Determining significant increases in credit risk

The transition from recognising 12-month expected credit losses (i.e. Stage 1) to lifetime expected credit losses (i.e. Stage 2) in IFRS 9 Financial Instruments is based on the notion of a significant increase in credit risk over the remaining life of the instrument. The focus is on the changes in the risk of a default, and not the changes in the amount of expected credit losses. For example, for highly collateralised financial assets such as real estate backed loans when a borrower is expected to be affected by the downturn in its local economy with a consequent increase in credit risk, that loan would move to Stage 2, even though the actual loss suffered may be small because the lender can recover most of the amount due by enforcing the collateral.

Entities are permitted to use changes in the risk of default over the next 12-month as a reasonable proxy for changes in credit risk over the remaining life of the instrument. However, this would not be appropriate for financial assets where there is only one significant payment obligation after 12 months.

The assessment and measurement of credit losses is an inherently subjective area, and therefore different indicators will be appropriate for different types of financial assets. Judgement will be required and implies that there may be a degree of diversity in practice with different expected losses being recorded by different entities for similar financial assets.

This is an inevitable consequence of a more forward looking ‘expected loss’ model. However, for most entities the expected credit losses model will require only 12-month expected losses to be recognised for the majority of their financial assets, meaning that the diversity in reported results may be reduced in comparison with an approach which required the immediate recognition of lifetime expected losses.

The IFRS 9 indicators for identification of lifetime expected credit losses.

IFRS 9 sets out guidance to assist entities in identifying information to be used to determine when a provision for lifetime expected credit losses is required. The application guidance sets out a wide range of potential sources of such information which includes:

  • Changes in internal pricing indicators,
  • Changes in external market indicators of credit risk,
  • Credit rating changes,
  • Changes to contractual terms that would be made if the financial asset was newly originated,
  • Adverse changes in general economic and/or market conditions,
  • Significant changes in the operating results or financial position of the borrower,
  • Increase in credit risk of other financial instruments of the same borrower,
  • Changes in the borrower’s regulatory, economic or technological environment,
  • Changes in the value of collateral or guarantees (including those provided by a related party of the borrower),
  • Changes in the amount of financial support available to an entity (for example, from its parent),
  • Expected or potential breaches of covenants,
  • Changes in the expected behaviour of the borrower, and past-due information,
  • Changes in the credit management approach.

The Guidance sets out in more detail a number of factors that entities will need to consider when making the determination of whether lifetime expected credit losses should be recorded.

Because of the inherent uncertainties towards all these estimates (expected credit losses, increase in credit risk) entities will need to develop clear policies to identify the transitioning between Stage 1 and Stage 2, incorporating some of the indicators set out in the application guidance as appropriate.

Rebuttable presumption – significant increase in credit risk

The standard contains a rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due. This means that when payments are 30 days past due, the financial asset is considered to have moved from Stage 1 to Stage 2, and lifetime expected credit losses are recognised. Past due is defined as failure to make a payment when that payment was contractually due. Feedback received by the IASB during the development of the new impairment model indicated than many entities manage credit risk on the basis of past due information, and have a limited ability to assess credit risk on an instrument by instrument basis in more detail on a timely basis.

The 30 days past due presumption can be rebutted if other reasonable and supportable information is available that demonstrates that, even if payments are 30 days or more past due, this does not represent a significant increase in the credit risk of the financial asset. This might be the case if the late payment was an administrative oversight which was subsequently rectified. Alternatively, the entity’s historical experience may indicate that the fact that amounts are more than 30 days past due does not provide evidence of a significant increase in the probability of default occurring, whereas amounts that are more than 60 days past due do.

It is expected that the 30 day rebuttable presumption will only be rebutted in limited situations. The 30 day past due is meant to act as a backstop indicator for when there has been a significant increase in credit risk.

IFRS 9 is clear that the 30 days past due test is not the only one to be applied if other information is readily available. Consequently, if credit risk management monitors forward looking macro information, or that information is available without undue cost or effort, entities are required to take that information into account and cannot solely rely on past due information. Therefore, even if information is not yet available on an individual loan by loan basis, entities should still group loans together based on shared risk characteristics such as instrument type, credit risk ratings, collateral type, date of initial recognition, remaining term to maturity, or by industry or by location, and provide for lifetime expected credit losses at portfolio level for those portfolios where the entity can identify a significant increase in credit risk.

EXAMPLE

Portfolio of retail mortgages and personal loans

  • Bank ABC provides mortgages and personal loans in Region Z,
  • As part of the loan application process, customers are required to provide information such as the industry within which the customer is employed, and the post code of the property that serves as collateral on the mortgage (when applicable),
  • The average loan to value ratio for all its mortgage loans is 70%,
  • Bank ABC tracks probability of default occurring by using past-due information,
  • A number of car manufacturers have production plants located within Region Z,
  • Bank ABC becomes aware of the declining profit of several major car manufacturers and, as a result of a number of public statements, expects the closure of several of the production plants in Region Z. It is expected that in addition to the closure of production plants, a number of service providers to the car manufacturers will also close,
  • Bank ABC also considers other forward looking information in addition to the past due status (to the extent that such information is available),
  • Bank ABC segments the mortgage portfolio to identify borrowers who work at the car production plants and borrowers who are employed by service providers to the car manufacturers, takes into account any other relevant forward looking information, and recognises lifetime expected credit losses for those mortgages (i.e. Stage 2) (even if no loans are yet past due),
  • For the mortgage loans portfolio, in estimating lifetime credit losses, Bank ABC takes into account the expected recovery from the real estate. This may result in expected credit losses on mortgage loans being very small, even though the loans are in Stage 2.

Practical expedient – low credit risk financial instruments

IFRS 9 includes a practical expedient for low credit risk financial instruments. Characteristics of low credit risk financial instruments include:

  • Strong capacity to meet its contractual cash flow obligations in the near term,
  • Adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the borrower’s ability to pay,
  • External rating of investment grade or an internal credit rating equivalent.

The instrument must be considered to have low credit risk from a market participant’s perspective. For low risk credit instruments, it is assumed that credit risk has not increased significantly at each reporting date. This means that only 12 month expected credit losses will be recorded for these financial instruments.

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