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BASEL III AND IFRS 9: THEIR INTERSECTION AND IMPLEMENTATION

CHALLENGES ON BANKS IN SOUTH AFRICA

Abstract

Financial Institutions are fast becoming, if not are already, the most regulated industry globally. Two pieces of regulation stand out in this discussion as the most recent guidelines to be complied with: Basel III and the Internal Financial Reporting Standards (IFRS) particularly IFRS 9. Both have been produced or accelerated into publication in response to the most recent financial crisis of 2007-09 to address flaws in the financial system namely capital management and impairment methodology. Basel III seeks to address capital management and strengthen capital adequacy, and IFRS 9 seeks to revamp accounting practices and to improve impairment methodology. The relationship between accounting for loan losses and capital adequacy however is sparsely understood. This research report seeks to investigate and illuminate how these two pieces of regulation relate to one another as they work concurrently in banks. It finds that there is an interconnected relationship between impairing assets, raising provisions for the impairment, retaining earnings, equity value, and capital adequacy. With the advent of IFRS 9 the requirements are such that all assets on the balance sheet are required to be impaired, increasing the need to raise provisions through the income statement. This decreases net income and therefore reduces the ability of banks to raise capital through retained earnings. The increase in impairment compounds the need for capital by decreasing Net Asset Value and reducing the value of equity. There is thus a further need to raise additional capital by retaining earnings or capital adequacy could fall below threshold levels. Leading up to adoption this leaves banks in a position where they are required to increase provisions and retain earnings. This will decrease dividends pay-outs and they could experience liquidity and capital adequacy pressure if the process is not managed effectively. Post adoption banks will be left in a stronger position as they will have an increased pool of provisions to buffer expected losses and a higher level of capital to buffer unexpected losses. The increased requirements of disclosures for both IFRS 9 and Basel III in combination will provide a comprehensive picture of a banks financial health and risk practices. This will decrease information asymmetry and will strengthen market discipline. The increased level of provisions and capital will tie up liquidity in banks and could have a knock on effect to the larger economy through banks decreasing lending. Overall Basel III and IFRS 9 with their stringent risk management practices, more forward looking methodologies and expanded capital, impairment, provision and disclosure requirements will strengthen the financial system and decrease bank fragility.

Author: Stuart Croll

Student Number: 0304640E

Supervisor: Professor Kalu Ojah

Masters of Management in Finance and Investment

Wits Business School

University of the Witwatersrand

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Declaration

I, Stuart Croll, hereby declare that thesis research report has been compiled completely on

my own and is my own work.

Any work that is not my own has been duly referenced and the correct credit given to the

author. The complete reference list can be found at the end of this document.

________________________

Stuart Croll

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Table of Contents

1. Introduction .................................................................................................................................... 1

1.1. The Increasing role of Bank Regulation ................................................................................. 1

1.2. Problem Statement ................................................................................................................ 8

1.3. Purpose of Research and Methodology .............................................................................. 10

1.4. Limitations ............................................................................................................................ 15

1.5. Report Structure ................................................................................................................... 17

2. Review of Relevant Literature ..................................................................................................... 18

2.1. Bank operations, their role in the economy and the need for regulation ......................... 19

2.2. The genesis and evolution of the Basel Accords ................................................................. 23

2.2.1. Basel I, II and III ............................................................................................................ 24

2.2.2. Basel Disclosure Requirements .................................................................................... 34

2.2.3. Additional Basel Releases ............................................................................................ 34

2.3. Part III: The genesis and evolution of the International Financial Reporting Standards ... 35

2.3.1. The ECL Model in More Detail ..................................................................................... 40

2.3.2. New Disclosures assumptions, assessment and operations ..................................... 44

2.4. Summary ............................................................................................................................... 46

3. The overlap and interaction of the Basel Accords and IFRS 9 .................................................... 48

3.1. What is the effect of the Basel Accords and IFRS 9 on managing the dynamic tension

between LLPs and expected loss, and Capital and unexpected loss? ............................................ 48

3.1.1. The relationship between the BCBS and Accounting Bodies ...................................... 48

3.1.2. The relationship between forward looking provisions and retained earnings .......... 51

3.1.3. The effects of early impairment on equity valuation ................................................. 59

3.1.4. Significant increase in credit risk ................................................................................. 61

3.1.5. The limitations of forward looking provisions lifetime modelling and economic

overlay 62

3.2. What will the short and long term impact be on the financial institutions Income

Statement and Balance Sheet? ........................................................................................................ 68

3.2.1. Income Statement Impact ............................................................................................ 68

3.2.2. Balance sheet Impact ................................................................................................... 72

3.3. Are the approaches of Basel and IRFS 9 aligned in any way and will they promote the

same outcome of financial sector health, decreased fragility and increased transparency in

banks financial reporting? .............................................................................................................. 74

3.3.1. The use of common metrics ......................................................................................... 74

3.3.2. Accuracy versus Prudence ............................................................................................ 76

3.3.3. Disclosures .................................................................................................................... 78

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3.4. What are the implementation challenges of Basel and IFRS 9? ......................................... 80

3.4.1. Skills .............................................................................................................................. 81

3.4.2. Systems and Data ......................................................................................................... 82

3.5. What will the affect be on bank strategy and the larger economy given the changes

required in Basel and IFRS? .............................................................................................................. 84

4. Conclusion .................................................................................................................................... 89

5. Bibliography .................................................................................................................................. 92

6. Appendices ................................................................................................................................... 95

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1. Introduction

1.1. The Increasing role of Bank Regulation

Financial Institutions are fast becoming, if not are already, the most regulated industry

globally. Increasing attention has been paid to bank behaviour and the way in which they

conduct business beginning in earnest in the mid-1970s with the establishment of the Basel

Committee on Bank Supervision (BCBS) and has continued to gain momentum up until

today. This considerable attention is due, in part, to the pivotal role financial institutions,

particularly banking institutions, play in the global economy as intermediaries of public

capital. As such any financial risk, shock or tremor felt within the financial sector has a direct

correlation with risk to public capital and the global economy. Regulation has been an

attempt to prevent the occurrence of financial shocks and the transmission of them to the

larger economy.

In South Africa financial institutions must deal with this plethora of regulation as like do

most developed and aspiring developed economies. The decision by relevant bodies has

been to align South Africa to global standards of regulatory adoption. Two pieces of

regulation stand out in this discussion as the most recent guidelines to be complied with:

Basel III and the Internal Financial Reporting Standards (IFRS) particularly IFRS 9.

Both have been produced or accelerated into publication in response to the most recent

financial crisis of 2007-09 which exposed significant flaws in, amongst other things:

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1. The way that banks used and leveraged their capital and how performed their course

of business. This put them into a position where they were unable to cushion

unexpected losses; and

2. The way that banks assessed and managed credit risk, the way they raised provisions

for loan losses accordingly, and what was reported about their financial position and

their assessment of that credit risk.

These flaws speak to the heart of banking operation effective risk management and both

have been identified as having contributed directly to the crisis. The first flaw relating to

levels of adequate capital to deal with unexpected losses from loan exposures is observed

by, amongst others, Wood (2014) who noted that The crisis highlighted that capital levels

were inadequate relative to banks enormous levels of (often off-balance sheet) leverage

and Vasquez and Frederico (2013) who recorded that banks with weaker structural liquidity

and higher leverage in the pre-crisis period were more likely to fail afterwards ergo they

did not hold sufficient equity capital.

The second flaw that of dealing effectively with credit risk is slightly more complex and

needs to be broken down into components of 1) recognising and managing credit risk, 2)

raising provisions for expected loan losses in order to mitigate loss, and 3) reporting or

disclosing the credit risk environment and actions taken (portfolio composition, assessment

of fair value, raised impairments etc.) through financial reporting.

