IFRS 9. Behind the Scenes of the Standard

04/ 04/ 2019

Vitaliy Gavrish. AC Crowe Ukraine The European financial sector, along with the European economy, as you well know, was affected by the global crisis in 2008. Such developments required action to reduce the adverse effect, accordingly. The actions taken turned to result in the classical set of much noise, confusion, looking for the ‘guilty’ party, punishment of the innocent, and reward of the ones that had nothing to do with the said. The introduction of IFRS 9 Financial Instruments as a guarantee of preventing financial crises in the future appeared in the run the icing on the cake. What is the way for IFRS 9 to protect the financial stability? The answer comes easy. The Standard obliges the financial participants to adequately assess the credit risks, on the one hand, and bans application of financial instruments for ‘dressed up’ financial results, on the other. What is the proposed way to implement the idea? The world is as old as the hills. The solution came with the Basel regulatory mechanisms embodied and implemented into IAS 39. The result was a newborn Frankenstein, which hardly anyone understands or loves, and which is at any means, in the long run, avoided. What is wrong with IFRS 9? Firstly, Basel is a merely regulatory mechanism to assist national banks with supervision and controls over the banking system as a whole. Unlike the IFRS based on the ongoing concern principle, Basel rests on one-year business continuance for an entity. Besides, as opposed to the IFRS Basel doesn’t consider each entity/institution unique. Such peculiarities once included into the IFRS shook a fairly simple and strictly arranged conceptual framework of the latter. Secondly, it suggests that the expected credit losses model be applied, which is too complicated and requires the informational flows. That, in its turn, leads to require involvement of experts to implement it and provide further support. Thirdly, it is the cost of IFRS 9 implementation as unpleasantly discovered, which, to some good extent, shocked financial companies, and banks, in particular. For many, such expenses exceeded the cost of audit for the entire 5 years’ length. If they had spent these funds on the design and development of methods to mitigate financial risks, the result would have been much more useful. All the above-mentioned particulars resulted in a number of IFRS 9 as restated and modified/amended. The first of the versions came to life in 2009 and the latest was published in 2014. Next, it took three years to implement the Standard. Where it took so long for the Standard to see life, could it critically affect financial reports, especially those by banks? As it was forecast the provisions against the credit risk had to increase multiple times and the performance volatility related to the transactions with capital tools had to grow essentially. In the end, the facts turn out to be at the extreme. The provisions could see an average increase by 5%, which may be deemed a statistics deviation. At the same time, the performance volatility associated with the transactions of capital instruments remained unchanged. As regards the implementation of IFRS 9, Sue Lloyd, the Vice-Chair of the IASB, sounded somewhat ambiguous. Let’s take a closer look at the expected credit losses model, the cornerstone of IFRS 9. Under the previous standard, the formula of computing credit losses looked this way, CL = EAD * PD (historical) * LGD (historical). Under IFRS 9, it transformed into ECL = EAD * PD (expected) * LGD (expected). There is no difference traceable for a non-technical or lay-person. On top of that, it is not every expert, who can explain the fundamental differences. It might take hours and hours to discuss the construction of the expected PD and LGD but from a statistics point of view and accounting for more or less long-term timespans, such will refer to match the historical ones. The so-called IFRS 9 experts enjoy a special flavor in a time-consuming and complicated explanation of the differences in approaches to valuation and measurement of the provisions based on an earlier response to the financial deterioration of the counterparty. At this moment, one may find one and small but critical substitute. They claim that following the preceding standard the credit risk level was growing jump-free, which may play for the newly adopted standard to adjust. In my opinion, it is one of the biggest economic tricks. With a significant experience in banking and awareness of responsibility, please kindly follow that the previous and current methods of calculating credit losses rest on the same principles. It does not matter whether it is Weibull’s function or Markov’s chains. The basic principle is the migration of a financial asset from one quality basket into the other. To this end, one might hardly predict any new happenings in the near future. In confirmation of my standing, you may kindly pay attention to the fact that the previous and newly adopted standards allow for the simplified matrices approach to valuation of the credit risk that has been subject to no change. In addition, the mentioned is not viewed as interesting as the question of who became the beneficiary from the implementation of the standard? Strange as it may seem, but we can see those who had to prevent the financial crisis, i.e. the companies both large-scale and highly-rated, and audit firms. The former were developing algorithms for calculating expected credit losses, while the latter were introducing those designed algorithms to finally enjoy mountable fees. If they had been definitely keen on identified cause for the financial crisis and prevent it, first of all, the European structures would have investigated the ways of rating agencies forecasting the developments and auditors verifying financial statements of bankrupting / bankrupted banks. For instance, the playwrights of Big Short conducted a small investigation and detected relations between the financial crisis and actions by the BIG-3 and the BIG-4. What is the most pragmatic way to implement IFRS 9? Firstly, avoid going for too complicated calculation algorithms of the expected credit losses. The complexity of the algorithm does not obligatorily mean its quality. IFRS 9 allows for application of various simplifications and they are worth applying. Secondly, approach the expenses reasonably. In the course of implementation do your best to follow your best practices and your own resources. Consider not only the cost of implementation but also that of support, for example, the actual market and expert data. Thirdly, pay due attention to the internal accounting processes of financial instruments and informational flows to service such. IFRS 9 shifts responsibility in the accounting course, from bookkeepers and accountants to the transaction initiators, i.e. from back office to front office. That altogether enables you to optimize processes on balance.

