Individual or collective assessment for impairment
Individual or collective assessment for impairment – An entity should normally identify significant increases in credit risk and recognise lifetime Expected Credit Losses (ECL) before default occurs or the financial asset becomes credit-impaired, either on an individual or collective basis. Individual or collective assessment for impairment
Depending on the nature of the financial instrument and the information available about its credit risk, it may not be possible (without undue cost or effort) to identify significant changes in credit risk at individual instrument level before the financial instrument becomes past due. It may therefore be necessary to assess significant increases in credit risk on a collective or portfolio basis.
This is particularly relevant to financial institutions with a large number of relatively small exposures such as retail loans. In practice, the lender may not obtain or monitor forward-looking credit information about each customer. In such cases the lender would assess changes in credit risk for appropriate portfolios, groups of portfolios or portions of a portfolio of financial instruments. Any
instruments that are assessed collectively must possess shared credit risk characteristics. This is to prevent significant increases in credit risk being obscured by aggregating instruments that have different risks. Individual or collective assessment for impairment
Most lenders of loans to corporate borrowers will possess much of the forward looking information at an individual borrower level and may already be including it in their risk assessments. However, compliance with the standard may require that this information is updated more often than may currently be the case. In contrast, most lenders to retail borrowers will not have this kind of information at the individual borrower level and will much more likely need to make use of a collective assessment.
Banks have hundreds of thousands, or even millions, of small exposures to retail customers and small businesses, for which they do not receive sufficient information to monitor the individual credit quality, beyond whether any payments are past due, and for which it would be impractical to reassess individually even if they possessed more data. Instead, they manage these exposures on an aggregated basis, combining past due data with historical statistical experience and sometimes macroeconomic indicators, such as interest rates and unemployment levels, that tend to correlate with future defaults. Individual or collective assessment for impairment
When instruments are assessed collectively, it is important to remember that the aggregation may need to change over time as new information becomes available.
Individual assessment
Example: The bank assesses each of its mortgage loans on a monthly basis by means of an automated behavioural scoring process based on current and historical past due statuses, levels of customer indebtedness, loan-to-value (LTV) measures, customer behaviour on other financial instruments with the bank, the loan size and the time since the origination of the loan. It is said that historical data indicates a strong correlation between the value of residential property and the default rates for mortgages. Individual or collective assessment for impairment
The bank updates the LTV measures on a regular basis through an automated process that re-estimates property values using recent sales in each post code area and reasonable and supportable forward-looking information that is available without undue cost or effort. Therefore, an increased risk of a default occurring due to an expected decline in residential property value adjusts the behavioural scores and the bank is therefore able to identify significant increases in credit risk of individual customers before a mortgage becomes past due if there has been a deterioration in the behavioural score. Individual or collective assessment for impairment
The example concludes that if the bank was unable to update behavioural scores to reflect the expected declines in property prices, it would use reasonable and supportable information that is available without undue cost or effort to undertake a collective assessment to determine the loans on which there has been a significant increase in credit risk since initial recognition and recognize lifetime ECLs for those loans. Individual or collective assessment for impairment
It should be noted that, in this example, the main source of forward looking information is expected future property prices. No account would appear to be taken of other economic data such as future levels of employment or interest rates. We assume that the Board took this approach to make the example simple, but it implies that future property prices are considered to provide a sufficient guide to future defaults that it is not necessary to take account of other data as well.
IFRS 9 first specifies that, if an entity does not have reasonable and supportable information that is available without undue cost or effort to measure lifetime expected losses on an individual instrument basis, it must assess lifetime losses on a collective basis. This exercise must consider comprehensive information that incorporates not only past due data, but other relevant credit information, such as forward looking macro-economic information. The objective is to approximate the result of using comprehensive credit information that incorporates forward-looking information at an individual instrument level. (IFRS 9 B5.5.4) Individual or collective assessment for impairment
Next, the standard sets out how financial instruments may be grouped together in order to determine whether there has been a significant increase in credit risk. (IFRS 9 B5.5.5) Any instruments assessed collectively must possess shared credit risk characteristics. It is not permitted to aggregate exposures that have different risks and, in so doing, obscure significant increases in risk that may arise on a subset of the portfolio. Examples of shared credit risk characteristics given in the standard include, but are not limited to:
Instrument type Individual or collective assessment for impairment
Credit risk ratings Individual or collective assessment for impairment
Collateral type Individual or collective assessment for impairment
Date of initial recognition Individual or collective assessment for impairment
Remaining term to maturity Individual or collective assessment for impairment
Industry Individual or collective assessment for impairment
Geographical location of the borrower Individual or collective assessment for impairment
The value of collateral relative to the asset (the loan-to-value or LTV ratio), if this would have an impact on the probability of a default occurring
The standard also states that the basis of aggregation of financial instruments to assess whether there have been changes in credit risk on a collective basis may have to change over time, as new information on groups of, or individual, financial instruments becomes available.(IFRS 9 B5.5.6) Individual or collective assessment for impairment
Individual or collective assessment for impairment
Depending on the nature of the financial instrument and the information available about its credit risk, it may not be possible to identify significant changes in credit risk at individual instrument level before the financial instrument becomes past due. It may therefore be necessary to assess significant increases in credit risk on a collective or portfolio basis. This is particularly relevant to financial institutions with a large number of relatively small exposures such as retail loans. Individual or collective assessment for impairment
In practice, the lender may not obtain or monitor forward-looking credit information about each customer. In such cases the lender would assess changes in credit risk for appropriate portfolios, groups of portfolios or portions of a portfolio of financial instruments. Any instruments that are assessed collectively must possess shared credit risk characteristics. This is to prevent significant increases in credit risk being obscured by aggregating instruments that have different risks. When instruments are assessed collectively, it is important to remember that the aggregation may need to change over time as new information becomes available. Individual or collective assessment for impairment
Assessment of changes in credit risk
The following information may be relevant in assessing changes in credit risk. The list is not intended to be exhaustive.