Regarding the first component credit risk practices the BCBS flagged this as an issue in

2000 by observing that the major cause of serious banking problems continues to be

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directly related to lax credit standards , poor portfolio risk management, or a lack of

attention to changes in economic or other circumstances. (BCBS, 2000). The second

component dealing with raising allowances or accounting for expected losses was observed

by the BCBS in 2015 (BCBS, 2015e) and other academics (Beatty and Liao, 2014; Beatty and

Liao, 2011; Bushman and Williams, 2009; Deloitte, 2015; IASB, 2014) where the general

theme of observations is that during the financial crisis credit loss recognition was too little

too late. The BCBS goes on to say in other papers that a significant cause of bank failures

is poor credit quality and deficient credit risk assessment and measurement. (BCBS, 2015a).

A large component of this is related to accounting practices and regarding this a mechanism

to assess and manage risk the BCBS concluded that - Many contend that accounting rules

fuelled the recent global financial crisis. (BCBS, 2015e).

The last aspect relating to disclosure is noted by Beatty and Liao (2014), BCBS (2015e),

Bouvatier et al (2013), and Kunt et al (2008) where they observe that banks are particularly

opaque when it comes to information dissemination and work within a particular confine of

information asymmetry making [it] difficult to assess, for example, their financial position

and risk taking and corporate governance practices (BCBS, 2015e) thus leading to difficulty

in enforcing market discipline.

In order to address the problem highlighted by the crisis of capital management to bolster

the existing capital management framework by reconfiguring regulatory capital structure

and by introducing a number of capital buffers and ratios to stabilise and prevent

unexpected losses the BCBS released Basel III: A global regulatory framework for more

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resilient banks and banking systems in June 2011 and is set to be implemented in January

2019.

The way banks manage and leverage the capital they hold is guided by the Basel Accords (of

which Basel III is the most recent) a set of guidelines on bank management principles,

sound capital management and financial stability and is published by the Basel Committee

on Bank Supervision (BCBS). The adoption of such guidelines is not mandatory however

Beatty and Liao observe that While the recommendations made by the committee do not

have legal force, they are designed to promulgate best practices and to encourage

convergence towards common approaches and standards. (2014).

In South Africa the bank supervisor, the South African Reserve Bank (SARB), has made the

decision to adopt the Basel Accords, and thus all banks in South Africa must comply with the

regulation. The most recent accord, Basel III, builds upon the previous versions of the

accords and introduces additional requirements to plug the gaps left open by Basel I and II.

The details of the accords will be discussed later but primarily they deal with bank

management, capital adequacy, capital buffers, liquidity, funding mechanisms and financial

viability of financial institutions.

To deal with the issues arising from the aspects of credit management discussed above of

adequate management of credit risk, improved accounting methodologies dealing with

recognising and raising allowances on loan exposures and for more transparent and

accurate financial reporting the International Accounting Standards Board (IASB)

accelerated and released IFRS 9: Financial Instruments in July 2014.

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The International Financial Reporting Standard (IFRS) promulgated by the International

Financial Reporting Committee are a set of documents that deal with a range of accounting

principles with the intent to create a global standard in accounting practice. At the time of

the financial crisis the accounting principles in use were the International Accounting

Standards (IAS) and the principles contained in IAS (particularly IAS 39 dealing with Financial

Instruments: Recognition and Measurement - a notoriously difficult to understand and

implement set of principles) have been observed as a core contributor of to the ineffective

impairment methodology as default was only brought about by a loss event. This principle

allowed impairment of assets to be delayed without adequate provisions being raised and

allowed write-offs to accrue to uncontrollable levels without the market knowing. This

caused major liquidity problems for banks and ultimately resulted bank failure.

The IASB is in the process of replacing IAS with IFRS a completely new set of principles

compared to IAS. Although IFRS deals with the whole range of accounting principles, one

standard in particular is of interest for this report IFRS 9: Financial Instruments and has

three sections; 1) classification and measurement, 2) impairment of financial assets, and 3)

hedge accounting. The implementation of Section 2 Impairment of Financial Assets and

the auxiliary disclosures it requires are the focus of this paper.

While both the issues identified have been cited to be a smoking gun in the wake of 2007-

09, the responses to each have been published by two separate bodies dealing with

distinctly different aspects of banking on the one hand capital and unexpected losses, and

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the other dealing with credit risk and expected loss. The bodies and the responses also have

distinctly different end goals which are summarised as follows:

The objectives of accounting standard setting differ from those of bank regulation.

General purpose financial reporting is concerned with providing information to

support a wide range of decision contexts and contractual arrangements.

[P]rudential bank regulation seeks to limit the frequency and cost of bank failures, and

to protect the financial.(Bushman and Williams, 2012)

Basel III and IFRS 9 then seemingly deal with different aspects of financial institutions in

isolation. This paper finds that this is not the case as they will operate in financial

institutions concurrently dealing with fundamentally the same concept assessing risk and

allocating income aside (either by provisioning or raising capital through retained earnings)

in order to prevent loss. In this way this paper finds there is a significant theoretical

relationship between the two frameworks. Each exerts influences upon organisational

decision making through their adoption upon the other in their approaches to credit risk,

their methodologies for assessing and managing thereof and the interplay between

allowances for expected (provisions) and unexpected (capital) loss, and the impetus towards

stringent disclosure requirements. It is these overlaps and influences primarily that this

paper is seeking to reveal and understand. Secondly, leading on from that this paper is

attempting to understand whether the two frameworks are going to work synergistically to

address the core value of each improved capital management and financial stability

promoted by Basel and true, fair and transparent accounting practices promoted by IFRS.

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Deloitte in their fifth iteration of surveys regarding IFRS in the banking industry reflect how

86% of their 59 global bank respondents believe there to be some overlap between IFRS and

the regulatory framework with 22% believing there to be a complete alignment. However

there is no additional information on how they overlap.

Source: Deloitte. 2015. Fifth Global IFRS Banking Survey Finding Your Way

The BCBS has released a number of papers recently addressing the potential interaction of

accounting standards and their capital framework. One of these is a set of guidelines

Guideline on Accounting for Expected Credit Losses (2015a) to assist with the alignment of

the implementations of the Basel Accords and IFRS. Another is a working paper The

Interplay of Accounting and Regulation and its Impact on Bank Behaviour: Literature Review

(2015e) in which they observe the lack of a documented relationship between IFRS and

Basel Accords interaction as follows While there is broad consensus that accounting rules

are an important determinant of bank behaviour, the specific mechanism and their

interaction with regulatory requirements are less well understood.(BCBS, 2015b).

This is a clear flag that investigation is required into the interaction of the Basel regulation

and accounting standards of IFRS 9. With regards to accounting regulation itself a number of

authors have expressed that there is a need to understand the impact of accounting

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standards on the financial industry (BCBS, 2015e; Beatty and Liao, 2011 and 2014;

Wagenhofer, 2011)

1.2. Problem Statement

The above lack of clarity in reconciling Basel and IFRS leaves a problem to investors,

depositors, economist and citizens alike where do these guidelines and principles overlap

and how does this overlap bode for financial stability? While Loan Loss Provisions (LLP) due

to IFRS and additional capital due to Basel have to be raised via bank income, impairment

methodology directly effects the net asset value and therefore the value of equity. LLPs are

processed through bank income statements as an operating expense i.e. they are seen as

a function of the normal course of business as a response to loans not performing. Capital

in contrast is raised through retained earnings and equity accumulation after operational

expense, tax, depreciation and amortization have been deducted. Given that there is a finite

quantum of income for banks each period then there exists a dynamic tension between LLPs

and equity capital and retained earnings because the bank must choose into which bucket it

is going to apportion its limited income.

As discussed above the Basel Accords lays out requirements for how much income must be

apportioned to Capital. IFRS 9 on the other hand prescribes a methodology for recognising

impairments and calculating provisions. These two pieces of separate regulation thus have a

direct influence on each other by setting out how income must be apportioned to the

relevant bucket and in doing so decreases the income available to be allocated to the other.

