leveraging risk rating capabilities for ifrs 9...

Leveraging Risk Rating Capabilities for IFRS 9 Impairment Calculations

December 8, 2015Emil Lopez

2Leveraging Risk Rating Capabilities for IFRS 9

Introduction

» Emil Lopez is an Engagement Manager in the ERS Services Group, based in New York, where

he leads risk rating and stress testing modeling projects for DFAST and CCAR institutions, and

spearheads the design of IFRS 9 solutions at Moody’s Analytics.

» Prior to joining the advisory group, Mr. Lopez oversaw operations for Moody's Analytics Credit

Research Database, one of the world's largest private firm credit risk data repositories, and was

the lead author of the semi-annual Middle Market Risk Report.

» Mr. Lopez received his MBA from New York University and received his BS in finance and

business administration from the University of Vermont.


Agenda

1. IFRS 9 Introduction

2. Key Implementation Challenges

3. Leveraging Existing Capabilities

4. How Moody’s Can Help


IFRS 9 Introduction1


» IFRS 9 is IASB’s response to the financial crisis and is intended to improve the accounting and

reporting of financial assets and liabilities. IFRS 9 replaces IAS 39 with a unified standard.

» In July 2014, IASB finalized the impairment methodology for financial assets and commitments.

» The mandatory effective date is January 1, 2018; however, the standard is available for early

adoption. Furthermore, the impact of the institution’s “own credit” changes can be applied early in

isolation.

» IFRS 9 covers three areas with profound implications.

IFRS 9 Objectives

Classification & Measurement

• Introduction of a logical approach for the classification of financial assets driven by cash flow characteristics and the business model in which an asset is held. This single, principle-based approach replaces existing rule-based requirements that are complex and difficult to apply.

Impairment

• Introduction of a new expected loss impairment model that will require more timely recognition of expected credit losses. Specifically, the new standard requires entities to account for expected credit losses from when financial instruments are first recognized, and it lowers the threshold for recognition of full lifetime expected losses.

Hedge Accounting

• The new model represents a substantial overhaul of hedge accounting that aligns the accounting treatment with risk management activities, enabling entities to better reflect these activities in their financial statements.


IFRS 9 Impairment Model

» One single impairment model that applies to all financial instruments in scope

– Financial assets that are debt instruments measured at amortized cost or FVOCI (loans, debt

securities, trade receivables)

– Lease receivables

– Loan commitments and financial guarantee contracts that are not measured at FVTPL

– Contract assets in the scope of IFRS 15

» A probability-weighted forward-looking expected loss model, instead of “incurred loss”

model in IAS 39

– It is no longer necessary for a credit event to have occurred before credit losses are recognized

– The measurement of allowance of credit loss depends on the instrument’s impairment stages

– An entity is required to base its assessment and measurement of expected credit losses on

historical, current, and forecasted information that is available without undue cost or effort


Impairment recognition: a forward-looking “expected credit loss” model

Increase in credit risk since initial recognition*

Stage 1 Stage 2 Stage 3

» As soon as a financial

instrument is originated or

purchased

» 12-month expected credit

losses are recognized in P&L

and a loss allowance is

established

» Serves as a proxy for the initial

expectation of credit losses

» If the credit risk increases

significantly from when the

entity originates or purchases

the financial instrument, the

resulting credit quality is not

considered to be low credit risk

» Lifetime expected credit losses

are recognized

» If the credit risk of a financial

asset increases to the point

that it is considered credit

impaired

» Financial assets in this stage

will generally be individually

assessed

» Lifetime expected credit losses

are recognized

*Special measurement requirement applies to purchased or originated credit-impaired financial assets, trade and lease receivables, and contract assets

Lifetime

1yr

ECLLifetime

1yr

ECLLifetime

1yr

ECL


Credit Loss calculation for IFRS 9

ECL = σPD x LGD x EAD x DF

» Point-in-Time PD required

» PDs needs to be extrapolated

over the remaining expected

lifetime of the asset

» Discount factor calculated

through current market rate or

Effective interest rate (EIR)

method

» Cash-flows through the lifetime of

the asset

» Usage model to determine EAD

through the lifetime of the asset.

