The Interaction of the IFRS 9 Expected Loss Approach with Supervisory Rules and Implications for Financial Stability

Abstract

This paper examines the interaction of the International Financial Reporting Standard (IFRS) 9 expected credit loss (ECL) model with supervisory rules and discusses potential implications for financial stability in the European Union. Compared to the incurred loss approach of IAS 39, the IFRS 9 ECL model incorporates earlier and larger impairment allowances and is more closely aligned with regulatory expected loss. The earlier recognition of credit losses will reduce the build-up of loss overhangs and the overstatement of regulatory capital. In addition, extended disclosure requirements are likely to contribute to more effective market discipline. Through these channels IFRS 9 might enhance financial stability. However, due to the reliance on point-in-time estimates of the main input parameters (probability of default and loss given default) IFRS 9 ECLs will increase the volatility of regulatory capital for some banks. Furthermore, the ECL model provides significant room for managerial discretion. Bank supervisors might play an important role in the implementation of IFRS 9, but too much supervisory intervention bears the risk of introducing a prudential bias into loan loss accounting that compromises the integrity of financial reporting. Overall, the potential benefits of the standard will crucially depend on its proper and consistent application across jurisdictions.

Keywords:

• IFRS 9
• impairment
• expected loss model
• bank supervision
• financial stability

Acknowledgements

This paper is adapted from the following study that was conducted at the request of the European Parliament’s Committee on Economic and Monetary Affairs: Novotny-Farkas, ‘The Significance of IFRS 9 for Financial Stability and Supervisory Rules’, European Parliament, 2015, http://www.europarl.europa.eu/RegData/etudes/STUD/2015/563461/IPOL_STU(2015)563461_EN.pdf. Copyright for that study remains with the European Parliament at all times.

Disclosure Statement

No potential conflict of interest was reported by the author.

Notes

1 In general, the purpose of financial reporting is to provide transparent and useful information to a wide range of financial statement users. Bank supervisors aim at ensuring the safety and soundness of the banking system by limiting the frequency bank failures and the cost imposed on deposit insurance systems.

2 This illustration mainly follows Gebhardt and Novotny-Farkas (2011) and Benston and Wall (2005).

3 See Camfferman (2015) for a detailed account of the historical development of the incurred loss model in IAS 39.

4 In particular, the Implementation Guidance of IAS 39 is very clear that ‘[a]mounts that an entity might want to set aside for additional possible impairment in financial assets, such as reserves that cannot be supported by objective evidence about impairment, are not recognised as impairment or bad debt losses under IAS 39’ (paragraph E.4.6.).

5 This paper does not cover the Financial Accounting Standard Board's Current Expected Credit Loss (CECL) model. O’Hanlon, Noor, and Li (2016) provide a detailed discussion of the differences between the IFRS 9 expected loss model and the CECL model.

6 Basis for Conclusions paragraph 5.93 littera b and paragraph 5.150 littera a.

7 IFRS 9 Basis for Conclusions paragraph 5.88.

8 For an excellent and more detailed discussion of the different perspectives on loan loss provisioning see Wall and Koch (2000) and Benston and Wall (2005).

9 See also Bushman and Landsman (2010, p. 267).

10 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013.

11 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013.

12 CRR Article 178 paragraph 1 littera b.

13 CRR Article 178 paragraph 1 littera b.

14 CRR Article 181 paragraph 1 littera a and EBA (2015a, p. 24).

15 According to the EBA’s report, EU banks use a variety of rating philosophies that impact the comparability and procyclicality of capital requirements for banks using the IRB approach; see EBA (2013b).

16 CRR Article 181 paragraph 1 littera h.

17 This is also acknowledged by the BCBS, see BCBS (2015a, paragraph 8).

18 IASB Staff Paper 14–16 December 2011, Reference 6A, paragraph 35 littera b.

19 CRR Article 171 paragraph 2 and Article 179 paragaph 1 littera a.

20 IASB Staff Paper 14–16 December 2011, Reference 6A, paragraph 35 littera d.

21 See Article 1 paragraph 2 of Commission delegated Regulation (EU) No 183/2014 of 20 December 2013.

22 Chircop and Novotny-Farkas (2016) find that banks affected by the removal of the prudential filter on unrealised gains and losses on AFS securities decreased the amount of risky investment securities in their AFS portfolio.