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If the income statement charge for provisions increases due to signing of bad assets or a

sudden increase in non-performing loans it will have a knock on effect of decreasing net

income and therefore there will be less profit available for retained earnings and return on

equity. This is observed by Leventis et al where they discuss that adjustments in LLPs will

affect retained earnings. (2011).

If the LLP income line is volatile due to quickly changing risk of the asset book then investors

will have less confidence in the financial performance of the company. Equity value will

decrease inherently because of impairment and will be compounded by a drop in demand

for traded shares resulting in the equity value dropping further. The reduction in equity

capital value will drop the capital adequacy ratio below threshold and thus banks will be

required to hold more retained earnings to meet capital adequacy requirements.

This potential conflict begs other questions. How is the introduction of this regulation going

to affect the banks lending behaviour due to increase need to write healthy assets,

especially given the stringent requirements of IFRS 9 credit loss recognition? How in turn

will this affect the larger economy in the form of the changing role of financial institutions as

financial intermediaries?

Auxiliary to this line of inquiry that of the interplay of capital and LLPs is the mechanism

in which banks communicate this information to stakeholders. Both the Basel Accords and

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IFRS 9, and IFRS in general, have introduced rigid disclosure requirements to address the

issue of information asymmetry of financial institutions. Have the disclosure requirements

then improved information flow regarding asset quality, the LLPs as a result, and the capital

position of the bank?

Fundamentally this paper seeks to understand how these two pieces of regulation will align,

impact and influence each other in more detail than outlined above. From there it seeks to

enlighten how, if at all, their intersection will either have a synergistic or conflicting effect

with regards to bank behaviour specifically when it comes to recognising, measuring and

impairing credit risk in the South African economy. Furthermore this report seeks to

understand the financial benefits, implementation cost and the ongoing cost of doing

business associated with the adoption of the Basel Accords and IFRS 9.

Both requirements are set to be implemented on January 1st 2019 (for measurement

periods beginning on the 1st Jan 2018). There is therefore no quantitative data available to

measure the true impact and interaction of the two pieces of regulation. In an attempt to

pre-empt the impact we can only hope to understand it through discussions with industry

expert and what the existing literature tells up which is predominantly in support of and

support between the two bodies producing the regulation. Little has been written on how

they will interact.

1.3. Purpose of Research and Methodology

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This research report sets out to pre-empt a quantitative inquiry into the actual interaction

and impact on bank behaviour of the Basel Accords and IFRS 9 once they have been

implemented. In as much as they have not been implemented, the existing literature which

has been produced largely by consulting and auditing firms has focused on the mechanics of

the requirements set out in each of the guidelines and have provided their interpretation

and implementation guidelines for the regulation independently. At the time of this writing,

no work has been done looking at the Basel Accords and IFRS 9 in conjunction with each

other and how they will interrelate as noted by Beatty and Liao (2014) that there is an

absence of literature examining the relationship between loan loss provision and

regulatory capital. This report is an attempt to fill the gap in theoretical literature regarding

how the dynamic tension between LLPs and Capital will play out in respect of this

regulation.

Starting from the premise that these regulatory frameworks exists and that while during the

development of the regulation wide consultation and feedback took place, once the final

versions were produced they became concrete paradigms of regulation. The frameworks

themselves and the principles contained therein are thus indisputable as mechanism of

bank operation. Adoption of the guidelines in South Africa is not voluntary as is directed by

the SARB and the Department of Trade and Industry (DTI). Therefore the way in which South

African banks must operate is indisputable and is informed solely by the principles

contained in the frameworks. This is in line with both the BCBS and IFRS underlying motive

to standardise the practices that they produce guidelines and standards about.

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That being said the frameworks are principles based. This means that their contents are a

set of high level guidelines and the operationalisation and implementation of them is left up

to individual institutions themselves. There is therefore a large degree of interpretation of

frameworks within the gambit of the high level requirements. This is opposed to rule based

framework approach where implementation is required exactly as is prescribed.

Additionally both the Basel Accords and IFRS provide choices within their frameworks that

provide institutions some degree of agency as to how they will implement the frameworks.

The choices deal with the degree to which they will adopt the provided principles to best

suit their business environment and their ability to fulfil the requirements. For example the

Basel Accords allow banks to choose between the Standardised, the Internal Rating Based or

the Advance Internal Rating Based approaches for calculating Risk Weighted Assets. IFRS 9

provides four practical expedience options in their standards to simplify the adoption where

it is fit for a given institution.

Adoption is of course not done by the institutions itself. The employees of those

organisations are the ones who are tasked with the assessment, interpretation, adoption

and implementation of the regulation and standards.

Due to the fact that neither IFRS 9 nor Basel III have been fully implemented there is a lack

of quantitative data that could be used to indicate their interaction and what impact they

would have on each other or how in combination they would affect bank operation and

behaviour.

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The final versions of Basel III and IFRS 9 were however released in 2013 and 2014

respectively and provide a tiered timing of implementation as mentioned IFRS 9 for the

financial year beginning 1st January 2018 and Basel III by the 1st of January 2019. Both have

rigorous requirements and in as much a considerable amount of work has been done by

financial institutions in preparing them and making them ready and complainant in time for

the adoption dates.

Taking all the above into consideration as well as the desire to investigate and provide a

real-time expert perspective, the author believes that in order to understand the interaction

of the Basel Accords and IFRS 9 in the most accurate way would be to meet and interview

employees of banks who are involved with, are experts of, or have knowledge of the Basel

Accords and/or IFRS 9. The interviewees perspectives are thus fresh with experience of the

mechanics of their interrelation and their functional operation within the context of

adoption.

After an extensive review of the Basel Accords and IFRS 9 their genesis, development and

iterations which will be discussed in the Chapter 2 five main themes were distilled in

relation to where their possible overlaps and interactions could take place. These in turn

formed the base research questions and are as follow:

1. What is the effect of the Basel Accords and IFRS 9 on managing the dynamic tension

between LLPs and expected loss, and Capital and unexpected loss?

2. What will the short and long term impact be on the financial institutions Income

Statement and Balance Sheet?

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3. Are the approaches of Basel and IRFS 9 aligned in any way and will they promote the

same outcome of financial sector health, decreased fragility and increased

transparency in banks financial reporting?

4. What are the implementation challenges of Basel and IFRS 9?

5. What will the affect be on bank strategy and the larger economy given the changes

required in Basel and IFRS?

From this basis a number of additional questions were developed that examine aspects of

the above main problem statements more specifically. The additional questions can be

found in Appendix A. The research participants experts and specialists in the fields of Basel

and IFRS 9 were asked to expand and discuss any themes over and above the specific

questions asked to take into consideration points that were not identified in the literature

review. This was also an opportunity to leverage their deep knowledge of the Basel

regulation and accounting standards.

Interviewees were asked to provide consent to participation with the assurance of

anonymity in publication. Any reference made of an interviewees comments is done under

pseudonym. All interviews were recorded with the full knowledge of participants. The

recordings were then transcribed and the contents analysed.

The analysis conducted was done in the form of a combination of iterative thematic and

enumerative methodologies. The interviewees answers were assed for pertinence to the

primary line of inquiry utilising a combination of block and file, and segmentation processes.

Statements were classified or coded into categories as follows:

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1. Those that dealt with the explanation, interpretation and mechanics of the Basel Accord

and capital adequacy;

2. Those that dealt with the explanation, interpretation and mechanics of IFRS and

provisions;

3. Those that dealt with the nature and requirements of disclosures;

4. Those that dealt with implementation challenges; and

5. Those that dealt with potential larger financial services industry and macro-economic

effects of adoption and implementation.

In Chapter 3 the categorised comments were then matched to relevant literature regarding

the relationship between LLPs and Capital, and the role that disclosures play in both the

Basel Accords and IFRS 9. Common trends in identified implementation challenges were

combined and collated. The same was done for the potential impact on the financial

services industry and the macro-economy.

