Impact on capital from IFRS9

There are many secondary impacts to consider, both operational and financial, such as the opportunities for improved pricing or collections strategies and the use of forbearance, the implications of debt sales, the requirements for monitoring, validation of more sophisticated models and the impact on capital.

One of the most significant impacts of the new IFRS9 provision standard is on capital requirements and the use of internal capital resources to meet these.Within the EU, the capital requirements regulation (CRR) set out the requirements for the calculation and reporting of an organisation’s capital requirements (the money they have to hold for expected losses (EL) and more importantly unexpected losses (UL) and how an organisation can utilise its capital resources (the cash or liquid instruments set aside to absorb these losses), in meeting these requirements.

The CRR sets out different standards and calculations based on whether you are a Standardised (STD) organisation or an Internal Ratings Based (IRB) organisation.

STD vs IRB

A STD organisation calculates its capital requirements based on a standard set of rules based on the type of asset, the level of collateral securing those assets and the level of provision for expected (or incurred) losses already raised against those assets to calculate the risk-weighted exposure amount (RWA) of those assets.

An IRB organisation has demonstrated that it is capable of calculating the RWA of the assets they have issued to customers based on their experience in a more sophisticated way, and as such the calculation is more sophisticated.

The calculation for capital requirements is similar, in that an organisation would still multiply the RWA by 8 per cent to generate a component of the capital requirement (it is normal for the RWA and therefore capital requirement to be higher under IRB for overdrafts) but the way provision is accounted for is different and it is dependent on whether provision is greater than the regulatory expected loss calculated under the CRR (found by multiplying the Basel components above; PD x LGD x EAD) in this case, £70.

There are other buffers in place and the regulator may request additional requirements but here we are only focusing on the 8 per cent minimum requirement.

So how does this all fit together?

So while many of these rules are potentially quite difficult to decipher, the basic outcomes for Capital requirement sare not.

• Typically for unsecured retail assets, RWA is larger under IRB than STD.

• Typically for secured retail assets, RWA is smaller under IRB than STD.

• Typically under either IAS39 or IFRS9 accounting standard the provision for secured assets will be smaller proportionally to the balance as a result of the effect of collateral, when compared to unsecured.

• Under STD, the provision directly affects the exposure amount and therefore the RWA.

• Under IRB, the provision does not directly affect the exposure or RWA, only the additional capital requirement as a result of the relationship with the expected losses.

How does this affect capital resources?

The CRR sets out which type and quality of capital must be used to meet the total 8 per cent minimum requirement, at least 4.5 per cent must be made of common equity tier 1 (CET1) items, no more 1.5 per cent can be made up of additional tier 1 (AT1) capital and no more than 2 per cent can be made of tier 2 (T2) capital.

The rules for what can be included are again quite complicated but a simplistic view would be:

CET1 & AT1: This is the best type of capital, for example, cash in reserve or share capital.

T2: Made up of numerous instruments, we are focusing on provisions set aside for credit losses.

The CRR also sets out the rules for how you meet these requirements, and critically for IFRS9, how the provision you set aside for losses can be used for a portion of this.

Provision is set aside for two distinct groups, provision for impaired (also known as specific provision) assets and provision for assets that are incurred but not reported (IBNR) (also known as general provision); that is, we know that an impairment has occurred but it has not yet been recognised through the customer missing a payment or requesting some type of forbearance for financial difficulties.

Under IFRS9, provisions are likely to go up substantially from IBNR provision today to the total of stage one and stage two under IFRS9. The increase is driven by two effects; because stage two will now recognise lifetime losses and; the outlook for the stage one population will increase to a minimum of 12 months – typically this represents an increase over the current IBNR loss emergence period. Provision for Impaired assets (stage three) is likely to remain broadly constant, as the treatment for these has not changed as significantly.

Under STD, only a small proportion (1.25 per cent of total RWA) of your general provision can count towards your T2 capital. Any excess requires new capital resources to cover the total of expected and unexpected losses. It is true that a rise in general provision results in a small reduction in T1 requirement as a result of the reduction in exposure, but this is not enough to offset the increase in provision that an organisation is holding. In aggregate (capital + provision) for a typical standardised bank an increase in provision will lead directly to more capital resources needing to beheld.

Under IRB, where the provision can be used depends on whether you have calculated that your regulatory expected losses is more than your provision or less. So where provision is less than your expected losses that counts towards your T1, so you still gain a benefit but this could be reduced under IFRS9. In this circumstance, the aggregate capital resources needed (provision + capital) remains constant.

Where your provision is greater than expected losses there is no benefit to T1 but that excess amount will count towards T2 up to a maximum of 0.6 per cent of total RWA. In this circumstance, the aggregate capital resources needed (provision + capital) remains constant with substitutions of T1 for T2 capital up to 0.6 per cent, and then the total increases beyond this.

So what does this all mean?

This is a complex subject (believe it or not, I have simplified much of the above) and as such to get to an answer, much thought and effort needs to be provided by individual organisations and their advisers to assess the impact for them, but the high level can be broken down to the following;

• STD organisations are likely to need more overall capital resources under IFRS9 to meet minimum requirements and to provide appropriately for losses.

• For IRB organisations the impact is more complex, and indeed depends on where in the economic cycle the assessment is taking place. During recessions, IFRS9 provision is likely to exceed regulatory expected losses and in this case there will be a capital cost in quality and possibly in total capital resources needed.

While this does put extra pressure on financial dervices firms to raise capital and probably prompts more challengers and building societies to explore their path to IRB in the short term, it should lead to a more secure industry in the long term, which must be what we are all striving towards.

Damien Burke is head of regulatory change at 4most Europe, a specialist credit risk analytics consultancy