IFRS 9 Financial Instruments for broker-dealers

IFRS 9 Financial Instruments for broker-dealers IFRS 9 Financial Instruments for broker-dealers 1

Overview 09 10 11 12 13 14 2015 2016 2017 2018 IASB Exposure Draft (ED) 1 Final IFRS 9 Standard * GPPC considerations FASB ED IASB updated ED EDTF Report Joint Supplementary Draft ITG Discussions BCBS G-CRAECL * does not include marco hedge Preparation for adoption of IFRS 9 Mandatory adoption Background Since the financial crisis, the IASB conducted a comprehensive review of IAS 39. In July 2014, the International Accounting Standards Board issued the final version of International Financial Reporting Standard 9 ( IFRS 9 ), bringing together all phases of accounting for financial instruments into a new standard, replacing International Accounting Standard 39 ( IAS 39 ) and all previous versions of IFRS 9. IFRS 9 is one of the biggest accounting standard changes in recent years, as it does not only impact on general ledger entries and financial statements, but also risk management, business model and financial performance of an entity. Preparing for IFRS 9 requires a thorough review and modification of existing workflow, policies and procedures, processes, data and systems. IFRS 9 introduces new requirements for: 1) Classification and measurement 2) Impairment 3) Hedge accounting It is effective for annual periods beginning on or after 1 January 2018, with early application permitted. Model development, data availability and system capability are some of the challenges that will take time to be addressed. It is crucial for management to start to consider the impact of IFRS 9, and how the business, people, and infrastructure can be ready for adoption in 2018. The preparation for IFRS 9 adoption requires management to allocate sufficient manpower and resources to understand and interpret the requirements under IFRS 9, develop models, conduct impact assessment, refine workflow, policies and procedures, perform parallel run, and transfer knowledge to the relevant departments. EY is the market leading organization for IFRS 9 experiences and insights, and have dedicated project teams to support you in the implementation of IFRS 9. 2 IFRS 9 Financial Instruments for broker-dealers

Key messages CFOs and finance Need to assess the impact on profit or loss over the transition period Need to manage early expectations of investors or other stakeholders and communicate the potential impact of the changes The accounting changes beyond those specific to IFRS 9 are significant there are more requirements on disclosures and changes to the financial statement presentation. Need to consider the capital and regulatory impact Need to assess the impact on downstream systems such as client profitability and relationship manager levels CFO may take this opportunity to further align risk and finance data. The upcoming accounting changes will impact several processes and systems. The interaction between fair value hedge accounting and impairment will be more complex under the new impairment model of IFRS 9. Alignment of key controls within the new processes will be required with the adoption of IFRS 9. COOs and operational function There could be changes in IT systems due to the implementation of IFRS 9. Amendment to the existing client sectors/portfolio to the impairment credit risk model will require additional data attributes and appropriate corporate governance structures to be put in place in the related systems and processes. CEO and business The list of allowable investment products may be changed as a result of the contractual cash flow characteristics test. A mechanism to manage buying and selling activities of financial assets shall be established for the business model test. CROs and risk function The new impairment rule of calculating expected loss will require evaluating available qualitative data, data processes used by risk and reconciliation with finance. This is the most significant of all the expected changes. The new implementation will require tracking and determining significant changes in credit risk throughout the lifetime of financial assets. The proposed changes to hedge accounting may allow additional hedging opportunities but will also cause changes to existing processes. The revised approach to classification and measurement of financial instruments may result in a change in instruments that can be used by treasury. It may also impact products sold or traded by front office which will require a change in risk management considerations. Regional organizations that are moving towards centralization of their finance and risk data information may consider centralizing credit risk modelling in a center of excellence. IFRS 9 Financial Instruments for broker-dealers 3

Classification and measurement Key changes Financial assets IFRS 9 introduces a new classification model for financial assets. Financial assets are classified according to their contractual cash flow characteristics and the business models under which they are held. The synopsis on the classification of financial assets is as below: Debt (including hybrid contracts) Derivatives Equity Contractual cash flow characteristics test (at instrument level) (SPPI test) Pass Fail Fail Fail Business model assessment (at an aggregate level) (BM test) Held for trading? 1 Hold-to-collect 2 BM with objective 3 Neither (1) contractual that results nor (2) cash flows in collecting contractual cash flows and selling financial assets Yes No Conditional fair value option (FVO) elected? Yes No FVOCI option elected? No No Yes Amortised cost Fair value through other comprehensive income (FVOCI) (with recycling) Fair value through profit or loss (FVPL) Fair value through other comprehensive income (FVOCI) (no recycling) 4 IFRS 9 Financial Instruments for broker-dealers