1.4. Limitations

This paper is seeking to understand the interplay between Basel and IFRS 9. Their existence

and legitimacy falls out of the scope of this paper in as much as possible alternatives and

whether these are the best mechanism to achieve financial sector health.

A large body of literature exists interrogating whether the Basel Accords strengthened or

weakened the financial system (Bertay et al, 2012; Cubillas, 2011; Danielson et al, 2001;

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Gale and Ozgur, 2004; Kretzschmar et al, 2009; Slovik and Cournede, 2011; Vazquez and

Federico, 2013). Again the legitimacy of the Basel Accords is not questioned in as much as

whether it should be there or not. Whether it has strengthen the financial system is only

discussed in relation to its interplay with IFRS.

In the same vein, the accounting literature focusing primarily on fair value accounting,

information asymmetry and market discipline (Beatty and Liao, 2014; Bushman and

Williams, 2012; Khan, 2014; Shaffer, 2010) is only used in as much as it relates to regulatory

capital adequacy and not whether fair value is an appropriate accounting methodology to

use. Information asymmetry and market discipline will only be discussed in relation to the

disclosure requirements of IFRS and whether this addresses the problems identified by the

crisis and not whether market discipline is a sufficient mechanism to moderate bank

behaviour, nor the mechanics of market discipline.

Additionally, there are three sections to IFRS 9. This paper focuses specifically on Section 2:

Expected Credit Losses. The other two sections Classification and Measurement, and

Hedge Accounting are not relevant to this paper other than a broad implication into asset

classification. Furthermore IFRS 9 considers all financial assets. This paper does not cover

financial assets that would fall into the Fair Value through Other Comprehensive Income

category contemplated in section 1. This category covers financial instruments such as

derivatives, futures, options, equity in other companies and hedges. This paper thus focuses

exclusively on Amortized Cost though Profit and Loss which considers traditional bank

products.

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Given that the implementation of Basel III and IFRS 9 are deadline for 2019, and the final

draft of IFRS was released in June 2014 and the final release of Basel III released in 2011 this

is a largely theoretical approach as the actual response and affect are yet to be seen and

quantified.

1.5. Report Structure

The report continues with a review of why regulation in banking is necessary in the first

place. It continues with a separate review of the development of the Basel Accords and IFRS

9 in Chapter 2. The reviews will detail the genesis of the requirement for regulation, discuss

the principles contained therein and the proposed mechanism of implementation and

adoption. This will be tailored to the relevance to financial institutions.

Chapter 3 then reviews the relevant relationships between the intersection of the Basel

Accords and IFRS 9 combining salient points recorded in interviews with participants with

relevant literature research question by research question. Additionally implementation

challenges and potential macro-economic and industry impact post adoption and

implementation are discussed.

In Chapter 4 the report concludes by summarising ventilated insights.

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2. Review of Relevant Literature

The following literature begins with a brief description of how banks operate particularly

their primary method of attaining funding for their business and how due to this way of

funding and operating banks play a fundamental role in the economy. Following on from

this we discuss why banks need to be regulated as they fulfil the role of custodian of

deposits, lender and intermediary.

From there it continues with a history of Basel in which it discusses the genesis and

development of the three accords highlighting key points in relation to this report in more

detail capital adequacy, the Basel approach to the treatment of credit risk and disclosures.

IFRS 9 will be discussed next and will follow a similar structure with regards to the history

and genesis of accounting standards and the evolution of IFRS 9 from its predecessor IAS 39.

This section will then branch out into the specific approaches of the standards requirements

for the measurement of credit loss contrasted against the replaced IAS 39, as well as the

IFRS 9 disclosure requirements.

As discussed in the preceding chapter this paper is concerned with the interaction of the

Basel Accords and IFRS 9. However in order to accommodate the distinct nature of the two

structural frameworks they will be discussed separately as set out above. Their interaction

will then be analysed in the following chapter. This combined analysis of multiple aspects of

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bank regulation and frameworks is in line with an emerging academic discourse in banking

and bank regulatory literature as Barth et al (2004) argue that in order to understand

banking regulation one must examine and extensive array of factors simultaneously to

identify these combinations of regulation and supervision policies that produce successful

banking systems.. The factors in this paper are the Basel Accords and IFRS 9 and whether

their interaction will produce healthier risk management and ultimately better managed

banks and a sounder economy.

2.1. Bank operations, their role in the economy and the need for regulation

Banks in their simplest form have existed for centuries with the oldest bank still in existence

being founded in 1400s. Traditionally banks operate by taking in deposits from parties

(creditors) and lending out money to other parties (debtors). The bank issues promissory

notes to creditors that upon demand their

money will be available when they want to

make a withdrawal. The bank will also

receive promissory notes from debtors who

agree to pay in full or pay a portion of the

money that they borrowed at the agreed

maturity date.

[Figure 1. Bank Balance Sheet Example]

The income that banks receive comes in the form of interest charged on the capital that is

lent out. Operating expenses are accrued by paying interest on deposited money. Profit is

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derived by the margin spread between what interest rate the bank pays to depositors and

the interest rate the bank charges borrowers.

As in most companies the money that the bank owners put down as start-up capital forms

the equity portion of the balance sheet. This equity together with the deposits that the bank

accepts forms the capital base from which the banks lends out money. In this way a banks

balance sheet structure is the same as any other company as it is composed of assets,

liabilities and equity where the loans are assets and deposits are liabilities. The financial

position of the bank will balances out at A = L + E as in the diagram above. Banks operate as

any other company would in that they use money (deposits and equity) to create products

or services (loans) which they sell at a profit. And, in as much as most companys capital

structure, leverage is a key mechanism of their balance sheet.

Leverage occurs in banks under the premise that equity and deposits are promissory notes.

Demand on these promissory notes is tenure based demand occurs at time intervals

equity generally has a long tenure1 while deposits a relatively shorter maturity where the

demand is still not immediate nor do the depositors all demand their money at the same

time. Understanding this demand-supply relationship banks will lend out more money than

they have taken in deposits because they predict that they will receive enough money in

repayments which generally happen at regular intervals to be able meet the demands on

the deposits. They in effect create capital as they create more loan value than they hold in

tangible liability (Leverage portion in the above diagram). While leverage began as early as

1 This is not describing publically available equity on a stock exchange which has a relatively short turn over.

21

the 1600s, it has become an increasingly important mechanism of modern bank operation

precipitated by the development of sophisticated ICT infrastructure and concepts such as

fractional reserve banking documented in Modern Money Mechanics (1961).

The leverage mechanism in banking is an important tool in money creation and credit

extension as the primary capital that banks hold can be recycled many times. The money

that is lent out to borrowers will then be taken and the borrowers in turn become

depositors by depositing it into the same or another bank. Banks then have additional

capital to lend out. This allows banks to create vast amounts of credit liquidity in the

market as illustrated in figure 2 below. However there is not only one bank, there are many.

Lending does not necessarily mean a debtor will come back and deposit the money into the

same bank. Banks lend into a void a financial system where money is virtually impossible

to track.

This way of working poses enormous risk. Actual capital is a minor portion of money in

circulation and the whole system works on balancing the maturity of deposit demand and

repayments received. It is very easy for a bank to lend out too much money into the system

to over leverage and then when the time comes they will not be able to meet the

demand on deposits called a bank run. Prudence dictates then that bank hold a

percentage of their capital in the event that a demand is made and they have not received

enough in repayments.

22

Figure 2: Expansion of capital. Source: Modern Money Mechanics (1992).

