective interest rate - EIR): Upon initial recognition of a financial asset, management estimates credit losses expected over the life of the asset Interest revenue is adjusted by a margin for initially expected future credit losses Over time, allowance is built for expected future credit losses by reducing the amount of net interest revenue recognized to reflect an estimate of expected losses Management estimates expected future credit losses on an ongoing basis Any changes in credit loss expectations both favorable and unfavorable are recognized immediately on a discounted cash flow basis as a gain or loss in earnings. 6

8 Basel Committee Proposal for Expected Loss (EL) Provisioning» Expected loss model, using IASB S model for fixed rate loans as starting point. Extended to variable rate loans by varying the contractual interest rate.» Recognises interest income on basis of EIR; EIR determined by applying single loss rate evenly to principal and interest over the life of the loan.» Loss rate includes quantitative element based on historical losses covering at least a complete economic cycle.» Interest payments received are allocated to interest income according to the EIR, excess set aside in allowance account.» Revisions of EL only when there are material changes to loss rates (objective and auditable evidence); subsequent revision of EIR will result in adjustment to the allowance account and the income statement over the residual life of the loans.» Open portfolio approach» General principle: expected loss covered by provisions, unexpected loss covered by regulatory capital 7

9 European Banking Federation Proposal» Expected Loss over the Life of the Portfolio (ELLP) Expected loss approach with elements of incurred loss model; application on loan-by-loan basis, closed or open portfolios. ELLP spread in the income statement over the average life of the portfolio (linearly or any better allocation). Changes in expectations about ELLP spread over remaining life of portfolio. Loans on which incurred losses are identified ( non-performing loans ), are separated from the portfolio. No further expected loss is calculated and the EL previously created allocated to the non-performing loans. An incurred loss impairment allowance is calculated for the non-performing loans and adjusted against the expected loss impairment allowance account. Reflects the fact that non-performing loans are the crystallization of the expected loss. Indicates intention to use impairment allowance created for whole portfolio (not pro rata) To the extent that impairment allowances are not sufficient to absorb losses, incurred losses are booked directly to the income statement 8»

10 Comparison of the various approaches 1. Pro-cyclicality IAS 39 ED 2009/12 BCBS EBF High; Lower than Lower than Lower than danger of under IAS 39, under IAS 39 under IAS 39 excess but volatility of and and dividend income ED 2009/12 as ED 2009/ 12; payouts in statement in revisions of EL potentially peak times, case of lead to higher than additional changes of adjustments BCBS if EL burden in credit loss over the calculation is downturns. expectations. residual life of stopped for the loans. whole portfolio in case of nonperforming loans. 8 88

11 Comparison of the various approaches 2. P&L Matching IAS 39 ED 2009/12 BCBS EBF Asymmetry of Symmetry of Symmetry of Symmetry of risk premiums risk premiums risk premiums risk premiums and expenses and expenses. and expenses. and expenses, leads to at least while increased loans in volatility of P portfolio are +L. performing.

12 Comparison of the various approaches 3.Timing of provisioning IAS 39 ED 2009/12 BCBS EBF Later Earlier, Earlier, Earlier, (problem of from day 1 from day 1 from day 1 timely (granting/ (granting/ (granting/ identification of extention of extention of extention of loss/trigger loan). loan). loan). event, loss identification period).

13 Comparison of the various approaches 4.Relevance of portfolios IAS 39 ED 2009/12 BCBS EBF Primarily loan- Approach implies Allows open Allows open by-loan basis; loan-by-loan or portfolios; portfolios; portfolio closed portfolio homogeneity of homogeneity of allowance basis; portfolios portfolios possible for homogeneity of (similar risk (similar risk insignificant portfolios characteristics) characteristics) loans or losses (similar risk highly relevant. highly relevant. incurred but not characteristics) reported ; lower highly relevant. overall relevance of homogeneity of portfolios.

14 Comparison of the various approaches 5. Complexity IAS 39 ED 2009/12 BCBS EBF Low, High, High, High, definition of difficult to but workload as expected trigger events model all risk should be lower loss for each only, no factors of a as revisions of portfolio should comprehensive portfolio; EL only in case be reviewed loss statistics regular of material and and modeling backtesting changes of loss recalculated required. necessary to rates. periodically, at review credit each reporting loss period. expectations.

15 Comparison of the various approaches 6. Objectivity, level of judgement IAS 39 ED 2009/12 BCBS EBF In case of early Increased level judgement judgement recognition of of judgement required with required with loss event, because regard to EL regard to EL estimation of periodic estimates; estimates; expected cash estimates of quality of model quality of model flows may be expected cash outputs highly outputs highly difficult. flows required; dependent on dependent on quality of model parameters. parameters. outputs highly dependent on parameters.

IASB s ED Financial Instruments: Amortised Cost and Impairment. 2 Key IAS 39 requirements and the ED proposals

ASB Constituents Meeting 6 May 2010 IASB s ED Financial Instruments: Amortised Cost and Impairment 1 Introduction 1.1 This paper is provided as background reading for the discussions at the ASB constituent