Typical impacted financial assets Financial liabilities The only change in respect of financial liabilities is related to liabilities designated as at FVPL using the fair value option, where the fair value changes that is attributable to the change in the entity s own credit risk is presented in other comprehensive income (OCI) instead of profit or loss, unless doing so would introduce an accounting mismatch. Margin loans Debt investments Other loans and receivables Equity investments Impact and challenges Contractual Cash Flow Characteristics (SPPI) test Subjective assessment on whether the loans or receivables are consistent with a basic lending arrangement (i.e., consideration such as time value of money and credit risk). Other elements such as exposure to changes in equity prices, prepayment option, or features of interest rate reset requires further assessment to be made. Business Model (BM) test To determine an appropriate aggregate level to reflect the business objective requires judgments and collaboration between finance, risk and business. BM model may also change over time resulting in different classification. Irrevocable election The election to adopt FVOCI for equity instruments is irrevocable, and gains or losses recognized in OCI are never reclassified from equity to profit or loss. Management should carefully consider the accounting impact before electing for FVOCI. Data availability and quality The SPPI and BM tests require collaboration between business and finance to provide a wide range of data which may not currently be readily available. Policies and workflow The front to back processes (e.g. data capturing, new requirements on SPPI and BM tests) has to be refined and testing template has to be developed. Reclassification of available for sale assets The SPPI and BM tests will potentially preclude certain available for sale debt assets to be qualified as FVOCI or amortised cost, and results in FVPL. Debt investments with features such as convertibles may not pass the test. A thorough assessment has to be made for each type of securities. Fair value The exception for equity instruments to be measured at cost under IAS 39 paragraph 46(c) is no longer applicable. There potentially will be more instruments to be carried at fair value and an additional effort will be required to value these investments. IFRS 9 Financial Instruments for broker-dealers 5

Impairment Key changes IFRS 9 replaces the existing incurred loss model by forward looking expected credit loss (ECL) model. The model applies to debt instruments measured at amortised cost or at FVOCI, lease receivables, trade receivables, contract assets, loan commitments and financial guarantee contracts that are not at FVPL, with the following approaches: General approach Applies to most loans and debt securities. Entities must recognize ECLs in two stages and is determined by whether there has been a significant increase in credit risk since initial recognition. Stage 1 Stage 2 Stage 3 Loss allowance updated at each reporting date Lifetime ECL criterion 12-month ECL (credit losses that result from default events that are possible within the next 12-months) Lifetime ECL Credit risk has increased significantly since initial recognition (whether on an individual or collective basis) + Credit-impaired Interest revenue recognised Effective Interest Rate (EIR) on gross carrying amount EIR on gross carrying amount EIR on amortised cost (gross carrying amount less loss allowance) Improvement Change in credit risk since initial recognition Deterioration Simplified approach For trade receivables or contract assets that result from transactions within the scope of IFRS 15 and do not contain a significant financing component, entities are required to apply the simplified approach. For trade receivables or contract assets that do contain a significant financing component, and lease receivables, entities have a policy choice to apply the simplified approach or the general approach. It does not require tracking of changes in credit risk, but requires recognition of lifetime ECLs at all times. 6 IFRS 9 Financial Instruments for broker-dealers