Fundamentally the biggest risk a bank faces is over leverage. Over leverage can occur in two

main ways. The first is if there is a bank run and there is a sudden demand for deposits. This

is largely sentiment driven people wanting to draw their money out and is largely

uncontrollable other than having enough capital (liquid or near liquid capital) to buffer the

withdrawals. The second occurs because of a deterioration in the loans that the bank has

made resulting in them not receiving repayment. This is largely a function of who the bank

lends to and what they lend it out for. This means that there are two predominant risk in

banks in order for them to continue operating in their leveraging business model one is

capital risk: the quality and amount of capital that the bank holds and two is credit risk: the

quality of its loan book and ensuring that capital lent out is recovered.

23

In the modern era banking has become intensely sophisticated and the banking system has

become unrecognisably interconnected. This has created a myriad of other risks that banks

face liquidity risk, interest rate risk, operational risk and market risk to name a few.

However that being said these other risk can be traced back at some point to either credit

risk or capital risk.

It is upon these two risk that the bulk of regulatory attention sits. As banks perform a vital

role in the economy as intermediaries by taking in deposits and in turn making capital

available to parties who require it through lending activities (Rajan and Zingales, 1998;

Levine, 2002), they make available needed funding for business, entrepreneurs and

individuals who would otherwise not have the access to funding. This stimulates economic

growth as Barth et al recognise the opposite by saying that Poorly functioning banking

systems impede economic progress, exacerbate poverty and destabilise economies.(2004).

If banks are allowed to over leverage, make poor lending decisions and misrepresent the

quality of their lending book they put the entire financial system and economic stability at

risk.

It is for this reason that the Basel Accords were produced to manage capital and provide

guidelines for sound credit practices, and IFRS 9 was developed to accurately assess credit

quality and fairly represent this to all stakeholders involved.

2.2. The genesis and evolution of the Basel Accords

24

The Basel Accords are a series of guidance documents produced by a sub-committee of the

Bank of International Settlements (BIS) located in Basel Switzerland - the Basel Committee

of Bank Supervision (BCBS) whose most prominent role has been their attempt to

establish a global capital management system and regulatory standard (Wood, 2014). The

notion of banking stability began as early as 1864 but has really only taken formal shape

since the 1980s with the precursor version of Basel I being produced in the late 1970s to

mid-1980s. Prior to this capital adequacy regulation was left predominantly up to the

individual banks themselves as an ad-hoc process.

The Accords have been produced in response to an ongoing problem of stress and volatility

in the financial services industry, and although the economic underpinnings of bank capital

regulation are not yet completely understood based on the theoretical literature, capital

adequacy is an important component of regulators evaluation of banks safety and

soundness. (Beatty and Liao, 2014).

2.2.1. Basel I, II and III

The first formalised Basel accord was promulgated in 1988 and introduced the basis of bank

management with the intention to Secure international convergence of supervisory

regulations governing the capital adequacy of international banks (BCBS, 1988) and thus

manage through capital management risk posed by the ever increasing sophistication of

bank products and the resultant interconnectedness of the financial industry. The principles

25

contained therein set the foundation of capital adequacy measured by the capital adequacy

ratio (CAR) (Equation 1).

Capital is understood to be loss absorbing or in other words banks can absorb losses

incurred from operations against the capital that they store up. The BCBS (1988) proposed

that capital or regulatory capital should be split into two tiers tier 1 and tier 2.

Regulatory capital should be composed of at least 50% a core element comprised of

equity and published reserves of post-tax retained earnings (tier 1) [and supplementary

capital] will be admitted into tier 2 up to an amount equal to that of the core capital. In

additional banks were permitted to add loan loss provisions (LLP) to tier 2 up to 1.25 of risk

weighted assets (RWA) which will be discussed shortly. Capital levels were initially pegged

at 4% for tier 1 and 8 % for tier 1 & 2 combined in Basel I.

Through the CAR, Basel introduced a view of capital as a function of the riskiness of the

assets that a bank wrote by measuring regulatory loss absorbing capital as a quotient of risk

weighted assets described as categories of assets weighed according to broad

categories of riskiness (BCBS 1988).

=Capital (Tier 1 or Tier 2)

RWA

[Equation 1]

While the concept of regulatory capital and the CAR was a sound one, in practicality a

fundamental problem of this accord emerged in that risk weighting for risk weighed assets

was an arbitrary weighting or a prescribed version of the BCBS perceived risks of asset

26

classes and not based on empirical calculation. The risk bucketing did not take into account,

nor provide enough granularity for measuring, the diverse nature of risk in the banking

environments.

Capital was not calculated effectively to manage unforeseen losses arising from operations

and in doing so failed to perform the function it was designed to do. For instance a well

performing corporate entity was bucketed into the corporate asset class together with a

poorly performing corporate entity which presented far more risk. Banks could therefore

price for the risk, sign both assets and raise the same amount of capital and reap the

commensurate interest income. This made banks more risky as they would not be raising

sufficient capital to match the risk of the poorer performing entity.

In addition banks would in order to alleviate the requirements of capital adequacy

engaged in regulatory arbitrage using mechanism such as securitization to move risk off

balance sheet and thus reduce the amount of capital required to be held. (Wood, 2014)

These shortfalls and behaviours did not achieve what the Accord was drawn up to do

manage risk in the financial sector and there is a body of literature that supports the

concept that there was an increase in risk under Basel I (Blum, 1999; Gennotte and Pyle,

1990; Koehn and Santomero, 1990).

27

In response to the amount of criticism received for Basel I, the BCBS then released

International Convergence of Capital Management and Capital Standards: A revised

framework colloquially known as Basel II in June 2004, set to be implemented by 2008. The

newly released framework build upon CAR and introduced a three pillar approach to bank

management. Under the three pillars were additional, improved and adapted approaches

and guidelines to capital management, risk assessment and governance and disclosures for

both capital management and risk assessment. The pillars are summarised as follows:

Pillar 1: Minimum Capital Requirements containing new definitions of Capital (the

tiers of capital), guidelines on dealing with credit risk (Standardised and Internal

Rating Based Approaches), Securitization Framework, Trading Book Issues and

Operational Risk;

Pillar 2: Supervisory Review Process detailing principles of the risk review and

assessment process (Internal Capital Adequacy Assessment Process or ICAAP) aimed

at addressing interest rate risk, credit risk, operational risk and market risk. ; and

Pillar 3: Market Discipline setting down disclosures requirements for capital and

the above mentioned risk categories.

While capital definitions remained largely unchanged from Basel I with regards to tier 1 & 2,

Basel II introduced a third tier consisting of short-term subordinated debt (BCBS, 2005).

The option for banks to include LLPs into tier 2 was also removed if they chose to adopt the

new methodology of calculating RWAs themselves (the Internal Rating Based approach

28

discussed shortly) but remained if they chose to continue to use the revised existing method

of the standardised risk weighting.

The most important introductions that came with Basel II was this new approach to

measuring and managing credit risk via risk weighted assets. This new approach gave banks

the option to choose between two approaches of credit risk assessment a prescribed

methodology of assigning credit risk and weightings of their RWA (the Standardised

Approach) or they could use their own internal data to model and assess credit risk called

the Internal Rating Based (IRB) approach.

This allowed banks to first categorise their exposures into asset classes2 as defined by Basel

II and then use environment specific, bank specific and risk specific metrics to model and

ultimately more accurately assess their own risk profile and their counterparty risk. The

RWA is an extensive calculation but is based on a primary parameters of risk defined as

Expected Loss (EL). This is calculated using the risk measures potential default (PD), loss

given default (Lgd), exposure at default (EAD) and an emergence factor (k).

The EL metric became the litmus paper of provisioning and was suggested by Basel to be

used to assess whether each EL or provisions adequately reflected the risk position of

the bank. (BCBS, 2004). These metrics have a distinct characteristics within the Basel context

2 (a) corporate, (b) sovereign, (c) bank, (d) retail, and (e) equity. (BCBS 2004)

29

primarily that the PD is calculated through-the-cycle over 5-7 years worth of data

calibrated to a 12-month horizon3.

