Low credit risk operational simplification

Low credit risk operational simplification

IFRS 9 contains an important simplification that, if a financial instrument has low credit risk, then an entity is allowed to assume at the reporting date that no significant increases in credit risk have occurred. The low credit risk concept was intended, by the IASB, to provide relief for entities from tracking changes in the credit risk of high quality financial instruments. Therefore, this simplification is only optional and the low credit risk simplification can be elected on an instrument-by-instrument basis.

This is a change from the 2013 ED, in which a low risk exposure was deemed not to have suffered significant deterioration in credit risk. The amendment to make the simplification optional was made in response to requests from constituents, including regulators. It is expected that the Basel Committee SCRAVL consultation document will propose that sophisticated banks should only use this simplification rarely for their loan portfolios.

For low risk instruments, the entity would recognise an allowance based on 12-month ECLs. However, if a financial instrument is not considered to have low credit risk at the reporting date, it does not follow that the entity is required to recognise lifetime ECLs. In such instances, the entity has to assess whether there has been a significant increase in credit risk since initial recognition that requires the recognition of lifetime ECLs.

The standard states that a financial instrument is considered to have low credit risk if: [IFRS 9.B5.22]

  • The financial instrument has a low risk of default
  • The borrower has a 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 ability of the borrower to fulfil its contractual cash flow obligations Low credit risk operational simplification

A financial instrument is not considered to have low credit risk simply because it has a low risk of loss (e.g., for a collateralised loan, if the value of the collateral is more than the amount lent (see collateral) or it has lower risk of default compared with the entity’s other financial instruments or relative to the credit risk of the jurisdiction within which the entity operates.

The description of low credit risk is broadly equivalent to ‘investment grade’ quality assets, equivalent to a Standard and Poor’s rating of BBB- or better, Moody’s rating of Baa3 or better and Fitch’s rating of BBB- or better. When applying the low credit risk simplification, financial instruments are not required to be externally rated. Low credit risk operational simplification

However, the IASB’s intention was to use a globally comparable notion of low credit risk instead of a level of risk determined, for example, by an entity or jurisdiction’s view of risk based on entity-specific or jurisdictional factors. [IFRS 9.BC5.188] Therefore, an entity may use its internal credit ratings to assess what is low credit risk as long as this is consistent with the globally understood definition of low credit risk (i.e., investment grade) or the market’s expectations of what is deemed to be low credit risk. Also, ratings should be adjusted to take into consideration the specific risks of the financial instruments being assessed. Low credit risk operational simplification

In practice, entities with internal credit ratings may seek to map their internal rating to the external credit ratings and definitions, such as Standard & Poor’s, Moody’s and Fitch. The description of the credit quality ratings by these major rating agencies are illustrated below1.

External credit ratings agencies

External credit ratings and definitions from the 3 major rating agencies

Low credit risk operational simplification

Low credit risk operational simplification

Low credit risk operational simplification

Investment grade would usually refer to categories AAA to BBB (with BBB- being lowest investment grade considered by market participants).

Investment grade would usually refer to categories Aaa to Baa (with Baa3 being lowest investment grade considered by market participants).

Investment grade would usually refer to categories AAA to BBB (with BBB- being lowest investment grade considered by market participants).

BBB

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

Baa

Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics

BBB: Good credit quality

Indicates that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.

Distinction line between investment grade and speculative grade

BB

Less vulnerable in the near-term but faces major on-going uncertainties to adverse business, financial and economic conditions.

Low credit risk operational simplification

Low credit risk operational simplification

Ba

Obligations rated Ba are judged to be speculative and are subject to substantial credit risk.

Low credit risk operational simplification

Low credit risk operational simplification

BB: Speculative

Indicates an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time. However, business or financial flexibility exists which supports the servicing of financial commitments.

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Examining the historical levels of default associated with the credit ratings of agencies such as Standard & Poor’s, the PD of a BBB-rated loan is approximately treble that of one that is rated A. Hence, some entities may wish not to use the low risk simplification and to treat the credit risk of an asset that is downgraded from A to BBB as significant, even though it is still investment grade.

Food for thought

The low credit risk simplification is generally not relevant if an entity originates or purchases a financial instrument with a credit risk which is already higher than that of an investment grade asset.

Similarly, this simplification also has limited use when the financial instrument is originated or purchased with a credit quality that is marginally better than a non-investment grade (i.e., at the bottom of the investment grade rating), because any credit deterioration to the non-investment grade rating would require the entity to assess whether the increase in credit risk has been significant.

It remains to be seen whether banks will use this operational simplification widely for their loan portfolios. Investors that hold externally rated debt instruments are more likely to rely on external rating agencies data and use the low credit risk simplification. However, it is important to emphasize that:

  • The default rates provided by external rating agencies are historical information. Entities need to understand the sources of these historical default rates and update the data for current and forward-looking information (see reasonable and supportable information) when measuring ECLs or assessing credit deterioration, as illustrated by the extract from IFRS 9 below.
  • Although ratings are forward-looking, it is sometimes suggested that changes in credit ratings may not be reflected in a timely manner. Therefore, entities may have to take account of expected changes in ratings in assessing whether there has been a significant increase in risk and to adjust their assumed default rates.

