IFRS 9 contains a (first) 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.
The second simplification available in IFRS 9 sets out a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.
Low credit risk, in the context of IFRS 9, is an indicator assigned to financial instruments deemed to
- have low default risk, that is a low likelihood of any credit event
- the borrower has a strong capacity to meet contractual cash flow obligations both 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
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) 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.
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. 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.
12 month ECL
It is an important and practica definition in IFRS 9 to minimise the accounting for impairments on financial assets for all IFRS reporting entities.
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.
An instrument categorized as low(er) credit risk does not require recognition of lifetime expected credit losses (ECL). See the use of low credit risk in Impairment of investments and loans to perfectly understand the benefits of using this indicator in calculating Expected credit losses.
Even if an instrument ceases to be categorized as low(er) credit risk, recognition of lifetime expected credit losses requires that there has been a significant increase in credit risk.
Use of credit ratings and/or CDS spreads
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.
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 has been 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.
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:
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.
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.
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).
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.
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.
Determination of lower credit risk
- Determination of the low(er) credit risk may be based on internal credit risk ratings or other methodologies that are consistent with a globally understood definition of low(er) credit risk and that consider the risks and the type of financial instruments that are being assessed.
- External ratings of ‘investment grade’ may be considered as having low(er) credit risk
- Financial instruments are not required to be externally rated to be considered to have low(er) credit risk.
- Financial instruments should be considered to have low(er) credit risk from a market participant perspective taking into account all of the terms and conditions of the financial instrument.
As an indicative calibration, a financial instrument with an external rating of investment grade is an example of an instrument that may be considered to have a low credit risk.
A loan is not considered to have a low(er) credit risk simply because:
- the value of collateral results in a low risk of loss. This is because collateral affects the magnitude of the loss when default occurs (Loss given default, rather than the risk of default),
- it has a lower risk of default relative to other financial instruments.
Where fits low credit risk into the IFRS 9 general approach
IFRS 9’s general approach to recognising impairment is based on a three-stage process which is intended to reflect the deterioration in credit quality of a financial instrument.
- Stage 1 covers instruments that have not deteriorated significantly in credit quality since initial recognition or (where the optional low credit risk simplification is applied) that have low(er) credit risk
- Stage 2 covers financial instruments that have deteriorated significantly in credit quality since initial recognition (unless the low credit risk simplification has been applied and is relevant) but that do not have objective evidence of a credit loss event
- Stage 3 covers financial assets that have objective evidence of impairment at the reporting date.
12-month expected credit losses are recognised in stage 1, while lifetime expected credit losses are recognised in stages 2 and 3.
Food for thought – effect of business combinations
When financial assets are acquired in a business combination, the reference point for measuring the initial level of credit risk of those assets is reset to the date of the business combination.
Entity C acquired Entity D in a business combination in June 2014. Entity D holds a loan from an associate that was considered low(er) credit risk when first advanced in 2012. In June 2014, the risk of default on this loan was considered to be significant. At the reporting date of December 2014, the risk of default remains the same as at June 2014.
Has there been a significant increase in credit risk at the reporting date of December 2014?
No. The date of the business combination is the reference date for the acquirer’s financial statements, not the acquiree’s date of initial recognition.
Low credit risk
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