Vitaliy Gavrish

AC Crowe Ukraine

The European financial sector, along with the European economy, as you well know, was affected by the global crisis in 2008. Such developments required action to reduce the adverse effect, accordingly. The actions taken turned to result in the classical set of much noise, confusion, looking for the ‘guilty’ party, punishment of the innocent, and reward of the ones that had nothing to do with the said. The introduction of IFRS 9 “Financial Instruments” as a guarantee of preventing financial crises in the future appeared in the run the icing on the cake.

What is the way for IFRS 9 to protect the financial stability? The answer comes easy. The Standard obliges the financial participants to adequately assess the credit risks, on the one hand, and bans application of financial instruments for ‘dressed up’ financial results, on the other.

What is the proposed way to implement the idea? The world is as old as the hills. The solution came with the Basel regulatory mechanisms embodied and implemented into IAS 39.

The result was a newborn Frankenstein, which hardly anyone understands or loves, and which is at any means, in the long run, avoided.

What is wrong with IFRS 9?

Firstly, Basel is a merely regulatory mechanism to assist national banks with supervision and controls over the banking system as a whole. Unlike the IFRS based on the ongoing concern principle, Basel rests on one-year business continuance for an entity. Besides, as opposed to the IFRS Basel doesn’t consider each entity/institution unique. Such peculiarities once included into the IFRS shook a fairly simple and strictly arranged conceptual framework of the latter.

Secondly, it suggests that the expected credit losses model be applied, which is too complicated and requires the informational flows. That, in its turn, leads to require involvement of experts to implement it and provide further support.

Thirdly, it is the cost of IFRS 9 implementation as unpleasantly discovered, which, to some good extent, shocked financial companies, and banks, in particular. For many, such expenses exceeded the cost of audit for the entire 5 years’ length. If they had spent these funds on the design and development of methods to mitigate financial risks, the result would have been much more useful.

All the above-mentioned particulars resulted in a number of IFRS 9 as restated and modified/amended. The first of the versions came to life in 2009 and the latest was published in 2014. Next, it took three years to implement the Standard.

Where it took so long for the Standard to see life, could it critically affect financial reports, especially those by banks? As it was forecast the provisions against the credit risk had to increase multiple times and the performance volatility related to the transactions with capital tools had to grow essentially. In the end, the facts turn out to be at the extreme. The provisions could see an average increase by 5%, which may be deemed a statistics deviation. At the same time, the performance volatility associated with the transactions of capital instruments remained unchanged.

As regards the implementation of IFRS 9, Sue Lloyd, the Vice-Chair of the IASB, sounded somewhat ambiguous.

Let’s take a closer look at the expected credit losses model, the cornerstone of IFRS 9. Under the previous standard, the formula of computing credit losses looked this way, CL = EAD * PD (historical) * LGD (historical). Under IFRS 9, it transformed into ECL = EAD * PD (expected) * LGD (expected).

There is no difference traceable for a non-technical or lay-person. On top of that, it is not every expert, who can explain the fundamental differences.

It might take hours and hours to discuss the construction of the expected PD and LGD but from a statistics point of view and accounting for more or less long-term timespans, such will refer to match the historical ones.

The so-called IFRS 9 experts enjoy a special flavor in a time-consuming and complicated explanation of the differences in approaches to valuation and measurement of the provisions based on an earlier response to the financial deterioration of the counterparty. At this moment, one may find one and small but critical substitute. They claim that following the preceding standard the credit risk level was growing jump-free, which may play for the newly adopted standard to adjust.

In my opinion, it is one of the biggest economic tricks.

With a significant experience in banking and awareness of responsibility, please kindly follow that the previous and current methods of calculating credit losses rest on the same principles. It does not matter whether it is Weibull’s function or Markov’s chains. The basic principle is the migration of a financial asset from one quality basket into the other. To this end, one might hardly predict any new happenings in the near future.

In confirmation of my standing, you may kindly pay attention to the fact that the previous and newly adopted standards allow for the simplified matrices approach to valuation of the credit risk that has been subject to no change.

In addition, the mentioned is not viewed as interesting as the question of who became the beneficiary from the implementation of the standard? Strange as it may seem, but we can see those who had to prevent the financial crisis, i.e. the companies both large-scale and highly-rated, and audit firms. The former were developing algorithms for calculating “expected credit losses,” while the latter were introducing those designed algorithms to finally enjoy mountable fees.

If they had been definitely keen on identified cause for the financial crisis and prevent it, first of all, the European structures would have investigated the ways of rating agencies forecasting the developments and auditors verifying financial statements of bankrupting / bankrupted banks. For instance, the playwrights of Big Short conducted a small investigation and detected relations between the financial crisis and actions by the BIG-3 and the BIG-4.

What is the most pragmatic way to implement IFRS 9?

Firstly, avoid going for too complicated calculation algorithms of the expected credit losses. The complexity of the algorithm does not obligatorily mean its quality. IFRS 9 allows for application of various simplifications and they are worth applying.

Secondly, approach the expenses reasonably. In the course of implementation do your best to follow your best practices and your own resources. Consider not only the cost of implementation but also that of support, for example, the actual market and expert data.

Thirdly, pay due attention to the internal accounting processes of financial instruments and informational flows to service such. IFRS 9 shifts responsibility in the accounting course, from bookkeepers and accountants to the transaction initiators, i.e. from back office to front office. That altogether enables you to optimize processes on balance.