Nevertheless, the choice of whether to apply the low credit risk simplification will likely create diversity in practice.

The following example illustrates the application of the low credit risk simplification.

Public investment-grade bond

IFRS 9.IE24-IE28 – Example 4

Company A is a large listed national logistics company. The only debt in the capital structure is a five-year public bond with a restriction on further borrowing as the only bond covenant. Company A reports quarterly to its shareholders. Entity B is one of many investors in the bond. Entity B considers the bond to have low credit risk at initial recognition in accordance with IFRS 9.5.5.10.

This is because the bond has a low risk of default and Company A is considered to have a strong capacity to meet its obligations in the near term. Entity B’s expectations for the longer term are that adverse changes in economic and business conditions may, but will not necessarily, reduce Company A’s ability to fulfil its obligations on the bond. In addition, at initial recognition the bond had an internal credit rating that is correlated to a global external credit rating of investment grade.

At the reporting date, Entity B’s main credit risk concern is the continuing pressure on the total volume of sales that has caused Company A’s operating cash flows to decrease.

Because Entity B relies only on quarterly public information and does not have access to private credit risk information (because it is a bond investor), its assessment of changes in credit risk is tied to public announcements and information, including updates on credit perspectives in press releases from rating agencies.

Entity B applies the low credit risk simplification in IFRS 9.5.5.10. Accordingly, at the reporting date, Entity B evaluates whether the bond is considered to have low credit risk using all reasonable and supportable information that is available without undue cost or effort. In making that evaluation, Entity B reassesses the internal credit rating of the bond and concludes that the bond is no longer equivalent to an investment grade rating because:

  1. The latest quarterly report of Company A revealed a quarter-on-quarter decline in revenues of 20 per cent and in operating profit by 12 per cent.
  2. Rating agencies have reacted negatively to a profit warning by Company A and put the credit rating under review for possible downgrade from investment grade to non-investment grade. However, at the reporting date the external credit risk rating was unchanged.
  3. The bond price has also declined significantly, which has resulted in a higher yield to maturity. Entity B assesses that the bond prices have been declining as a result of increases in Company A’s credit risk. This is because the market environment has not changed (for example, benchmark interest rates, liquidity etc are unchanged) and comparison with the bond prices of peers shows that the reductions are probably company specific (instead of being, for example, changes in benchmark interest rates that are not indicative of company-specific credit risk).

While Company A currently has the capacity to meet its commitments, the large uncertainties arising from its exposure to adverse business and economic conditions have increased the risk of a default occurring on the bond. As a result of the factors described in paragraph IE27, Entity B determines that the bond does not have low credit risk at the reporting date.

IE27 Entity B applies the low credit risk simplification in paragraph 5.5.10 of IFRS 9. Accordingly, at the reporting date, Entity B evaluates whether the bond is considered to have low credit risk using all reasonable and supportable information that is available without undue cost or effort. In making that evaluation, Entity B reassesses the internal credit rating of the bond and concludes that the bond is no longer equivalent to an investment grade rating because:

  1. The latest quarterly report of Company A revealed a quarter-on-quarter decline in revenues of 20 per cent and in operating profit by 12 per cent.
  2. Rating agencies have reacted negatively to a profit warning by Company A and put the credit rating under review for possible downgrade from investment grade to non-investment grade. However, at the reporting date the external credit risk rating was unchanged.
  3. The bond price has also declined significantly, which has resulted in a higher yield to maturity. Entity B assesses that the bond prices have been declining as a result of increases in Company A’s credit risk. This is because the market environment has not changed (for example, benchmark interest rates, liquidity etc are unchanged) and comparison with the bond prices of peers shows that the reductions are probably company specific (instead of being, for example, changes in benchmark interest rates that are not indicative of company-specific credit risk).

As a result, Entity B needs to determine whether the increase in credit risk since initial recognition has been significant. On the basis of its assessment, Company B determines that the credit risk has increased significantly since initial recognition and that a loss allowance at an amount equal to lifetime expected credit losses should be recognised in accordance with IFRS 9.5.5.3.

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Some of the challenges in assessing whether there has been a significant increase in credit risk (including the use of the low credit risk simplification) and estimating the expected losses, are illustrated in the following example. It illustrates different ways of identifying a significant change in credit quality and different input parameters for calculating expected losses for a European government bond, which result in very different outcomes and volatility of the IFRS 9 expected loss allowance.