» Point-in-time LGD required; not

LGD using downturn scenario

» LGD term structure over the

lifetime of the asset


Key Implementation Challenges2


Key Implementation Challenges

» The standard is silent on some topics in the new requirements, e.g. discount rate,

definition of “undue cost or effort”

» Finding the right balance between high quality and practicality

» Dynamic and granular portfolio segmentation

» Transfer criteria for significant credit risk

» Measuring expected credit losses

» Including forward-looking information in the impairment model

» Data requirements

» Systems, processes & automation

» Underwriting & limits systems


Leveraging Existing Capabilities3


Essential Activities for Successful Deployment of IFRS 9 Impairment Framework

• Existing practices

• Portfolio segmentation

• Stage classification

• Modeling approach for Lifetime EL

Segmentation, Modeling &

Transferring Criteria

• Forward looking adjustments

• Model acquisition, development, or enhancement

• Model validation

Model Deployment

• IFRS9 Provision Construction

• Sensitivity Analysis

Provision Simulation

• Management Communication

• Implementation Recommendation

Change Management/

Implementation

Phase 1 Phase 2 Phase 3 Phase 4

~8 weeks ~6-8 weeks

Roadmap Design

~12-24 weeks ~4-6 weeks


Roadmap Design Activities

» Model availability (i.e.,

Basel models, stress test

models) across different

portfolios

» Default definition and

modeling approach

» Existing provision

policies and processes

» Existing provision levels

Review Existing

Practices

» Size and complexity of

the institution

» Materiality of the

segments

» Availability of risk

modeling tools

» Data availability

» Credit risk profile

Evaluate Portfolio

Segmentation

» Existing credit policies

» Rating model risk drivers

» Rating granularity

» Monitoring and forbearance

detection processes

» Rebuttable presumption of

30-days past due

» External benchmarks of

“low risk”

» Alternatives definitions of

“significant” increase in

credit risk (relative,

absolute, etc.)

Evaluate Stage

Classification

Approaches

» Segment materiality

» Existing model

soundness,

effectiveness, and

degree of alignment with

IFRS 9 requirements

» Availability of

commercial solutions

» Data availability

» Existing credit policies

Evaluate EL

Modeling

Approaches


Illustrative Stage Classification Framework

Starting point

Bank-specific assessment


Potential Methodologies for Estimating Expected Credit Losses

The proposed guidance allows for portfolio-specific methodologies for estimating expected credit losses

Discounted Cash

Flow Model (DCF)

» Forecast future cash flows (or cash shortfalls) over the remaining term

» Discount the cash flows at the effective interest rate

» ECL is the Amortized Cost Basis less the PV of expected Future Cash Flows

Loss Rate

» Apply a historic loss rate percentage, usually at the segment and risk-grade level

» Update/adjust for current conditions and supportable forecasts

» Provision matrices where loss rates are applied to aging category (e.g., trade receivables)

Roll Rate

» Most common for retail portfolios

» The percentage of accounts or dollars that “roll” from one stage of delinquency to the next

» Update/adjust for current conditions and supportable forecasts

PD, LGD, and EL

» Widely used

» Provides the greatest insight into the ECL estimate

» Typically delivered through single-obligor models or scorecards for wholesale portfolios


Evaluating Loss Modeling Approaches

Segment / Model

Decision

Sustain Enhance DevelopBuy

“Fine as is” “Adjust existing

model”

“Acquire vended

model”

Borrow

“Use Stress

Testing model”

“Build new

model”

Deployment Timeline/Cost

LOW HIGHAlignment with IFRS 9 Requirements

Illustrative Loss Modeling Decision Tree

» Such a decision tree will help ensure the institutions are leveraging existing rating

and stress testing capabilities to the extent possible


How Moody’s Can Help4


Moody’s Offering for Modelling IFRS 9

Advisory Services offer a

comprehensive solution to

identify the best IFRS 9 models for

the Institution

Moody’s is a market leader for

point-in time PD and LGD models.

Models can be used for

benchmarking as well as

forecasting IFRS 9 impairment.

Moody’s provides with a

comprehensive set of

Macroeconomic Scenarios for

all the IFRS 9 needs

Moody’s manages a vast set of

data for modelling purposes

providing historical and full

segment coverage.

Scenario

Analyzer


19

» IFRS 9 EL Benchmarking provides PD, LGD, and EL estimates for user defined

cohorts. It provides client’s a benchmark to their own internal data or can

supplement for areas where data is limited. Need Data?

Have Internal

Rating?

» EL Calculator for IFRS 9 provides a link between a Moody’s rating and an IFRS 9

compliant PD/LGD/EL term structure. In addition the tool has forecast

capabilities for IFRS 9 requirements based on one or many scenarios.

Need Rating

Models?

» Our PD and LGD models cover major asset classes including commercial and

industrial (C&I), commercial real estate (CRE), and various retail segments (auto,

mortgage, etc.). The models can deployed off the shelf or calibrated to the

collective experience of member institutions.

Need Repeatable

Calculation

Platform?

» Scenario Analyzer is a software platform that can be utilized to automate the

IFRS 9 calculations and can link directly into different accounting systems.

Moody’s Analytics Tools to Support IFRS 9 Impairment Calculation


Stage Classification and Loss Estimation Services

Risk Measure Conversion/ Adjustment

Portfolio Segmentation

Stage Classification

Criteria

PD/LGD Modeling &

Benchmarking

EAD Modeling

Cash Flow Modeling

Multi-Year EL Calculation


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