Basel II also formalised the exercise of disclosures. The committee expressed the rational for

the introduction of disclosures as follows:

The Committee aims to encourage market discipline by developing a set of

disclosure requirements which will allow market participants to assess key

pieces of information on the scope of application, capital, risk exposures, risk

assessment processes, and hence the capital adequacy of the institution.

(BCBS, 2004)

The BCBS proposed that pillar three would support the other two pillars by making bank risk

taking behaviour more transparent to outside stakeholders asserting that Market discipline

can contribute to a safe and sound banking environment (BCBS, 2004), particularly where

risk assessment especially under IRB approach was now dependant on self-determined

risk parameters. Other mentions of disclosures appear as early as 1997 in The Core

Principles for Effective Banking Supervision where Demirgc-Kunt et al observe that the

Countries aiming to upgrade banking regulation and supervision should consider giving

priority to information provision over other elements of the core principle (2008). The

disclosure framework should include the approaches and assumptions about the risk

universe managers and directors face. The disclosure requirements however focused

3 Through-the-cycle and calibrations therefoe involve finding the central tendency of five years worth of data

and then adjusting a twelve months data sets average to that central tendency to give the standard deviation of that years data around the five year average.

30

fundamentally on capital adequacy requirements and risk assessment policies and

processes.

Despite the updated approaches contained in Basel II, the bank regulation again came under

criticism. Wood (2014) observed that the loosening of bank regulation [under Basel II]

given the hindsight offered by the financial crisis, seems a serious mistake. Other academic

studies of Basel II reflect that [Basel II] has failed to address the key deficiencies of the

global financial regulatory system (Danielsson et al, 2001). A primary criticism of Danielsson

et al and echoed by Beatty and Liao (2011) was that capital adequacy combined with

market imperfections leads to more pro-cyclical bank lending.

Basel II was in the process of being implemented at the time ruminations of the financial

crisis of 2007-09 began. The framework was criticized because some its principles were cited

to have contributed if not caused the crisis. One of the criticism was that insufficient capital

had been raise to deal with enormous off balance exposures and the build-up of leverage

in the trading book to prevent systemic market risk to the financial sector and there had

been a gradual erosion of the level and quality of the capital base itself (BCBS, 2011b).

In response to the financial crisis, the BCBS again reviewed the existing guidelines and began

the development of a host of new regulation. As an immediate corrective action they

released Revisions to the Basel II market risk framework or Basel 2.5 in February 2011.

This document set out revisions to the market risk framework contained in Basel II and

31

sought to 1.) [supplement] the current value-at-risk based trading book framework with an

incremental risk capital charge and 2.) To introduce a calculated stressed value-at-risk

model (BCBS, 2011b).

The BCBS also began the development of the third generation of Basel Accords Basel III: A

global regulatory framework for more resilient Banking. The final version of Basel III was

released in June 2011. This document did not fundamentally change anything of the

previous Basel I and II in term of the three pillar approach. The new framework instead

introduced some amendments and additional measure to 1.) Enhance the quality of capital,

2.) Enhance risk coverage, 3.) Supplement risk based capital requirements, 4.) Reduce pro-

cyclicality, and 5.) Address risk and interconnectedness of the global financial system (BCBS,

2011a).

This was proposed to be achieved by altering the definitions of capital and the introduction

of new ratios and buffers. These included three capital buffers and a number of funding and

liquidity buffers to supplement regulatory capital in its loss absorbing capacity. These

measures have been put into place to ensure that banks seek out the most effective funding

structure and are protected sufficiently should they experience a sudden stressed

environment.

Basel III made amendments to the definition of capital by first doing away with Tier 3 capital

contained in Basel II. It has been observed that there is the evident intention of

32

strengthening Tier 1 component. (Kubat, 2014). Basel have achieved this by splitting up

Tier 1 capital into two part Tier 1: Common Equity (CET)4 and Tier 1: Additional Capital5.

Tier 2 contains instruments and stock not included in tier 1, as well as provisions for loan

losses up to 1.25% of RWA. They have also raised the minimum requirements of capital

adequacy - Tier 1 equity must have be a minimum of 4.5% RWA, total Tier 1 a minimum of

6% RWA and Tier 1 & 2 a minimum of 8%.

The BCBS states that the main impetus of releasing Basel III is to improve the banking

sectors ability to absorb shocks arising from financial and economic stress (BCBS, 2011a).

Speaking to the newly introduced measures mentioned above the BCBS have introduced the

following buffers to supplement the loss absorbing capacity of regulatory capital.

1. A Capital Conservation Buffer: This has been introduced to form part of CET as an

additional 2.5% of RWA bringing total CET to 7%. This has been done so banks will

be able to absorb erosions of capital in times of stress so that they do not drop

capital levels below requirements (Kubat, 2014) and falls into the category reducing

pro-cyclicality.

2. A Counter Cyclicality buffer: This will managed and prescribed by bank regulators in

each jurisdiction and can be between 0 - 2.5% of RWA. The idea behind this buffer is

that in expansion periods banks should store additional capital to prevent the pro-

4 Tier 1 Common Equity includes 1) Common shares, 2) Stock surplus, 3) Retained earnings, 4) Accumulated

other comprehensive Income, and 5) Regulatory adjustments. 5 Tier 1 Additional Capital includes 1) Instruments issued by the bank that may be included as additional

capital, 2) Stock surplus resulting from those instruments, 3) Instruments issued by consolidated subsidiaries, and 4) Regulatory adjustments.

33

cyclicality of downturn periods and also falls into the category of reducing pro-

cyclicality.

3. There is an additional buffer currently under debate for Systemically Important

Financial Institutions (SIFI) and would again be prescribed by local regulators.

Current estimates peg the buffer between 1% and 2.5% (Wood, 2014) raising

total capital requirements to near 15.5% of RWA.

Furthermore in order to manage the excessive build-up of leverage, the BCBS have

introduced the Leverage Ratio that speaks to supplementing risk-based capital requirements

and is detailed as follows.

1. A Leverage Ratio: Described as a simple, transparent and non-risk-based

indicator (Kubat, 2014), this ratio is intended to capture the risk inherent in on and

off balance sheet exposures. Measuring Tier 1 Capital as a quotient of On and Off

Balance sheet exposures, this ratio must exceed 3%. Prohibitive rules prevent the

reduction of balance sheet exposures through collateral and the netting off of loans

and deposits.

The BCBS have also included in Basel III standard ratios for effective liquidity management

by introducing ratios to promote short term liquidity resilience (Liquidity Coverage ratio)

and long-term funding management (Net Stable Funding ratio).

1. The Liquidity Coverage Ration: This ratio ascribes different liquidity positions to each

bank balance sheet item both asset and liability and measures the net

inflow/outflow of the liquidity position over a 30 day period. The inflow must exceed

the outflow in this time (ratio of 100%). The ratio is intended to ensure banks

remain liquid under stressed periods.

34

2. The Net Stable Funding Ratio: This ratio ascribes a funding position to each bank

balance sheet item both asset and liability as a required versus available position.

The available funding must be greater than the required funding (100%) and is

intended to manage the medium and long term funding structure of banks.

2.2.2. Basel Disclosure Requirements

In addition to Basel III and Pillar 3 of Basel II, the BCBS also released a separate standard for

disclosures name Revised Pillar 3 Disclosure Requirements in January 2015 in order to

enhance regulatory disclosures regarding Pillar 1. Barth et al find that regulatory and

supervisory practices that force accurate information disclosures, empower private sector

monitoring of banks. (2004 in Demirgc-Kunt et al, 2008) Accordingly in this publication the

BCBS detail report templates for required disclosures regarding 1) Risk management and

RWA, 2) Linkages between financial statements and regulatory exposures, 3) Credit risk, 4)

Counterparty credit risk, 5) Securitization, and 6) Market risk are to be used to provide

sufficient information and enhance comparability of a banks material risk.