Use of credit ratings and/or CDS spreads

– to determine whether there have been significant increases in credit risk and to estimate expected credit losses

Introduction

A significant challenge in applying the IFRS 9 impairment requirements to quoted bonds is that the credit ratings assigned by agencies such as Standard & Poor’s (S&P), and the historical experience of losses by rating grade, can differ significantly with the view of the market, as reflected in, for instance, credit default swap (CDS) spreads and bond spreads.

To illustrate the challenges of applying IFRS 9 to debt securities, it was examined how the expected loss could be determined for a real bond issued by a European government on 16 September 2008 and due to mature in 2024.

For three dates, the IFRS 9 calculations were applied to this bond, which is assumed to have been acquired at inception. In January 2009, the Standard & Poor’s credit rating of the government was AA+, but by January 2012, its rating was downgraded to A. The bond was further downgraded to BBB– in March 2014 before recovering to BBB in May 2014.

Three approaches

Shown below are three approaches:

  1. Approach 1: Use of S&P credit ratings both to determine whether the bond has significantly increased in credit risk and to estimate ECLs
  2. Approach 2: Use of S&P credit ratings to determine whether the bond has significantly increased in credit risk and CDS spreads to estimate ECLs
  3. Approach 3: Use of CDS spreads both to determine whether the bond has significantly increased in credit risk and to estimate ECLs

Based on the historical corporate probability of default (PDs) from S&P for each assessed credit rating (approach 1) and based on the CDS spreads (approach 2 and 3), the loan loss percentages were calculated below. For the calculations, an often used loss given default of 60% was applied. To calculate 12-month PDs, the 12-month maturity point was chosen on the CDS curve and for lifetime PDs the maturity point was chosen.

The percentage loss allowances were, as follows:

The percentage loss allowances 2

Approach 1

According to the credit ratings, the bond was ‘investment grade’ throughout this period. Hence, using the ‘low risk’ simplification, the loss allowance would have been based on 12-month ECLs.

Using the corporate historical default rates implied by the credit ratings and an assumption of 60% LGD to calculate the ECLs, the 12-month allowance would have increased from 0.01% on 31 January 2009 to 0.04% three years later, increasing to 0.18% by 31 March 2014.

It should be stressed that the historical default rates implied by credit ratings are historical rates for corporate debt and so they would not, without adjustment, satisfy the requirements of the standard. IFRS 9 requires the calculation of ECLs, based on current conditions and forecasts of future conditions, based on ‘reasonable and supportable information’. This is likely to include market indicators such as CDS and bond spreads, as illustrated by Approach 2.

Approach 2

In contrast to Approach 1, using credit default swap spreads to calculate the ECLs and the same assumption of 60% LGD to calculate the ECLs, the 12-month allowance would have increased from 1.1 on 31 January 2009 to 2.98% three years later, declining to 0.34% by 31 March 2014. The default rates implied by the CDSs are significantly higher than would have been expected given the ratings of these bonds.

The loss allowances are, correspondingly, very much higher and very volatile. It might be argued that CDS spreads are too responsive to short-term market sentiment to calculate long term ECLs, but it would appear difficult to find other ‘reasonable and supportable information’ to adjust these rates so as to dampen the effects of market volatility. Low credit risk operational simplification

Approach 3

Credit ratings are often viewed by the market as lagging indicators. For these bonds, the ratings are difficult to reconcile with the default probabilities as assessed by the markets. It might be argued that it is not sufficient to focus only on credit ratings when assessing whether assets are ‘low risk’ since, according to CDS spreads, the bond was not ‘low risk’ at any time in the period covered in this example, as it showed a significant increase in 1 year PD after inception (based on CDS spreads). Low credit risk operational simplification

The 1 year PD increased from 0.44% on issue to 1.84 by 31 January 2009. Assessing the bond as requiring a lifetime expected loss at all three dates, based on CDS spreads, would have given much higher loss allowances of 18.29%, 30.89% and 13.81%.

The counter-view might be that CDS spreads are too volatile to provide a sound basis for determining significant deterioration. Perhaps the best way to make the assessment of whether a bond has increased significantly in credit risk is to use more than one source of data and to take account of the qualitative indicators as described in the standard. Low credit risk operational simplification

Similar results to that obtained in Approach 3 would have been obtained if the investor had used Approach 2, but decided not to use the low risk simplification. Low credit risk operational simplification

The calculated ECL figures shown above differ significantly depending on the approach taken as to how to determine a significant change in credit quality and the parameters used for the calculation. Those based on CDS spreads are both large and very volatile, reflecting the investor uncertainty during the period, when the possibility of default depended as much on the political will of the European Union to maintain the integrity of the Eurozone than the economic forecasts for this particular country. Low credit risk operational simplification

As a result, the disparity between the effect of the use of credit grades and CDSs is probably more marked than for most other security investments. Nevertheless, the same challenges will be found with other securities, albeit on a smaller scale.

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Low credit risk operational simplification Low credit risk operational simplification Low credit risk operational simplification Low credit risk operational simplification Low credit risk operational simplification Low credit risk operational simplification Low credit risk operational simplification

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