significant changes in internal price indicators of credit risk Individual or collective assessment for impairment
changes in the terms of an instrument that reflect changes in credit risk (eg more stringent covenants)
significant changes in external market indicators of credit risk (eg the length of time or extent to which a financial asset has been below amortised cost)
existing or expected adverse changes in the regulatory, economic, or technological environment that significantly affect, or are expected to affect, the borrower’s ability to meet its debt obligations Individual or collective assessment for impairment
an actual or expected significant change in the operating results of the borrower Individual or collective assessment for impairment
significant changes in the value of the collateral supporting the obligation or in the quality of guarantees or credit enhancements
reductions in financial support from a parent entity that are expected to reduce the borrower’s incentive to make scheduled contractual payments
expected breaches of contract that may, for example, lead to covenant waivers or amendments, or interest payment holidays
significant changes in the expected performance and behaviour of the borrower Individual or collective assessment for impairment
past due information. Individual or collective assessment for impairment
Possible sources of data to use in assessing significant increases in credit risk
Internal data
Borrower-specific external data
significant changes in
internal price indicators
changes in other rates or terms
actual or expected downgrade to internal credit rating or behaviour score
expected changes in loan documentation or expected breach of covenant
actual or expected downgrade to external credit rating
increases in credit risk of borrower’s other instruments
actual or expected deterioration in borrower’s financial performance.
Broader external data
adverse changes (actual or expected) in
borrower’s financial performance
borrower’s business, financial or economic conditions
borrower’s regulatory, economic or technological environment
adverse changes in value or quality of any
supporting collateral
shareholder guarantee or financial support.
Macro risks
Unemployment rates – The increase in unemployment may can an economic downturn, a decrease in unemployment may cause labour costs to rise in excess of productivity increases. When unemployment is high, some people become discouraged and stop looking for work; they are then excluded from the labour force. This implies that the unemployment rate may fall, or stop rising, even though there has been no underlying improvement in the labour market.
Price indexes – Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy’s general price level or a cost of living. More narrow price indices can help producers with business plans and pricing. Sometimes, they can be useful in helping to guide investment. Examples are: – Consumer price index, – Producer price index, – Employment cost index, Export price index, – Import price index, and – GDP deflator.
Monetary policy variables – Monetary policy is referred to as being either expansionary or contractionary. Expansionary policy occurs when a monetary authority uses its tools to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. The opposite of expansionary monetary policy is contractionary monetary policy, which maintains short-term interest rates higher than usual or which slows the rate of growth in the money supply or even shrinks it. This slows short-term economic growth and lessens inflation.
Interest rates – Higher interest rates increase the cost of borrowing which can reduce physical investment and output and increase unemployment. Higher rates encourage more saving and reduce inflation. Obviously lower interest rates are presumed to do the opposite. See also The European Central Bank’s response to the financial crises.
Exchange rates – A country may gain an advantage in international trade if it controls the market for its currency to keep its value low, typically by the national central bank engaging in open market operations in the foreign exchange market. In the early twenty-first century it was widely asserted that the People’s Republic of China had been doing this over a long period of time
Housing starts – Housing starts is an economic indicator that reflects the number of privately owned new houses (technically housing units) on which construction has been started in a given period. These data are divided into three types: single-family houses, town houses or small condos, and apartment buildings with five or more units.
Agricultural exports – The major agricultural commodities imported are rice, wheat and sugar followed by coffee and cocoa, sheanut and palm oil.
Commodity prices such as gold – Gold prices are assumed to reflect the beliefs of commodities traders. If they think the economy is doing poorly, they will buy more gold. If they think the economy is doing well, they will buy less gold. Gold prices reveal what savvy investors know about economic health. Here are examples of how that works.
Individual or collective assessment for impairment
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