2.2.3. Additional Basel Releases

The BCBS has released a number of additional documents to refine and clarify certain

aspects of bank management. These include Revisions to the Standardised Approach for

credit Risk (BCBS 2015b) and Guidelines for accounting for expected credit losses. (BCBS,

2015a). Collectively these documents attempt to minimise the variable interpretation of the

35

BCBS set of guidelines for capital management, bank management and bank stability and

bring synergies to all stakeholders. The revision to the standardised approach seeks to

bolster credit risk assessment and bring closer alignment between the standardised and

AIRB approaches.

The guidelines for accounting seeks to align the Basel approach to credit risk management

and the IFRS approach to credit risk. These documents will be discussed in more detail later

on in the following chapter as they form a fundamental base of this papers analysis.

Overall Basel III and its supporting publications seek to address the criticism and evident

issues with Basel I and II and have been comprehensive in doing so. Whether the new

regulation will actually solve the problems is yet to be seen with its implementation in 2019.

2.3. Part III: The genesis and evolution of the International Financial Reporting

Standards

The development of the accounting standards has been an evolution from accounting

theory the proper way to measure assets and liabilities, the proper way to measure

business performance, the determination of allowable dividend payments, the protection of

creditors in the event of bankruptcy and the taxation of corporations (Baker and Burlaud,

2015) to the establishment of an accounting standards setting body in order to give

legitimacy to the development of common, homogenous accounting principles or Generally

Accepted Accounting Principles.

36

Initially most of the academic theory emanated from Europe, particularly Germany. Despite

this central source of accounting theory, accounting principles were fragmented in their

development as each country adopted and utilised their own interpretation of accounting

definitions. The eventual establishment of accounting setting bodies made significant steps

in integrating and standardising accounting principles across localities. Two bodies emerged

as leading influences from this evolutionary process: The Financial Accounting Standards

Board (FASB) in the US and the International Accounting Standards Committee (FASC)

representing 112 countries from the rest of the world including South Africa. The need by

the global business community for a common set of accounting principles has grown in

parallel with the emergence of accounting standard bodies and has become a highly

demanded issue of discussion and debate among accounting professionals around the

globe (Shil et al, 2009).

In 1973 the International Accounting Standards Committee (IASC) began the development

of a series of standards called the International Accounting Standards (IAS) in an attempt to

homogenise and standardise global financial reporting. These standards were adopted by

the IASC member states and became the dominant set of accounting principles around the

world. The US however retained their own US-GAAP.

In 2001 the IASC was replace by the International Accounting Standards Board (IASB) where

the impetus again became to broker and develop a global set of accounting standards. An

37

agreement was signed between this newly formed body and the FASB in 2002 a

memorandum of understanding called the Norwalk Agreement that committed them to

working together to develop a convergent set of standards. (Paul and Burks, 2010; Shil et Al,

2009) This agreement set in motion the beginning of the developments of the International

Financial Reporting Standards (IFRS) to replace the previous IAS.

What the IAS and IFRS are is a series of documents of accounting principles that outlines the

conceptual definitions, framework and treatment of among others: assets, liabilities, equity,

financial position, income recognition, operating expenses, cash flow, and financial

impairment. They form a fundamental role in guiding financial reporting where the global

demand for relevance (predictive value, and timeliness) and reliability (verifiability,

neutrality, and representational faithfulness) requires business to measure their business

performance and produce financial reports in a readable format. The IFRS are intended to

allow investor (and depositors) who are reviewing financial statements of an institution in

line with the standards to make well informed and rational decisions when assessing the

financial position and performance of organisations.

The major focus points of IFRS are centred on enhanced decision making usefulness, the

asset-liability approach, and fair value measurement. (Wagenhofer, 2011). With these

principles as the guiding approach, the IASB has been systematically replacing IAS.6 While

there are a host of IFRS standards, each one dealing with a particular aspect of accounting

6 A number of principles contained in IAS have continued into IFRS including 1.) Fair value or faithful

representation of company financial position, 2.) Financial statements must be presented as a going concern consideration, 3.) Accrual based accounting, 4.) Materiality, 5.) Frequency of reporting, 6) Comparative and Consistent reporting. (IAS 1 and IFRS 1)

38

principle, of particular relevance to banks is the standard IFRS 9: Financial Instruments. IFRS

9 replaces IAS 39: Financial Instruments: Recognition and Measurement. This particular

standard governs the classification of financial assets, the recognition of financial asset

performance and guidelines on how to calculate their fair value and associated provision

against that impairment.

IAS 39 was a rule based document and was notoriously difficult to implement and apply

(BCBS, 2015c; IFRS 9, 2014) and the incurred loss model contained therein in which there

has to be objective evidence of impairment or a loss event7 has been described as

reactive and was subject to criticism during and after the Global Financial Crisis for

recognising losses too little, too late (BDO, 2014). Accounting bodies have disputed this

observation by saying that the standard allowed early recognition of impaired assets but

that adopters chose to recognise deterioration in credit quality at the point of default.

(BCBS, 2015c; Beatty and Liao, 2011).

IAS 39 was however the accounting standard concerning impairments at the time of the

financial crisis. This event and the resulting criticism of IAS 39 forced the IASB to accelerate

the development of IFRS 9. In April 2009, the IASB announced an accelerated timetable for

replacing IAS 39, in response the financial crisis. (Spector, 2012). Under the Norwalk

Agreement the FASB and IASB set out to 1.) Develop a global standard of accounting for loan

losses with the intention of creating a homogenous standard and 2.) Decrease volatility in

7 According to IAS 39, impairment exists if, and only if, there is objective evidence as a result of one or more

events that occurred after the initial recognition of the asset (a loss event) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated. (Spector 2012).

39

impairments and income statement movements. Agreement between the IASB and FASB

could however not be reached and the project was abandoned by the FASB who decided to

pursue their own standard to govern asset valuation and impairment.

The IASB however went ahead with their redefining of impairment methodology project and

published the final version of IFRS 9 in July 2014. IFRS 9 has been developed to be principles8

based and the standard contains three parts: I.) Classification and Measurement, II.)

Impairment, and III.) Hedge Accounting. This paper is primarily concerned with Part II:

Impairment which has introduced a completely new way of recognising and accounting for

loan losses. They have done so by introducing a model to account for and impair financial

assets an expected credit loss (ECL) model.

Why this is of particular importance to banks is that their business model operates by

lending out money or the issuing of financial assets. As discussed in part I of this chapter,

not recouping the money lent out poses an enormous risk to the bank. The inability to

calculate the fair value or the miscalculation of the value of the asset side of the business

means that banks do not know the financial position or how much money they need to set

aside in order to keep their business solvent. It means that the bank is not managing its risk

appropriately and has the potential to bring the bank to a position of illiquidity. Despite

being primarily focused on part II, there is a need to include some sections of part I as it

8 Principles based means that the Standard contains high level philosophies that must be interpreted when

implementing. Rules based means that every step is a prescribed approach and leaves very little room for interpretation.

40

pertains to the classification of assets which govern securitised assets and thus falls into a

different income statement line category that amortization assets.

2.3.1. The ECL Model in More Detail

In contrast to IAS 39 which required a default event for the asset to be impaired,

fundamental to the ECL model is a change in the perspective of time from loss event or

default event close to the occurrence of default to expected loss where the loss is

measured as a weighted default probability over the lifetime of the asset. The ECL model

has introduced a change in the horizon of accounting for loss by changing how a loss is

defined, the events that bring about the loss, how the loss is measured and how the loss is

impaired.

An ECL arises when there is difference between the present value expected cash flow from

the asset and the present value projected contract cash flow from the asset, which takes

into consideration the amount and timing of contractual payment (BDO 2014). The most

important impact in the change in measurement horizon is the recognition than all financial

assets has an intrinsic risk of default or a differential in projected cash flow, even at its

inception. This means that the ambit of the ECL model falls over ever asset a bank possess.