Purchased or originated credit-impaired approach For financial assets that are considered to be credit-impaired on acquisition or origination, the EIR is calculated taking into account the initial lifetime ECLs in the estimated cash flows, resulting in a credit adjusted EIR. The resulting fair value at initial recognition already takes into account lifetime expected losses and there is no additional 12-month ECL allowance. Typical impacted financial assets Loan commitments not at FVPL Bank balances Margin loans Commission/ fees receivables Debt instruments at amortised cost /FVOCI Financial guarantee contracts not at FVPL Accounts receivables Lease receivables Deposits with exchange/ clearing house Reverse repurchase agreement Impact and challenges Forward looking elements Considerable judgement is required to incorporate forward looking element into the ECL model. Default rates provided by external rating agencies are historical information and may not be solely relied upon when designing the ECL model. Entities need to understand the sources and update the data for current and forward-looking information. Significant increase in credit risk Loss allowance would be measured at lifetime ECL if the credit risk on that financial instrument has increased significantly. It is crucial to set up the framework for the transfer criteria, which should be forward-looking and cannot be purely dependent on past due information or level of collateralization. Factors not in current system Entities should start to store the key factors in the systems for future use. For example EIR, rating at origination, etc. Definition of lifetime Determination of lifetime is important in ECL modeling as it drives the provisions for stage 2 exposures. Behavioral model and prepayment model are commonly used to estimate the lifetime of the financial instruments. Financial impact ECL generally results in larger loss allowances. On transition, this will reduce equity and have an impact on regulatory capital. Expanded disclosure The impairment disclosures have been expanded significantly. The objective of the new disclosures is to enable users to understand the effect of credit risk on the amount, timing and uncertainty of future cash flows. Management should plan well ahead to produce sufficiently detailed information to comply with the new requirements. Probability of default In measuring ECL, management will need to consider segmentation of margin loans based on risk characteristics (e.g. geographic, industry). Loss given default Loan-to-value ratio is one of the common indicators currently used to monitor credit risk exposures. Management is required to consider forward looking element and other key parameters in the ECL model (e.g. liquidity, concentration). IFRS 9 Financial Instruments for broker-dealers 7

Hedge accounting Key changes Hedge accounting under IAS 39 is often criticized as being complex and rule-based, ultimately not reflecting an entity s risk management activities. Consequently, the objective of IFRS 9 is to reflect the effect of an entity s risk management activities in the financial statements. The key changes are as follow: Positive changes Hedge risk components Less volatility in P/L (exclusion of time value of options, forward points and currency basis) Aggregated exposures as hedged item Elimination of the 80-125% quantitative threshold No retrospective effectiveness test Emphasis on qualitative factors for prospective effectiveness assessment Hedging using credit derivatives Expanded ability to hedge net positions or hedge layers of hedged items in fair value hedges Rebalancing instead of discontinuation and redesignation No change or neutral impact Hedge documentation required at inception Three types of hedge relationships remain the same Fair value hedge Cash flow hedge Net investment hedge Ineffectiveness is measured and booked Disadvantages Unclear how guidance on macro or dynamic cash-flow hedging is carried forward in IFRS 9 Voluntarily de-designation prohibited if risk management objective remains the same Disclosure (IFRS 7) is more onerous Impact and challenges Hedge effectiveness assessment It will be prospective and can be qualitative, depending on the complexity of the hedge. It is an objective-based test that focuses on the economic relationship between the hedged item and the hedging instrument. Management is required to determine the assessment mechanism to comply with the requirements. Effect of credit risk Judgement has to be used in determining when the impact of credit risk is dominating the value changes. Entities shall also perform and document their monitoring activities over credit risk of hedging relationships. Rebalancing mechanism An entity has to rebalance a hedging relationship if that relationship still has an unchanged risk management objective but no longer meets the hedge effectiveness requirements regarding the hedge ratio. An effective rebalancing mechanism to adjust hedge ratio has to be developed. Workflow and documentation With the objective of emphasizing on aligning accounting with risk management and the introduction of effectiveness requirement on assessing economic relationship, effect of credit risk and rebalancing mechanism etc., the existing hedge accounting workflow needs to be refined and will require involvement of business, risk management and finance. 8 IFRS 9 Financial Instruments for broker-dealers

