IFRS 9 and CECL Credit Risk Modelling and Validation: A Practical Guide with Examples Worked in R and SAS

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Chapter 1

Introduction to Expected Credit Loss Modelling and Validation

Abstract

As a response to incurred losses criticisms, both the International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB) worked to redesign accounting standards towards an expected credit loss paradigm. The aim was to anticipate loss recognition by avoiding issues experienced—in particular—during the 2007–2009 financial crisis. Starting from an initial joint effort for a unique solution, IASB and FASB agreed on common principles, but then issued two separated standards. IASB's International Financial Reporting Standard number 9 (IFRS 9), issued in 2014, relies on a three-bucket classification, where one-year or lifetime expected credit losses are computed. On the contrary, FASB's Current Expected Credit Loss (CECL) accounting standard update 2016–13 (topic 326: credit losses) follows a lifetime perspective as a general rule. IFRS 9 and CECL are separately introduced in Sections 1.2 and 1.3 to point out their similarities and differences. Then the focus is on the link connecting expected credit loss estimates and capital requirements as detailed in Section 1.4. As a final step, a book overview is provided in Section 1.5 as a guide for the reader willing to grasp on overview of the entire expected credit loss modelling and validation journey.

Keywords

Current expected credit loss (CECL); expected loss (EL); International financial reporting standard number 9 (IFRS 9); point-in-time (PIT) estimate; risk weighted assets (RWAs); through the cycle (TTC) estimate; unexpected loss (UL)

As a response to incurred losses criticisms, both the International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB) worked to redesign accounting standards towards an expected credit loss paradigm. The aim was to anticipate loss recognition by avoiding issues experienced—in particular—during the 2007–2009 financial crisis.

Starting from an initial joint effort for a unique solution, IASB and FASB agreed on common principles, but then issued two separated standards. IASB's International Financial Reporting Standard number 9 (IFRS 9), issued in 2014, relies on a three-bucket classification, where one-year or lifetime expected credit losses are computed. On the contrary, FASB's Current Expected Credit Loss (CECL) accounting standard update 2016–13 (topic 326: credit losses) follows a lifetime perspective as a general rule.

IFRS 9 and CECL are separately introduced in Sections 1.2 and 1.3 to point out their similarities and differences. Then the focus is on the link connecting expected credit loss estimates and capital requirements, as detailed in Section 1.4. As a final step, a book overview is provided in Section 1.5 as a guide for the reader willing to grasp on overview of the entire expected credit loss modelling and validation journey.

Key Abbreviations and Symbols

CECL Current expected credit loss

 Exposure at default for account i in sub-portfolio s at time t

ECL Expected credit loss

FASB Financial Accounting Standard Board

IASB International Accounting Standard Board

IFRS International financial reporting standard

 Loss given default for account i in sub-portfolio s at time t

 Probability of default for account i in sub-portfolio s at time t

PIT Point-in-time

RWA Risk weighted asset

TTC Through the cycle

UL Unexpected loss

1.1 Introduction

Since the adoption of the incurred losses archetype by both IASB and FASB, a series of concerns have been expressed about the inappropriateness of delaying the recognition of credit losses and balance sheet financial assets overstatement. The recent (2007–2009) financial crisis uncovered this issue to its broader extent by forcing a profound review of accounting standards, culminating with the International Financial Reporting Standard number 9 (IFRS 9) (IASB, 2014) and Current Expected Credit Loss (CECL) (FASB, 2016). IFRS 9 goes live in 2018 by considering not only expected credit loss (ECL) rules, but also classification mechanics and hedge accounting. Hereafter, our focus is limited to ECLs. On the other hand, FASB's new impairment standard will be effective for SEC filers for years beginning on or after December 15, 2019 (with early adoption permitted one year earlier), and one year later for other entities.

The key innovation introduced by new accounting standards subsumes a shift from a backward-incurred-losses perspective towards a forward-looking ECL representation. This change implies a deep review in terms of business interpretation, computational skills and IT infrastructures. Furthermore, a deeper senior management involvement is at the very heart of new accounting standards practical implementation. A holistic perspective is required in such a complex framework involving widespread competences to be aligned on a common goal.

Figure 1.1 summarises the key areas touched in this chapter as an introduction to the main topics discussed throughout the book.

Figure 1.1 ECL engine: topics explored throughout the chapter.

•  IFRS 9. Despite the non-prescriptive nature of the accounting principle, common practice suggests relying on the so-called probability of default (PD), loss given default (LGD) and exposure at default (EAD) framework. Banks estimate ECL as the present value of the above three parameters' product over a one-year or lifetime horizon, depending upon experiencing a significant increase in credit risk since origination. Section 1.2 starts by describing the key principles informing the staging allocation process. Three main buckets are considered: stage 1 (one-year ECL), stage 2 (lifetime ECL), stage 3 (impaired credits). The focus, then, moves on ECL key ingredients, that is, PD, LGD, EAD. A forward-looking perspective inspires IFRS 9 by emphasising the role of economic scenarios as a key ingredient for ECL computation. Based on this, an easy parallel can be drawn between ECL and stress testing.

