International Financial Reporting Standards 9 (IFRS 9) Financial Instruments

Temenos Briefing Document

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Contents

Classification and Measurement

Impairment Accounting

Hedge Accounting

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03Glossary

Overview of IFRS 9

IFRS across the globe

05Crux of IFRS 9

05Three main areas of IFRS 9

09Strategy from Temenos for IFRS 9How can Temenos help?

Key offerings as part of the IFRS 9 solution in Temenos Core Banking

Availability of the IFRS 9 solution in Temenos Core Banking

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11Contacts

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GlossaryAbbreviation DefinitionIFRS International Financial Reporting Standards

AMC Amortised Cost

FVTPL Fair Value Through Profit & Loss

FVTOCI Fair Value Through Other Comprehensive Income

EIR Effective Interest Rate

ECL Expected Credit Loss

EAD Exposure at Default

LGD Loss Given Default

PD Probability of Default

CCC Contractual Cash Flows

FA Financial Asset

FL Financial Liability

Overview of IFRS 9The International Accounting Standards Board (IASB) has published a new IFRS 9 to address the shortcomings of the existing International Accounting Standard 39 (IAS39) by mandating a new method for applying risk metrics to accounting relating to the Financial Instruments.

The changes to financial instrument accounting are likely to have the greatest impact on banks and other financial institutions.

The package of improvements introduced by IFRS 9 includes the following:

• a logical model for classification and measurement;

• a single, forward-looking ‘expected loss’ impairment model; and

• a substantially-reformed approach to hedge accounting.

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IFRS across the globeWorldwide more than 100 countries require, permit or are converging to IFRS. The changes to financial instrument accounting are likely to have the greatest impact on the banks and other financial institutions.

Countries that require or permit IFRS 9

Countries converging to IFRS with the goal of adoption

Countries pursuing convergence to IFRS 9 but no plan to adopt in the near future

Country StatusUS US GAAP

Japan Converging to IFRS

UK IFRS

France IFRS

Canada Converging to IFRS

Germany IFRS

Hong Kong IFRS

Switzerland IFRS or US GAAP

IFRS implementation status with the top global capital markets:

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The overview of the IFRS 9 project is summarized by the following analysis, answering the four important questions:

Crux of IFRS 9

What?IFRS 9 Financial Instruments introduces new guidance for:

• Classification and measurement• Impairment accounting • Hedge accounting• Revised methodology for own credit risk

Who?All banks and insurance entities reporting according to IFRS need to comply with IFRS 9.

When?The IASB published the final version of IFRS 9 Financial Instruments in July 2014. IFRS 9 will come into effect on 01 January 2018. However, the standard is available for early application for the financial year beginning from 01 Jan 2017.

Why? (business rationale)IFRS 9 Financial Instruments requires banks to move from an incurred loss model to an expected loss model. For the first time, banks will have to recognize not only credit losses that have already occurred but also losses that are expected in the future.

In addition, IFRS 9 addresses the so-called ‘own credit’ issue, whereby banks and other financial institutions book gains through profit or loss as a result of the value of their own debt falling due to a decrease in credit worthiness when they have elected to measure that debt at fair value.

The standard also includes a simplification of the classification and measurement categories for financial assets and an improved hedge accounting model to better link the economics of risk management with its accounting treatment.

Three main areas of IFRS 9

Classification and measurement

Hedge accounting

Impairment accounting

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Classification and measurementClassification determines how financial assets are accounted for in financial statements and, in particular, how they are measured on an ongoing basis. Requirements for classification and measurement are the foundation of the accounting for financial instruments. The requirements for impairment and hedge accounting are based on that classification.

IFRS 9 largely carries forward the scope of IAS 39. All financial instruments that are in scope of IAS 39 are in scope of IFRS 9.

IFRS 9 classification:• is a principle based approach • is based on business model and nature of cash

flows• is a business model driven re-classification• own credit gains and losses presented in OCI

for FVO liabilities

Measurement - Financial Assets

IFRS 9 applies one classification approach for all the Financial Assets including those that contain embedded derivative feature.

Two criteria’s are used to determine how financial asset should be classified & measured:

1. the entity’s Business Model for managing Financial Assets

2. the Contractual Cash Flow Characteristic of the Financial Assets

FINANCIAL ASSETSBusiness Models for: Objective

Amortised Cost - AMCIs to hold assets in order to collect Contractual Cash Flows.

Fair Value Through Other Comprehensive Income - FVTOCI

Is achieved by both collecting Contractual Cash Flows and selling FA.

Fair Value Through Other Profit Loss A/c. - FVPL

All other business models will follow FVPL.