All assets are therefore placed into one of the three stages and is automatically impaired

whether it has actually defaulted or not. This is vastly different to IAS 39 where only

defaulted assets were impaired. The requirements of IFRS 9 impairment methodology

means that all assets must have a corresponding provisions raised against the intrinsic

41

impairment. Again this means that a provision will have to be raised for some percentage of

every assets exposure.

[Figure 3]

The ECL model is structured around a three stage impairment recognition model [Figure 1]

that measures this inherent default risk in increasing degrees of probability. The three stage

model is based on whether there has been a significant deterioration in the credit risk of a

financial asset.9(BDO, 2014). The models applies different rules to the input variables used

to calculate expected credit loss through the different stages. Impairment (and the

corresponding provision) increases as the asset moves through the buckets and the chance

of default increases.

Recognising and measuring potential credit loss requires input variables potential default

(PD), loss given default (Lgd), exposure at default (EAD), and future interest income. PD and

Lgd under IFRS 9 are both calculated using either a 12-month or life-time horizon metric

9 The definition of Significant Increase in Credit Risk (SICR) is vague in the IFRS 9 document. Ostensible as will

be discussed later it is the increase in the chance that a contractual obligation will not be fulfilled money not received from a debtor in the case of a bank.

42

depending on the stage. The horizon for measurement begins at initial recognition and

carries on through the entire life of the asset therefore fundamentally different to IAS 39.

The basis of the models mechanism significant increase in credit risk is the criteria that

informs the movement of a financial asset through the three stages. BCBS describes the

IASB ECL model as a relative model. This means that the assessment of significant increase

in credit risk is based on comparing credit risk on exposures at the reporting date relative to

credit risk upon initial recognition. (BCBS, 2015a). There are important elements of the

models definition and working that require discussion.

The first point is that the input variables of PD and Lgd are calculated over the lifetime of

the financial asset and is calculated using all possible default events over the expected life

of the financial instrument. Expected credit losses are the weighted average credit loss with

the probability of default as the weight. (PWC, 2014). The 12-month horizon represents a

financial assets lifetime expected credit losses that are expected to arise from default

events that are possible within the next 12 month period (BDO, 2014). This has heavy

bearings on calculating and allocating provisions as statistically there is a much greater

chance of an asset defaulting over its lifetime than say the Basel definition of a 12 month PD

horizon. This is argued to be a more accurate assessment of expected credit loss. The

lifetime approach of IFRS 9 requires not only the above when it comes to PD, but that PD be

calculated for a number of potential credit outcomes over the assets lifetime. These PD are

weighted by the probability of the outcome occurring and aggregated to form the assets

43

overall PD, as observed by PWC above. This ensures that the calculated ECL is as unbiased to

all possible outcomes as possible given the available set of information.

The second point is the probability of default metric under IFRS differs from regulatory PD,

other than lifetime versus 12 month horizon discussed above, in that it should be a point in

time (PiT) measure rather than a through the cycle (TTC) measure. The calculation to get

the PiT PD begins with the lifetime PD and uses a Vasicek model to adjust the lifetime PD to

PiT PD taking into consideration the prevailing current and future macro-economic

conditions which is defined as applying an economic overlay. In calculating PD in this

manner it takes on a forward looking orientation which was absent from previous

accounting regimes. The PiT PD therefore does not neutralise the economic cycle conditions

which TTC PD does and is intended to provide a more accurate calculation of forward

looking credit loss and view of financial risk as the PD is in sync with the economic cycle.

The third point is that the use of PiT PD is a primary methodological component in assessing

the significant increase in credit loss. The significant increase should look at the change in

the risk of a default occurring over the expected life of the financial instrument rather than

the change in ECL. (PWC 2014). When assessing the significant increase in credit risk

when calculating the PD using the scenarios and applying the economic overlay

stakeholders should include in their assessment all reasonable and supportable past,

current and future information. PWC observes that in doing this lifetime ECL are expected

to be recognized before a financial asset becomes delinquent. (PWC 2014) Which speaks to

the forward looking orientation for loan loss recognition of IFRS 9. The second stage of the

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ECL model then becomes extremely important as it allows for the early recognition and

management of potential (or non-performing) financial assets. This point as it pertains to

the relationship of LLP to capital will be discussed at length in the following chapter.

The forth is that IFRS 9 allows for the aggregation of risk categories with common

characteristics. Assessment can therefore take place at the individual right through to

portfolio level where individuals in the population composing the portfolio share

characteristics. This is intended as an early warning signal for credit risk management across

the asset book enabling timeous actions and to prevent blind spot shocks.

Ultimately the ECL model will be used to calculate by how much they have to impair their

assets and what they will set aside as provisions for the expected loss. Changes in ECL

provisioning will occur through the income statement and depending on the instrument will

be processed as fair value through profit or loss (FVPL) and operational line item in

banking or fair value through other comprehensive income (FVOCI). FVOCI is vitally

important when measuring instruments such as securitised assets, shares in other

companies or private equity bundles because OCI is charged in the income statement after

net income. This means that any change in a change OCI immediately affect retained

earnings and equity it directly affects the capital of a bank.

2.3.2. New Disclosures assumptions, assessment and operations

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Together with the requirements set out above with regards to Excepted Credit Loss, its

calculations, considerations and assumptions, a new disclosures section has been include

into IFRS 7: Disclosures to accommodate the wide-ranging assumptions required by the

principles based IFRS 9 ECL model as Leventis et al observes that [IFRS] require[s] extensive

disclosures relative to prior standards (2011). A summary of the disclosure requirements

is contained in table 1 below and covers every aspect of IFRS 9 from SICR to portfolio

composition between the three stages to what assets are classified as FVPL or FVOCI.

AREA DETAIL

Credit Management Practices

Determination of SICR.

Determination of default.

Asset groupings.

Write-off policies.

Renegotiated contracts.

Inputs, Assumptions and Estimation

Techniques

Inputs and techniques use for Stage 1, 2

and 3.

Reconciliation of opening and closing

amounts of loss allowance and gross

carrying amounts showing key drivers of

change for each of the three stage,

including a separate section of the same

variables by Credit Risk Concentration.

How forward looking information has been

used to determine ECL.

Changes in the estimation techniques.

Collateral or Other Credit Enhancements

Descriptions of collateral held.

Gross carrying amount of assets with ECL of

zero due to collateral.

Table 1 (BDO 2014 and PWC 2014)

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As observed, the goal of IFRS is to create a homogenous approach to managing credit risk

and to enable stakeholders to make informed decisions. Given that IFRS 9 is principles based

the role of disclosures becomes critically important as the principles leave much to

interpretation of the adopters. The stringent disclosure requirements of what the adopters

have interpreted as significant increase in credit risk and the composition of the portfolio

that is influenced by that interpretation are an attempt to give stakeholders the view that

IASB thinks they should have in order to make informed decisions.

Fundamentally IFRS 9 is trying to address the shortfalls of IAS 39 by introducing a forward

looking and more accurately represented expected credit loss model. The introduction of

IFRS has created murmurs of uncertainty for implementers firstly because of the sheer

magnitude of implementation requirements and secondly due to its interpretive nature.

2.4. Summary

Banks play a pivotal role in the functioning of the economy as the intermediaries of capital.

Their behaviour is intently watched and draws much scrutiny as it is the subject of

increasingly more and more regulation and control. The financial relationship between the

fundamental two elements of banking operation the relationship between managing the

risk of lending and retaining sufficient capital to buffer losses; that of expected and

unexpected losses has been shown to be informed and governed by two distinctly

different bodies: The Basel Committee for Bank Supervision and International Accounting

Standards Board. The regulation and guidelines that these two bodies who produce The

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Basel Accords governing capital regulation and IFRS 9 setting a standard approach to

accounting for loans losses are inextricable linked to one another as capital is raised

through retained earnings while an increase/decrease in impairments will directly

increase/decrease provisions and converse