How EY can help? Impact assessment Classification and measurement Identify in-scope financial assets Perform SPPI test and identify debt instruments that fail the test Identify portfolios and perform the BM test Analyze classification options for management s assessment and decision Quantify the resulting financial impact Identify operational impacts and gaps in data, IT systems and processes Explore methodology to fair value unlisted shares currently carried at cost Impairment Identify in-scope financial assets Collect historical data and facility data for model development Advise on expected credit loss model with forward looking element Advise on defining significant increase in credit risk Identify operational impacts and gaps in data, IT systems and processes Quantify the resulting financial impact Implementation Design policies and procedures Define a revised chart of account and develop disclosure requirements Develop: BM test template, SPPI decision tree Expected credit loss model template Hedge documentation, effectiveness testing and rebalancing templates Advise on and implement changes to processes and controls Initiate IT change requests for system modifications Provide training and knowledge transfer to relevant staff member and management Dry Run Assess readiness of the developed model, templates and processes during a dry-run Assist management in performing this trial run, observe any issues of areas for further improvement, provide recommendations for remediation and assist in their implementation Hedge accounting Design effectiveness assessment criteria Define credit risk domination Design rebalancing mechanism Explore opportunity to adopt hedge accounting under IFRS 9 IFRS 9 Financial Instruments for broker-dealers 9

Selected credentials EY is highly experienced in providing support for the planning and implementation of IFRS 9 across multiple regions, including Hong Kong, Australia and the UK. Our teams of professionals work closely with the IASB, UK and international regulators to support and drive IFRS 9 interpretations and judgments, and align the new requirements to existing accounting and regulatory capital models, helping high quality tailor-made options to be developed. Major note-issuing bank in Hong Kong Provided detailed assessment on the impact of IFRS 9 on impairment based on existing client portfolio and identified the areas with significant impact/input required by management in the implementation stage Supported and assisted the client to implement the other two topics of IFRS 9, namely classification and measurement and hedging Hong Kong branch of a leading bank in mainland China Provided gap analysis, financial impact analysis and development of expected credit loss model Supported on preparation of functional specifications for impairment model implementation Provided tools and templates for conducting the contractual cash flow characteristics test for classification and measurement Explored opportunities to develop new hedging strategies Hong Kong commercial bank Demonstrated workflows for conducting business model and contractual cash flow characteristics test Illustrated impairment modelling approaches on PD, LGD, EAD and lifetime estimate for different portfolios Demonstrated model pilot test, back testing methodology, model maintenance threshold consideration, validation standard, stress test criteria and industry practices Provided detail financial impact assessment on the impact of IFRS 9 on classification and measurement and impairment Investment bank listed in US, Japan and Singapore Conducted financial impact assessment on adoption of IFRS 9 on classification and measurement and impairment Identified operations and IT system impact to cater for IFRS 9 requirements, and the impact on local regulatory requirements Assisted to develop expected credit loss model for various types of financial assets Supported the client on development on accounting policy manuals Asset management business of an international banking group Demonstrated workflows for conducting business model and contractual cash flow characteristics test Illustrated impairment modelling approaches on PD, LGD, EAD and lifetime estimate for different portfolios Conducted sharing of pragmatic undertaking of impairment assessment, data challenges, common issues and pitfalls Advised on impact of IFRS 9 to business operation, financial results and regulatory capital requirements Global banking group in Australia EY supported the early adoption of IFRS 9 for this major Australian bank Impacts were estimated using current models with extrapolation techniques. For commercial portfolios different adjustments were made to PD, LGD and EAD to assess sensitivity of the provision output to different methods to make models IFRS 9 compliant. For retail portfolios current delinquency based models were extrapolated to assess lifetime losses, with different assumptions based upon LEL methodology and EAD Through an 18-month engagement, the client has been provided with a framework to build an IFRS 9 compliant loan loss provision model, as well as assurance and support that the model and provision calculations are able to be implemented Global UK banking group with significant operations in Hong Kong Supported the bank in assessing their readiness to implement IFRS 9 across their entire portfolio and setting out the timelines, cost and effort in a multi-year IFRS 9 roadmap Provided appropriate insight on IFRS 9 interpretations, readiness and challenges gained through supporting top tier banks globally to support the identification of pain points and potential options Provided a focused current state and gap assessment of credit risk models and measurement stress testing and forward-looking business planning policies and definitions impairment operating model, governance roles and responsibilities impairment process, systems and data Identified services options tailored for the client s business, drawing on our experience of emerging industry standards in measurement and operation under the new standard Developed an IFRS 9 implementation roadmap, identified key decision areas, effort and skill set requirements, from initiation, through design, development and parallel run to live reporting under IFRS 9 10 IFRS 9 Financial Instruments for broker-dealers

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