Measurement - Financial Liabilities

IAS 39’s treatment of financial liabilities is carried forward to IFRS 9 essentially unchanged. This means that most financial liabilities will continue to be measured at amortised cost. IFRS 9 includes the same option as IAS 39 that permits entities to elect to measure financial liabilities at fair value through profit or loss if particular criteria’s are met.

FINANCIAL ASSETSBusiness Models for: Objective

Amortised Cost - AMC

More or less similar to IAS 39.

Fair Value Through Other Profit Loss A/c. - FVPL

Impairment accountingThe three-bucket impairment model is a new requirement of IFRS 9, which will replace the existing Incurred Loss Model with the new Expected Loss Model.

Drawbacks of the Incurred Loss Model of IAS 39

During the financial crisis, there was a delayed recognition of credit losses on loans (and other financial instruments) and this was identified as a weakness in the existing accounting standards. The existing model in IAS 39 (an ‘incurred loss’ model) delays the recognition of credit losses until there is an evidence of a trigger event.

As the financial crisis unfolded, it became clear that the incurred loss model gave room to a different kind of earnings management, namely to postpone losses. Even though IAS 39 did not require waiting for actual default before impairment is recognized, in practice this was often the case.

The Expected Loss Model under IFRS 9

It is a forward-looking expected credit loss model that will result in more timely recognition of loan losses and is a single model that is applicable to all financial instruments subject to impairment accounting. It eliminates the threshold for the recognition of expected credit losses, so that it is no longer necessary for a trigger event to have occurred before credit losses are recognized. Consequently, more timely information is required to be provided about expected credit losses.

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Important Concepts – Expected Loss Model

12 month Expected Losses

Portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months, after the reporting date

Lifetime Expected Losses Credit losses are an expected present value measure of losses that arise if a borrower defaults on their obligation throughout the life of the financial instrument

Exposure At Default Amount outstanding with the obligor at the time of default

Probability of Default Probability that the obligor will default within a given time horizon

Loss Given Default Percentage loss incurred relative to the EAD

3 Bucket Model

Change of credit risk since initial recognition

Stage 1 Stage 2 Stage 3Initial recgonition

Loss allowance

Apply effective interest rate to

12-month expected credit loss

Gross carrying amount

Lifetime expected credit losses

Gross carrying amount

Lifetime expectedcredit losses

Net carrying amount

Significant increase in credit risk?

Objective evidence for impairment?

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Hedge accounting (optional requirement)

The new hedge accounting model enables companies to better reflect their risk management activities in the financial statements. This will help investors to understand the effect of hedging activities on the financial statements and on future cash flows.

The goal of the new hedge accounting model is to align the accounting treatment with the risk management activities. In accordance with IFRS 9, the hedging of both non-financial and financial components is possible. IFRS 9 does not distinct between hedging on financial items e.g. LIBOR risk component of a bond and non-financial items for instance hedge the oil price component of jet fuel. IFRS 9 looks at whether a risk component can be identified and measured and does not distinguish between types of items. This will enable more entities to apply hedge accounting that reflects their risk management activities.

SIMILARITIES between IAS 39 and IFRS 9

Terminology Definitions of Hedged Items/Hedging Instruments are the same.

Documentation Formal documentation process is the same.

Categories Cash Flow/Fair Value/Investment Hedge Categories are the same.

Applicability Under both the standards it is not an obligation but a choice.

DIFFERENCES between IAS 39 and IFRS 9

Area IAS 39 IFRS 9

Testing the Hedge Effectiveness

Allows both prospective and retrospective test for the hedge effectiveness.Specifies the numeric test for the hedge effectiveness between (80-125%).

Allows only prospective test for the hedge effectiveness.

Principle based criteria for the test.

Rebalancing Terminating the current hedge and start the new one.

Allows rebalancing without the need to terminate.

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How can Temenos help?Applying our functional/technical understanding of the rules and our experience of working with the financial sector, we are able to analyse clients’ business models to help them understand the practical and financial implications of any new regulations and to develop strategies for dealing with such implications.

With the arrival of the new IFRS 9, it is more important than ever to plan for the impact of regulatory rules, and design an efficient response. Our structure allows us to keep our clients updated on recent developments and enables member clients to benefit directly from our combined knowledge and experience. Our experience in developing and implementing the IAS 39 at various banks across the globe will benefit our clients to meet their IFRS 9 obligations with limited disruption to their business.

Key offerings as part of the IFRS 9 solution in Temenos Core BankingClassification and measurement

• Classification of the financial instruments in to the following three buckets:• Amortised Cost (AMC)• Fair Value Through Other Comprehensive Income (FVTOCI)• Fair Value hrough Profit or Loss (FVPL)

• Measurement of the financial instruments:

Business Model Measurement

For the contracts measured at Amortised Cost

• Ability to project the Contractual cash flows of the financial instruments• Ability to compute the Effective Interest Rate (EIR)• Ability to calculate the Amortised Cost (NPV of the CCF discounted at the EIR)• Ability to do a disclosure at Fair Value

For the contracts measured at Fair Value

Equity Instruments• Ability to recognise the unrealised profit/loss on a daily basis based on the price• Ability to realise the actual profits upon sale.

