The science of IFRS 9 and the art of Basel

(2^nd of two parts in a series of articles)
IFRS 9 is an International Financial Reporting Standard (IFRS) promulgated by the International Accounting Standards Board on July 24, 2014. It addresses the accounting for financial instruments and features three main topics: classification and measurement of financial instruments; impairment of financial assets; and hedge accounting. It will become effective in 2018 and replaces International Accounting Standards (IAS) 39 Financial Instruments: Recognition and Measurement and all previous versions of IFRS 9. In this article, IFRS 9 is referred to as a “science” because of its systematically organized body of information and measurements on specific topics.
Basel III (or the Third Basel Accord or Basel Standards) is a global, voluntary regulatory capital and liquidity framework agreed upon by the members of the Basel Committee on Banking Supervision (BCBS) in 2010–11. It was scheduled to be introduced from 2013 until 2015; however, the implementation has been extended to March 31, 2019. Another round of changes was agreed upon in 2016 and 2017 (informally referred to as Basel IV) and the BCBS is proposing a nine-year implementation timetable, with a “phase-in” period to commence in 2022 and full implementation to be expected by 2027. Basel III was developed in response to the deficiencies in financial regulation that came to light after the financial crisis of 2007–08. Basel III is intended to strengthen banks’ capital requirements, liquidity, maturity profile, and leverage. It also introduced macroprudential elements and capital buffers designed to improve the banking sector’s ability to absorb shocks from financial and economic stress; and reduce spillover effects from the financial sector to the real economy. Basel is an “art” form in the context of the need to perform skillful planning and creative visualization in fully comprehending its dynamic processes and uncertainties.
In last week’s article we began by looking at how financial institutions have come to terms with IFRS 9 implementation, as well as the regulatory changes resulting from the Basel reforms.
We discussed the IFRS 9 adoption journey for some banks, looking at the different elements that bank leaders had to take into consideration, from strategy to risk management, from capital planning to adoption of technology. We now continue the discussion by looking at some questions that banks should consider.
DO BUSINESS MODELS REFLECT OUR STRATEGIC DIRECTION AND THE WAY WE DO BUSINESS?
It is important to note that IFRS 9 uses the term “business model” mainly for loans and fixed income instruments, to establish the right classification given the objective and basis for remuneration. In practice, business models have a wider asset-based definition, covering not only loans and bonds but also equities, derivatives and even alternative investments. Either way, these are narrowed constructs for a typical business model, whose elements broadly include objective, markets and products, value-adding processes, resources, and organization and structure.
With that clarification, let us examine and challenge the three interdependent stages and tools used in developing “ex-ante” business models for IFRS 9 purposes:

1. Tactical and strategic asset allocation (the investment and deployment mechanisms as we know it);

2. Asset-liability management (or ALM, the matching and management of the point-in-time balance sheet and providing information support for management – mainly through the Asset-Liability Committee – in performing its deployment and regulating functions); and,

3. The strategic balance sheet (a scenario forecasting tool imbued with strategic options, usually covering a 3-5 year horizon, which helps management perform its steering function).

Asset-Liability Management exercises typically incorporate duration and interest rate gap management strategies and would make the fixed income investments eligible for Fair Value classification under Other Comprehensive Income. Investments that have tactical churn elements — especially in the light of the trading book boundary discussions implied by the Fundamental Review of the Trading Book regulation — are likely to be classified under Fair Value Through Profit or Loss.
Another question that arises is whether there is a possibility for certain investments to be viewed as having an objective of collecting contractual cash flows particularly if these are matched against established funding and maturity tenors using optimization techniques. There is no pre-ordained answer. At this stage, banks are advised to concentrate on the connection between their strategic balance sheet and strategic asset allocation (SAA). For readers from the insurance and pension sectors, you may wish to read our Feb. 12, 2018 article “Mindful Investing” and Strategic Asset Allocation as part of your post-implementation preparations under IFRS 9.
ARE WE MAXIMIZING THE USE OF RISK MODELS AND STRESS TESTING APPROACHES FOR PROVISIONING PURPOSES?
While banks should maximize or enhance their existing models and approaches, they have to be clear on their attitude to the use of internal models. Should these be used all the way from provisioning to stress testing and just introduce model breaks? Or should they be limited to provisioning?
In our “Financial Regulatory Reform Series: What it means for bank business models” article published in 2013, we wrote that, with the Basel III reforms, there was a perception of retrenchment from internal models for Pillar I capital adequacy calculation, with simpler, more standardized approaches being considered, either by replacing the internal models approaches, introducing a floor, or requiring additional benchmarks. We expected internal models to be increasingly used in planning tools, particularly for strategic and risk-based capital planning. IFRS 9 raised the bar in the use of models and estimation approaches, and this is conceptually appropriate given the reporting objective on financial performance, as opposed to the prudential filter of the regulators. There are already guidelines or proposals on how to manage the difference between IFRS 9’s ECL and regulatory provisions, ranging from the treatment of the regulatory floor and the “Stage 1 ECL” that is broadly similar to the purpose of the general loan loss provision, except that this amount may be treated as an appropriation of retained earnings rather than reflecting it as an expense. Whatever is the final guidance, we expect a wedge between how banks measure risk and provisions internally and what they must report externally.
ARE WE READY FOR PARAMETRIC THINKING?
Institutions that adopted the now-replaced IAS 39 regime and immersed in the internal ratings-based approaches of Basel will feel that there is a collective déjà vu, as quantitative and statistical techniques start to dominate the methodology discussions. But the science parts of IFRS 9 go beyond the methodological and computational dimensions. We are grappling with a change in mental model where the routine assessments for specific, collective and incurred-but-not-reported impairment (incurred loss) are being replaced by expansive and forward-looking views (expected credit loss or ECL). This foreseeing function would require a systematic organization of knowledge and not just an aggregation of data as well as methodical inquiry of phenomena and behavior and not just pattern seeking in static portfolios and historical attributes. Perhaps there is wisdom for the accounting standard-setters not to pre-ordain the use of models to avoid rendering a dynamic assessment requiring adaptive thinking and approaches to become rigid.
In the next article in this series, we will discuss the rise of parametric thinking in calculating ECL and illustrate its application to Corporate and Institutional exposures, with suggested methodology adjustments for areas like Infrastructure and Agri-Value Chain Financing.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
 
Christian G. Lauron is a Partner of SGV & Co.