•  CECL. Few methodologies are mentioned under FASB (2016) to compute ECLs. In this regard, Section 1.3 provides an overview of approaches one may adopt to align with CECL requirements. Loss-rate, vintage and cash flow methods are inspected by means of illustrative examples. These non-complex approaches are not further investigated throughout the book. Indeed, the focus of the book is on more complex methods based on PD, LGD and EAD to leverage similarities with IFRS 9.

•  ECL and capital requirements. Section 1.4 highlights some of the key connections linking accounting standards and regulatory capital requirements. Firstly, internal risk-based (IRB) weighted assets are introduced. Secondly, expected credit losses are scrutinised in the context of regulatory capital quantification. IFRS 9 and CECL impact on common equity Tier 1, Tier 2 and total capital ratios is pointed out by means of a few illustrative examples.

•  Book structure at a glance. Both IFRS 9 and CECL require an outstanding effort in terms of data, modelling and infrastructure. A deep integration is required to coherently estimate ECLs. For this reason Section 1.5 provides a guide for the reader through the journey. An introduction to each chapter is provided together with a narrative highlighting the key choices made in presenting each topic.

1.2 IFRS 9

The recent (2007–2009) financial crisis urged a response not only from a capital perspective, but also from an accounting point of view. Indeed, BIS (2011) introduced new constraints to banking activity and enforced existing rules. Capital ratios were strengthened by defining a consistent set of rules. Leverage ratio was introduced as a measure to prevent banks expanding their assets without limit. Liquidity ratios (that is, liquidity coverage ratio and net stable funding ratio) constituted a response to liquidity problems experienced during the crisis. Finally, stress testing was used as a key tool to assess potential risks on a wider perspective by encompassing economic, liquidity and capital perspectives all at once.

From an accounting perspective, IASB introduced the new principle, IFRS 9 (IASB, 2014). Its most important innovation refers to credit losses estimation. In terms of scope, the new model applies to:

•  Instruments measured at amortised cost. Assets are measured at the amount recognised at initial recognition minus principal repayments, plus or minus the cumulative amortisation of any difference between that initial amount and the maturity amount, and any loss allowance. Interest income is calculated using the effective interest method and is recognised in profit and loss.

•  Instruments measured at fair value through other comprehensive income (FVOCI). Loans and receivables, interest revenue, impairment gains and losses, and a portion of foreign exchange gains and losses are recognised in profit and loss on the same basis as for amortised cost assets. Changes in fair value are not recognised in profit and loss, but in other comprehensive income (OCI).

A necessary condition for classifying a loan or receivable at amortised cost or FVOCI is whether the asset is part of a group or portfolio that is being managed within a business model, whose objective is to collect contractual cash flows (that is, amortised cost), or to both collect contractual cash flows and to sell (that is, FVOCI). Otherwise, the asset is measured at fair values profit and loss, and ECL model does not apply to instruments measured at fair value profit and loss (for example, trading book assets).

Figure 1.2 summarises the key topics investigated throughout Section 1.2.

Figure 1.2 Workflow diagram for Section 1.2.

Section 1.2.1 introduces the staging allocation process. Indeed, IASB (2014) relies on the concept of significant increase in credit risk to distinguish between stage 1 and stage 2 credits. For stage 1, one-year ECL holds, whereas for stage 2 lifetime ECL needs to be computed. Stage 3 refers to impaired credits and lifetime ECL applies. Section 1.2.2 provides an overview of the key ingredients commonly used to compute ECL. Indeed, apart from simplified approaches, probability of default (PD), loss given default (LGD) and exposure at default (EAD) are key elements for ECL estimate.

1.2.1 Staging Allocation

IFRS 9 standard (IASB, 2014) outlines a three-stage model for impairment based on the following:

•  Stage 1. This bucket includes financial instruments that have not had a significant increase in credit risk since initial recognition or that have low credit risk at the reporting date. For these assets, one-year ECL is recognised and interest revenue is calculated on the gross carrying amount of the asset (that is, without deduction for credit allowance). One-year ECL is the expected loss that results from default events that are possible within one year after the reporting date.

•  Stage 2. Financial instruments that experienced a significant increase in credit risk since initial recognition, but that do not have objective evidence of impairment are allocated to stage 2. For these assets, lifetime ECL is recognised. Interest revenue is still calculated on the gross carrying amount of the asset. Lifetime ECL refers to all possible default events over the expected life of the financial instrument.

•  Stage 3. Assets that have objective evidence of impairment at reporting date are allocated to stage 3. For these assets, lifetime ECL is recognised and interest revenue is calculated on the net carrying amount (that is, net of credit allowance).

In line with the above, the definition of significant increase in credit risk plays a key role throughout the entire IFRS 9 process. Indeed, this is the trigger causing ECL to be computed over a one-year instead of lifetime horizon. Reasonable and supportable information—available without undue cost or effort—including past and forward-looking information, are at the very root of the decision. Few presumptions inform this process as listed