Transition in the Expected Credit Loss (ECL) model, part 1

As financial institutions still battle to report Quarter one provisions, many CFOs are still worried by the huge impairment provisions. The newly adopted International Financial Reporting Standards Nine (IFRS9) seeks to address the short comings of the International Accounting Standard 39 (IAS 39) in terms of recognition and measurement. The key emphasis brought about by IFRS 9 is the move away from an incurred loss model towards a forward looking expected credit loss model (ECL).

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In the incurred loss model, banks would report the losses after they have incurred. However, under the new ECL model, Supervised Financial Institutions (SPIs) are required to hold loss provisions against all exposures with inherent credit risk, rather than against only those assets that have actually defaulted. The requirement calls for financial institutions to make provisions on loans or investment assets from the date of origination. The impairment provisions against the financial assets are subject to change from time to time – one financial asset can shift from one stage to another depending on the economic variables and historical data of the client.

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IFRS 9 utilises three distinct credit stages to categorise impairment exposures. Financial assets are categorized accordingly in the three stages:

Stage 1 – This accommodates for performing assets that have not experienced any significant deterioration in credit quality since origination. The provisions required under IFRS 9 for these exposures are based on a 12 month expected credit loss;

Stage 2 – Assets which continue to perform against the agreed terms but there has been a significant increase in the associated credit risk since origination. Financial institutions are required to incur a lifetime expected credit loss against stage 2 exposures. The financial institution is supposed to monitor indicators that trigger an increase in credit risk.

Stage 3 – Here, actual loss has incurred. This stage aligns with the previous IAS 39 incurred loss model where a provision was only made when there was objective evidence of impairment. Stage 3 assets are also required to incur a lifetime expected credit loss provision. 

The transition of a financial asset from stage 1 to stage 2 assets and the associated change in provisioning methodology for such assets is driven by whether or not the exposure has experienced a significant increase in credit risk. However, IFRS 9 does not explicitly define what can be considered a significant increase in credit risk. Individual financial institution must monitor indicators that signal an increase in credit risk.

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In part 2, we will explain factors financial institutions need to monitor to inform a rise in the credit risk of your customers.

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