Low credit risk financial instruments

Low credit risk financial instruments – IFRS 9 introduces an exception to the general model of recognitin that, for “low credit risk” exposures, entities have the option not to assess whether credit risk has increased significantly since initial recognition. It was included to reduce operational costs for recognising lifetime expected credit losses (LEL) on financial instruments with low credit risk at the reporting date. Low credit risk financial instruments

Although use of the low-credit-risk exemption is provided as an option in IFRS 9, the Committee expects that use of this exemption should be limited. In particular, it expects banks to conduct timely assessment of significant increases in credit risk for all lending exposures. In the Committee’s judgment, use of this exemption by banks for the purpose of omitting the timely assessment and tracking of credit risk would reflect a low-quality implementation of the expected credit losses (ECL) model and IFRS 9.

In that context, banks should always recognise changes in 12-month ECL through the allowance where there is not a significant increase in credit risk and a move to LEL measurement if there is a significant increase in credit risk. In the Committee’s view, in order to achieve a high-quality implementation of IFRS 9, any use of the low-credit-risk exemption must be accompanied by clear evidence that credit risk as of the reporting date is sufficiently low that a significant increase in credit risk since initial recognition could not have occurred.

According to IFRS 9 B5.5.22, the credit risk on a financial instrument is considered low if:

  1. the financial instrument has a low risk of default; Low credit risk financial instruments
  2. the borrower has a strong capacity to meet its contractual cash flow obligations in the near term; and Low credit risk financial instruments
  3. 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.

To illustrate the meaning of low credit risk, IFRS 9 B.5.5.23, cites as an example an instrument with an external “investment grade” rating. The Committee is of the view that this is only an example and that all lending exposures that have an “investment grade” rating from a credit rating agency cannot automatically be considered low credit risk. The Committee expects banks to rely primarily on their own credit risk assessments in order to evaluate the credit risk of a lending exposure, and not to rely solely or mechanistically on ratings provided by credit rating agencies (where the latter are available). Nevertheless, optimistic internal credit ratings, as compared with external ratings, would require additional analysis and justification by management.

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.

The low credit risk simplification is not meant to be a bright-line trigger for the recognition of lifetime ECL. Instead, when credit risk is no longer low, management should assess whether there has been a significant increase in credit risk to determine whether lifetime ECL should be recognized. This means that just because an instrument’s credit risk has increased such that it no longer qualifies as low credit risk, it is not automatically included in Stage 2, Management needs to assess if a significant increase in credit risk has occurred before calculating lifetime ECL for the instrument. Low credit risk financial instruments

Interest calculation

Calculate interest revenue on gross carrying amount (i.e. continue original effective interest rate interest income recognition).

If a financial instrument has low credit risk, then an entity is allowed to assume at the reporting date that no significant increase in credit risks has occurred.

Operational simplifications

Low credit risk is one of three operational simplifications or reliefs to companies for assessment of credit risk, together with past due status and 12-month risks  as an approximation for a change in lifetime risksLow credit risk financial instruments


Determination of low credit

  • Determination of the low credit risk may be based on internal credit risk ratings or other methodologies that are consistent with a globally understood definition of low credit risk and that consider the risks and the type of financial instruments that are being assessed. Low credit risk financial instruments
  • External ratings of ‘investment grade’ may be considered as having low credit risk Low credit risk financial instruments
  • Financial instruments are not required to be externally rated to be considered to have low credit risk. Low credit risk financial instruments
  • Financial instruments should be considered to have low credit risk from a market participant perspective taking into account all of the terms and conditions of the financial instrument.

Food for thought

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 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.

Example

Company H owns real estate assets which are financed by a five-year loan from Bank Z with a PD of 0.5% over the next 12 months (the entity assessed that, for this particular instrument, changes in the 12-month ECL are considered a reasonable approximation of changes in lifetime ECL). The loan is secured with first-ranking security over the real estate assets.

Subsequent to initial recognition, the revenues and operating profits of Company H have decreased because of an economic recession. Furthermore, expected increases in regulation have the potential to further negatively affect revenue and operating profit. These negative effects on Company H’s operations could be significant and ongoing.

As a result of these recent events and expected adverse economic conditions, Company H’s free cash flow is expected to be reduced to the point that the coverage of scheduled loan payments could be tight. Bank Z estimates that a further deterioration in cash flows might result in Company H missing a contractual payment on the loan and becoming past due.

As a consequence of these facts, the PD has increased by 15% to 15.5%. Low credit risk financial instruments

At the reporting date, the loan to Company H is not considered to have low credit risk. Bank Z therefore needs to assess whether there has been a significant increase in credit risk since initial recognition, irrespective of the value of the collateral that it holds. It notes that the loan is subject to considerable credit risk at the reporting date because even a slight deterioration in cash flows could result in Company H missing a contractual payment on the loan. As a result, Bank Z determines that the credit risk (that is, the risk of a default occurring) has increased significantly since initial recognition. Consequently, Bank Z recognizes lifetime expected credit losses on the loan to Company H.

Although lifetime expected credit losses should be recognized, the amount of the expected credit losses will reflect the recovery expected from the collateral on the property value and might result in the expected credit loss being very small. Low credit risk financial instruments

Analysis: In this case, the bank considered both PD and other information (such as macroeconomic and client-specific information), in order to determine whether a significant increase in credit risk occurred. An assessment based on LGD information only would not have identified that credit risk has increased significantly for the asset. Nevertheless, when calculating ECL the bank should factor in the expected recovery from collateral. Low credit risk financial instruments

Low credit risk financial instruments

Low credit risk financial instruments

Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments Low credit risk financial instruments

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