Whilst the journey to International Financial Reporting Standard 9 (IFRS 9) compliance has come at quite a cost to many credit-granting businesses, many are using the in-depth analytical exercise as an opportunity to make more informed decisions in their business.
Today we talk to one of Principa’s leading IFRS 9 analysts about some of the learnings he has acquired over many engagements with banks and retailers who have embarked on the IFRS 9 journey.
What is IFRS 9 and how has this affected businesses?
In summary, IFRS 9 requires changes to modelling and reporting practises when looking at expected credit losses (ECL). This is to address criticisms relating to impairment models that were used during the financial crisis of 2008.
A significant amount of analytical effort is required to develop an IFRS 9 solution. This may result in additional costs (from a resourcing and audit perspective). We found that the cost burden can be mitigated by using IFRS 9 to improve internal risk management and monitoring initiatives. In doing so, the IFRS 9 solution will help you understand your credit risk behaviour better. This, in turn, will allow you to tailor your origination and collection strategies to align with your strategic goals. IFRS 9 modelling and reporting suites are often best utilised when they are used for multiple purposes.
Is IFRS 9 focused on being more cautious in estimating provisions?
The focus is accuracy. The models developed need to produce an accurate provision figure to be reported on in the appropriate financial period. A figure that is too high will result in a delay in the distribution of profits. Conversely, being under-provided may result in future strain from distributing profits too early.
IFRS 9 could be used as an opportunity to interrogate existing impairment methodologies to ensure that they represent business needs appropriately. The forward looking nature of IFRS 9 provision calculations will also allow each organisation to gain a view of future scenarios that may influence the expected level bad debts.
Beyond accounting provisions reporting, how can a business leverage off the work done in IFRS 9?
Some IFRS 9 model components could be used for risk management purposes. For example:
- Early warning indicators could be developed by looking at accounts with significant increases in credit risk
- Key risk indicators could be developed by looking at the number of accounts in a certain stage and tracking the triggers defined for the “increase in credit risk”
- Market related insights are incorporated into many IFRS 9 models which will give a view of what macro-economic factors affect your portfolio
How are IFRS 9 models being used in budget setting?
We’ve worked with a variety of organisations from banks, to specialist lenders and retailers. Those who build dynamic IFRS 9 models are in a position where they can use the models for budget and scenario setting purposes. This is because most models don’t only give the required impairment figure, but show the impairment number and how this figure is expected to change under different economic circumstances. In addition, some models are developed by looking at how cash flows develop over time. This will allow the model user to determine future expected cash flows per segment.
“IFRS9 has brought businesses closer to their data. This has given them the opportunity to make more informed decisions.”
Examples of possible budgeting and scenario analytics include:
- Creating macro-economic stresses and determining their impact on impairments
- Determining the effect of writing new business on impairments
- Creating additional scenarios to assess the impact of increased purchases, payments or write-offs in the budgeting period or simply the impact of a change in effective interest rate
The IFRS9 model insights allow for a range of scenarios to be interrogated and challenged internally so that your organisation can agree on an appropriate budget or stress testing cases.
How have IFRS 9 discussions affected businesses' relationships with auditors?
At Principa we’ve had dealings with each of the Big 4 auditing firms whilst working alongside our credit-granting clients. IFRS 9, of course, requires considerable analytical effort which thereafter demands auditing.
Many of our clients have leveraged off this opportunity to have an empirically driven rigorous conversation with their auditors. We have witnessed improved relationship between client and auditor through the mutual development of a deep understanding of credit risk.
Do you have any final comments to businesses with IFRS 9 concerns?
If you are still to adopt IFRS 9, it’s not too late particularly if your financial year-end is towards the end of the calendar year. There are various approaches that could be adopted – some relatively generic and cheap and others more bespoke and costly. While both approaches may satisfy your auditor, the latter will bring more insights into your business which should benefit you in the long-run.
If you have adopted IFRS 9, you should have begun the continued monitoring of your models. If your deployed solution adopted, for example, a vintage based approach (perhaps your primary focus was on meeting a looming deadline), you might want to consider model enhancement. As discussed earlier, there are many areas where an enhanced model may bring value to the business beyond compliance requirements.
For more information on how Principa can assist you with your IFRS 9 requirements. Contact us here.
About the Author, David Hatherell
David is a fully qualified actuary with a predictive modelling background and was previously employed by a large South African bank. Being the Head of Capital and Provisions in the retail mortgage space, his main responsibilities included guiding the model calibration process for IFRS9. He is currently working in the prescriptive modelling team, assisting with IFRS9 related financial modelling and has proven experience in the financial modelling, data analytics and reporting space.