Interest bearing Instruments• Ability to project the Contractual cash flows of the financial instruments• Ability to link the Market Rate to the instrument• Ability to calculate the Fair Value (NPV of the CCF discounted at the Market Rate)

Impairment accounting

• New centralised impairment calculator will be developed in the system to move towards the Expected Loss Model and do the necessary impairment accounting by: • Classifying the financial assets in to three buckets i.e. Stage 1, Stage 2 and Stage 3.• Start recognising the ECLs from the initial recognition.• Calculate and account for the ECLs based on the stage of the asset.

Strategy from Temenos for IFRS 9

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Stage Requirement Impairment Loss

Stage 1

• As soon as a financial instrument is originated or purchased, 12-month expected credit losses will be recognised in profit or loss and a loss allowance will be established.

• For financial assets, interest revenue will be calculated on the gross carrying amount (i.e. without adjustment for expected credit losses).

12M ECL = 12M Cash Shortfalls12M ECL = NPV of (CCF – ECF)Where Expected Cash Flows = Contractual Cash Flows *(1 – PD.12M *LGD)

Stage 2

• If the credit risk increases significantly and the resulting credit quality is not considered to be low credit risk, full lifetime expected credit losses will be recognised.

• Lifetime expected credit losses will only recognised if the credit risk increas-es significantly from when the entity originates or purchases the financial instrument.

LTM ECL = 12M Cash ShortfallsLTM ECL = NPV of (CCF – ECF)Where Expected Cash Flows = Contractual Cash Flows *(1 – PD.LTM *LGD)

Stage 3

• If the credit risk of a financial asset in-creases to the point that it is considered credit-impaired, interest revenue will be calculated based on the amortised cost (i.e. the gross carrying amount adjusted for the loss allowance).

• Financial assets in this stage will gener-ally be individually assessed.

ECL = Recoverable Value Less Book Valuewhere, Recoverable Value = NPV of ECF discounted @ EIRBook Value = NPV of the CCF discounted at the EIR

Note:

IFRS 9 is an accounting and reporting standard with a combination of accounting and risk areas. In order to work out the ECLs, system will require the following two statistical elements relating to risk:

• Probability of Default (PDs)• Loss given Default (LGDs)

The guidance issued for IFRS 9 compliance states that the financial institutions could use the above two elements derived out of their Basel regulation compliance.

The system will provide an ability to consume the above two elements in to Temenos Core Banking system either from the client’s external risk system or Temenos Insight Risk.

Hedge accounting (optional requirement)

• The hedge accounting solution will offer:• Ability to state the Hedge Types• For e.g. Fair Value/Cash flow/Investments• Ability to document the Hedge Relationships• For e.g. Start Date, End Date, Hedge Type, Details of Hedged Items and Hedging Instruments &

Hedge Status• Ability to define the Accounting Rules based on the type of the Hedge• Ability to raise the Hedge Accounting Entries

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Availability of the IFRS 9 solution in Temenos Core BankingThe below timeline will be followed for the IFRS 9 project from Temenos to roll the product out by end of Q2 of 2017 giving them enough time to be complaint with the IFRS 9 effective from 01 Jan 2018 onwards.

Following licenced modules will be required based on the type of the clients:

RETAIL CLIENTS

IFRS 9 Compliance Area Modules

Classification & Measurement Impairment Accounting of Financial Assets

IA + I9 + PV

Hedge Accounting (Optional requirement) IH

With IFRS 9 compliance in Temenos Core Banking, the new functionality will be controlled by a new licence code – I9 and will be licensed under Module 3 level. The presence of the new licence code will control the ability for the banks to use the new options/calculations as required under the new IFRS 9 regulation.

Note:

IA, PV and IH are the existing modules.

Contacts

For any further queries and interest in getting the IFRS 9 Solution in Temenos Core Banking, please get in touch with:

Anish Shah Product Manager Temenos UK Ltd5th Floor, 71 Fenchurch Street, London EC3M 4TD, UKT: +44 20 7423 3700 D: +44 20 7423 3865E: anish@temenos.com

2016 2017May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr

Requirements Design, Coding, Model & Testing UA Testing Training & Handover Rollout

CORPORATE & PWM CLIENTS

IFRS 9 Compliance Area Modules

Classification & Measurement Impairment Accounting of Financial Assets

IA + I9

Hedge Accounting (Optional requirement) IH

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