23 CRR Article 467 CRR and Article 468.

24 See the EBA’s (2015c) Supervisory Disclosure document for the national options according to CRR Article 467 paragraph 2.

25 CRR Article 150 paragraph 1 littera d.

26 For example, the 2011 EBA stress test reveals that only 36 out of the 90 participating EU banks applied the IRB approach to sovereign debt, and only 20 % of the sovereign portfolio of the 90 EU banks is covered by the IRB approach (ESRB, 2015). As a result, most EU banks do not have to hold capital against any the sovereign exposures to EU Member States.

27 For example, the ‘sovereign subsidy’ for a bank from an arguably ‘safe’ country such as Germany or France would increase with the amount invested in riskier sovereign debt such as that of GIIPS countries (Greece, Italy, Ireland, Portugal and Spain). In turn, these banks would be exposed to sovereign risk in peripheral countries endangering core EU countries’ financial stability. For a detailed discussion and empirical evidence see Korte and Steffen (2015).

28 For a more detailed discussion, see Gebhardt (2016).

29 Pillar 2 is implemented in the EU in the CRD IV Directive 2013/36/EU.

30 Core Principle 17 in BCBS (2012).

31 Core Principle 18 in BCBS (2012).

32 Core Principle 18 Essential Criteria 7 in BCBS (2012).

33 See also Gaston and Song (2014).

34 See BCBS (2015a, paragraph 3) and IFRS 9 Basis for Conclusions BCE.139.

35 The EBA has issued a number of Technical Standards and Guidelines aiming to achieve consistency in supervisory practices. The EBA Standards and Guidelines are legally binding as per Article 1 paragraph 2 and Article 8 paragraph 1 littera a and b of EBA Regulation (Regulation (EU) No 1093/2010) and Article 107 CRD IV (Directive 2013/36/EU).

36 However, as discussed above, this is similar to the requirements under IFRS 9.

37 See for an overview Bushman (2016).

38 However, it should be noted that expected bail-outs, too-big-to-fail status, etc. can severely undermine market participants’ incentives to discipline banks. See, for example, Rochet (2005); Stephanou (2010).

39 For an overview of the relevant disclosure requirements see Ernst & Young (2014, pp. 79–80).

40 See EBA website: http://www.eba.europa.eu/regulation-and-policy/transparency-and-pillar-3.

41 Regulatory measures that could raise incentives for monitoring by market participants include increasing the cost of private bank failure by redesigning safety nets and credibly committing not to bail out failing banks. Furthermore, incentives for bank management to respond to market signals could be increased by strengthening corporate governance mechanisms (Stephanou, 2010, p. 7)

42 See also Gaston and Song (2014, p. 16).

43 For an overview of this literature see EBA (2013b).

44 In a similar vein, participants in the fieldwork carried out by the IASB ‘noted that the better an entity is able to incorporate forward-looking and macroeconomic data into its credit risk management models, the more responsive the loss allowance would be to changes in credit risk’ (IFRS 9 Basis for conclusions BCE.136).

45 The ‘cliff effect’ refers to an abrupt and significant increase in loan loss allowances and is illustrated in Figure 2 by the step at the Stage 1/Stage 2 threshold.

46 The IASB’s fieldwork indicates that participants ‘found it difficult to incorporate more forward-looking data (for example, macroeconomic data) at a level that enabled them to identify specific financial assets for which there have been significant increases in credit risk since initial recognition’ (IFRS 9 Basis for Conclusions BCE134).

47 These studies are extensively reviewed in Beatty and Liao (2014).

48 For a more comprehensive review of the literature on the interplay of accounting standards and bank regulation see BCBS (2015b).

49 Council Directive 86/635/EEC of 8 December 1986.