How does IFRS 9 Expected Credit Loss work and how to analyse ECL?
IFRS 9 Financial Instruments is an international accounting standard that sets out the classification, measurement, impairment, and derecognition of financial instruments. The standard includes an expected credit loss (ECL) model for the calculation of impairment on financial assets, replacing the incurred loss model used in previous accounting standards.
Expected Credit Loss (ECL) is a method of estimating how much money a bank may lose in the future if borrowers fail to repay their loans or other debts. This is a way to anticipate and prepare for potential losses.
ECL differs from the way credit losses were calculated in the past, where companies only considered losses that had already occurred. ECL looks forward, considering the current economic conditions and the creditworthiness of borrowers to estimate how much a bank may lose in the future.
Imagine lending money to a friend and knowing that he has lost his job, then it’s more likely that he’ll not be able to repay the loan on time or at all. In the same way, a bank that lends money to other people or businesses uses ECL to assess the risk that it won’t get its money back and make a provision for that possibility.
In short, ECL is a method of estimating expected credit losses over the life of a financial asset that is intended to improve the timeliness and transparency of the allowance for loan losses (a provision to cover losses expected in the future) and to provide a more accurate picture of the credit losses that can be expected on financial assets so that companies are better prepared for potential losses.
Three stages in ECL
Under IFRS 9, ECL is calculated in three stages:
- Stage 1: 12-month ECL, which is the expected credit loss over the next 12 months.
- This stage is applied to all financial assets, except for those that have low credit risk and are not past due.
- The calculation of 12-month ECL is based on the credit loss that is expected to occur within the next 12 months.
- This is calculated using the bank’s own assumptions about the future credit risk of the borrower.
- Stage 2: Lifetime ECL, which is the expected credit loss over the remaining life of the asset.
- This stage is applied to financial assets that have experienced a significant increase in credit risk since initial recognition.
- The calculation of lifetime ECL is based on the credit loss that is expected to occur over the remaining life of the asset. This is calculated using the bank’s own assumptions about the future credit risk of the borrower, as well as forward-looking information, such as expected changes in economic conditions.
- Stage 3: Lifetime ECL, which is the expected credit loss over the remaining life of the asset, but taking into account forward-looking information.
- This stage is applied to financial assets that have experienced a significant increase in credit risk since the end of the previous reporting period.
- The calculation of lifetime ECL is based on the credit loss that is expected to occur over the remaining life of the asset. This is calculated using the bank’s own assumptions about the future credit risk of the borrower, as well as forward-looking information, such as expected changes in economic conditions, and any other relevant information.
The framework used to determine a significant increase in credit risk is set out below.
Stage 1
- 12-month ECL
- Performing
Stage 2
- Lifetime expected credit loss
- Performing but has exhibited significant increase in credit risk (SICR)
Stage 3
- Credit-impaired
- Non-performing
The movement from one stage to another is based on the changes in credit risk of the financial assets. Financial instruments that are not already credit-impaired are originated into stage 1 and a 12-month expected credit loss provision is recognised. Instruments will remain in stage 1 until they are repaid, unless they experience significant credit deterioration (stage 2) or they become credit-impaired (stage 3). Instruments will transfer to stage 2 and a lifetime expected credit loss provision recognised when there has been a significant change in the credit risk compared to what was expected at origination.
It’s important to note that the movement between stages is not a one-time event but it’s an ongoing process. The bank should continuously assess the credit risk of its financial assets and reclassify them to the appropriate stage if there is a significant increase in credit risk.
ECL in Different Economic Cycles
Economic conditions can affect the credit risk of a borrower and, therefore, the expected credit loss on a financial asset. When economic conditions deteriorate, the risk of default on loans and other financial assets increases, which results in higher expected credit losses.
In IFRS 9, the calculation of expected credit loss takes into account forward-looking information, including the bank’s own assumptions about future economic conditions. This means that when economic conditions are expected to deteriorate, the calculation of expected credit loss should reflect this and result in higher impairment provisions.
