IASB delivers expected credit loss model

Jan 22, 2015

Blog URL:

http://www.sageworks.com/blog/post/2014/07/25/IASB-delivers-expected-credit-loss-model.aspx

Despite much deliberation and an initial desire to converge ideologies, the International Accounting Standards Board (IASB) and its American counterpart, the Financial Accounting Standards Board (FASB) were unable to draft uniform revisions to the current incurred loss model for the ALLL. Due to fundamental disagreements on how impairments should be modeled, the two bodies diverged and set out to issue their own standards relating to the calculation of the ALLL.

Yesterday, on Thursday, July 24th, the IASB took action.

In the effort to develop a more forward-looking “expected loss” approach for recognizing credit losses, the IASB issued a new international standard, known as IFRS 9. Under this new model, financial institutions must recognize both losses that have already occurred, as well as losses that are expected in the future. This is a substantial change from the former IAS 39 model, in which institutions were only required to recognize a loss when it was incurred.

The new IFRS 9 Financial Instruments will go into effect on January 1st, 2018 and will be the new standard for recognizing credit losses in over 100 countries. This has notable ramifications for all financial institutions that may be impacted by the standard.

For one, the new model accelerates the rate at which losses will be reflected on the balance sheet. Whereas before, a loss would only be recognized as it was incurred, the new model will require that banks recognize a loss once it is expected. In addition, the data requirements for effectively measuring loss are far more demanding under the new model (below image details data requirements needed for CECL as proposed). In order to calculate the loss allowance under IFRS 9, institutions must now take into consideration both historic AND forecast information. This change in legislation is a byproduct of the financial crisis of 2008, among other things, when banks’ reserves were undercapitalized with respect to the condition of their loan portfolios. The intention of IFRS 9 is to make reserves more representative of actual credit losses by recognizing appropriate losses when they are expected.

One notable country that will not governed by the new IFRS 9 standards is the United States. Instead, the US will be subject to the FASB’s new Current Expected Credit Loss model (CECL), expected to be released in the coming months. The former divergence of the IASB and FASB was the result of fundamental differences in how each body believed institutions should account for credit losses. The IASB, in its new IFRS 9 legislation, does not call for lifetime expected losses to be recognized unless there is evidence of deteriorating credit quality. That is in stark contrast to the proposed CECL model which calls for recognition of losses over the life of the loan, requiring institutions to recognize losses at the origination of the loan (even if the loan is fully performing). This concept is intended to bring further transparency into an institution’s overall credit risk and the methodology by which they allocate provisions.

The IASB’s IFRS 9 and the FASB’s CECL model, in theory, should result in more timely recognition of expected credit losses, and should better position institutions’ reserves to be reflective of the economic environment. Many bankers expect this to result in increased ALLL levels to the tune of 30-50 percent. As such, the proposals are met with mixed levels of approval, and until today, varying levels of skepticism as to whether they would actually be enacted. With the emergence of IFRS 9 by the IASB, however, it would be difficult to refute the emergence of a new American accounting standard for the ALLL. The advent of IFRS 9 is likely to shift many American bankers’ eyes in the direction of FASB, and one can only anticipate we will be hearing more of CECL in the near future.

For more information on FASB’s proposed CECL model, and what it means for financial institutions, reference our whitepaper, FASB’s CECL Model: How to Prepare NowOr, register for the upcoming webinar, IASB’s Model Finalized: How Will It Impact Us?