Low credit risk

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.

It is an important and practical definition in IFRS 9 to minimise the accounting for impairments on financial assets for all IFRS reporting entities.

The instrument must be considered to have lower 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.

Under adverse changes in economic and business conditions in the longer term a low credit risk borrower, may (but need not) have reduced ability to meet contractual cash flow obligations.

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.

Determination

• 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.

Examples

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.

Practical insight – 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.

Example
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