For example, if a bank has a loan to a borrower operating in an industry that is expected to be negatively affected by a recession, the bank will need to take this into account when calculating the expected credit loss on the loan. The expected credit loss on the loan would be higher if the entity expects the borrower to default due to the recession.
It’s important to note that the ECL calculation will be different for each financial institution and will depend on the nature and level of credit risk of its financial assets and the assumptions it makes about future economic conditions. For instance,
- A multinational bank will have to run economic forecasting for all jurisdictions that require estimation of credit losses.
- Different products will require different macroeconomic indicators.
- Beyond a “foreseeable future”, GAAP and IFRS permit the use of historical data.
- Over- and under-provisioning will depend on how far apart economic forecasts and actual economic outcomes are.
What is the impact of ECL to commercial banks?
The ECL model requires banks to estimate lifetime expected credit losses on financial assets, not just credit losses incurred up to the reporting date. This may result in higher allowances and thus a decrease in reported profits.
There are several ways that ECL can impact commercial banks:
- Increased allowances: ECL requires banks to make higher allowances, which may lead to a decrease in reported profits.
- Higher loan loss reserves: Banks are required to set aside higher loan loss reserves, which may affect their capital adequacy ratios.
- Changes in loan portfolio: Banks may need to review and adjust their lending practices to ensure they are in line with ECL requirements. This may lead to changes in the type and quality of loans in their portfolio.
- Increased data and systems requirements: Banks must have robust data and systems in place to support ECL calculations.
- Increased transparency and comparability: ECL will provide more transparent and comparable information on the credit risk of financial assets, which can help investors and other stakeholders better understand a bank’s financial condition.
Overall, the impact of ECL on commercial banks will depend on the nature and level of credit risk of their financial assets and assumptions about future economic conditions. Banks will need to review and adjust their internal policies and procedures to ensure they are consistent with ECL requirements.
How does ECL align with Basel III?
Expected Credit Loss (ECL) under IFRS 9 and Basel III are both aimed at improving the measurement and management of credit risk. However, ECL focuses on the accounting treatment of credit risk, while Basel III focuses on the regulatory capital requirements for credit risk.
Basel III introduced a new framework for the calculation of expected credit losses, which is similar to the ECL model in IFRS 9. Banks are required to calculate the lifetime expected credit losses on their financial assets and to hold regulatory capital against these losses.
Both ECL under IFRS 9 and Basel III aim to improve the measurement and management of credit risk. However, ECL is an accounting standard and Basel III is a regulatory standard.
ECL under IFRS 9 will have an impact on the accounting treatment of credit risk, which will affect the reported financial results of a bank. While Basel III will have an impact on the regulatory capital requirements of a bank, which will affect the amount of capital that a bank must hold to meet the regulatory requirements.
What should retail investors focus on ECL?
Retail investors should focus on several key aspects of the expected credit loss (ECL) model when assessing the financial performance and risk of a bank.
- Impairment provisions: ECL can result in higher impairment provisions, which can lead to a reduction in reported profits. Retail investors should look at the impairment provisions as a percentage of total assets or as a percentage of revenue to understand the impact of ECL on the bank’s financial performance.
- Credit risk of the bank’s portfolio: ECL requires companies to estimate the lifetime expected credit losses on financial assets. Retail investors should look at the credit risk of the bank’s portfolio, such as the types of assets, the credit quality of the borrowers, and the geographical distribution of the assets.
- The bank’s assumptions about future economic conditions: ECL takes into account forward-looking information, such as the bank’s own assumptions about future economic conditions. Retail investors should understand the bank’s assumptions and how they might affect the credit risk of the portfolio.
- Compliance with IFRS 9: Retail investors should ensure that the bank is in compliance with IFRS 9 and understand the impact of ECL on the bank’s financial statements.
- Comparison with peers: Retail investors should compare the bank’s financial performance and credit risk with its peers to understand the impact of ECL in the context of the industry.
By understanding these key aspects of ECL, retail investors can better evaluate the credit risk and the financial performance of a company and make informed investment decisions.
