Step 3 Define significant increase in credit risk

Step 3 Define significant increase in credit risk – Although the focus for IFRS 9 Financial Instruments is on financial institutions such as banks and insurance companies, ‘normal’ operating entities are also affected by IFRS 9. Maybe their investment and loan portfolios are less complex but in operating a business and as part of the internal credit risk management practice policy making it is still important to implement the impairment model under IFRS 9 Financial Instruments. This is step 3 which started with an introduction in Impairment of investments and loans.

Step 3 Define significant increase in credit risk The assessment of a significant increase in credit risk is paramount in determining when to switch between 12-month Expected Credit Losses (ECL) and the lifetime ECL basis.

This assessment is conducted each reporting date and entails consideration of changes in the risk of default occurring over the expected life of the financial instrument, rather than changes in the amount of ECL (ie the magnitude of loss) if the default were to occur.

Significant increase in credit risk not defined

Because of the judgmental and subjective process of measuring expected credit losses, IFRS 9 does not define ‘significant increase in credit risk’ and the reporting entity has to define this criterion in the context of its specific types of instruments and business environment. Step 3 Define significant increase in credit risk

Assessment of significant increase in credit risk

Various approaches may be applied in assessing whether there has been a significant increase in credit risk for investments or loans. Step 3 Define significant increase in credit risk

In general significant increase in credit risk, in the context of IFRS 9, is a significant change in the estimated Default Risk (over the remaining expected life of the financial instrument).

Use a multi-criteria model for default risk assessment of counterparties, that incorporates value judgments and dealing with qualitative aspects. And it is more about the change in indicators over time than in just the current status of an indicator, is is getting worse, are only a few indicators getting worse and what is the answer you are receiving on questions after new orders are boarded.

Ultimately the approach may vary according to the level of sophistication of the entity, the financial instrument and the availability of data. In many cases, qualitative and non-statistical quantitative information may be sufficient for the impairment assessment. In other cases a statistical model or credit rating process may be used. Alternatively a mixture of quantitative and qualitative information may also be relevant, see Step 1 on the identified examples of financial, market and management criteria. Consider developing an indicator-based approach to timely assess significant increase in credit risk of customers as part of the entity’s internal credit risk management practices.

30 days past due

IFRS 9 includes a rebuttable presumption that the condition for recognising lifetime ECL is met when payments are more than 30 days past due unless the reporting entity has information that is more forward-looking than data about past due payments (available without undue cost or effort), then that information needs to be considered and the entity cannot solely rely on past-due data.

Risk increase indicators

Risk Indicators the can establish whether there has been a significant increase in credit risk vary considerably depending on the nature of the borrower, the product type, internal management methods and external market resources. Step 3 Define significant increase in credit risk

Elements to Consider

  • Quantitative Elements: Scorecards or Risk Rating Systems after setting thresholds for determining what constitutes a significant increase in credit risk in terms of the score or rating
  • Qualitative Elements Step 3 Define significant increase in credit risk
  • Backstop Indicators Step 3 Define significant increase in credit risk
  • Low Credit Risk exception Step 3 Define significant increase in credit risk

The following lists provide some examples: Step 3 Define significant increase in credit risk

Internal (Management) Indicators

  • Significant changes in internal price indicators of credit risk (the credit spread / premium that would be charged currently for similar risk)
  • Other changes in the rates of terms of an existing financial instrument that would be significantly different if the instrument was newly originated
  • Significant changes in external market indicators of credit risk for a particular financial instrument or similar financial instruments with the same expected life
  • Changes in the entity’s credit management approach in relation to the financial instrument; ie based on emerging indicators of changes in the credit risk of the financial instrument, the entity’s credit risk management practice is expected to become more active or to be focused on managing the instrument, including the instrument becoming more closely monitored or controlled, or the entity specifically intervening with the borrower
  • Expected changes in the loan documentation including an expected breach of contract that may lead to covenant waivers or amendments, interest payment holidays, interest rate step-ups, requiring additional collateral or guarantees, or other changes to the contractual framework of the instrument
  • Past due information Step 3 Define significant increase in credit risk
  • Significant increases in credit risk on other financial instruments of the same borrower. Step 3 Define significant increase in credit risk
  • Significant changes in the expected performance and behaviour of the borrower, including changes in the payment status of borrowers in the group (for example, an increase in the expected number or extent of delayed contractual payments or significant increases in the expected number of credit card borrowers who are expected to approach or exceed their credit limit or who are expected to be paying the minimum monthly amount) Step 3 Define significant increase in credit risk
  • A significant change in the quality of the guarantee provided by a shareholder (or an individual’s parents) if the shareholder (or parents) have an incentive and financial ability to prevent default by capital or cash infusion. Step 3 Define significant increase in credit risk
  • Significant changes, such as reductions in financial support from a parent entity or other affiliate or an actual or expected significant change in the quality of credit enhancement, that are expected to reduce the borrower’s economic incentive to make scheduled contractual payments. Credit quality enhancements or support include the consideration of the financial condition of the guarantor and/or, for interests issued in securitisations, whether subordinated interests are expected to be capable of absorbing expected credit losses (for example, on the loans underlying the security). Step 3 Define significant increase in credit risk

External (Market) Indicators

  • Credit spreads Step 3 Define significant increase in credit risk
  • Credit default swap prices for the borrower Step 3 Define significant increase in credit risk
  • Length of time (duration) or the extent (degree) to which the fair value of a financial asset is less then the amortized cost
  • Other market information related to the borrower Step 3 Define significant increase in credit risk
  • Significant change in the value of the collateral supporting the obligation or in the quality of third-party guarantees or credit enhancements, which are expected to reduce the borrower’s economic incentive to make scheduled contractual payments or to otherwise have an effect on the probability of a default occurring. For example, if the value of collateral declines because house prices decline, borrowers in some jurisdictions have a greater incentive to default on their mortgages.
  • Actual or expected significant downgrade in an external credit rating Step 3 Define significant increase in credit risk
  • Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or an actual or expected significant increase in unemployment rates
  • An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations, such as a decline in the demand for the borrower’s sales product because of a shift in technology.
  • Actual or expected significant internal credit rating downgrade or decrease (worsening) in behavioral scoring used to assess credit risk internally
  • Actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased Balance Sheet leverage, liquidity, management problems or changes in the scope of business or organisational structure (such as the discontinuance of a segment of the business) that results in a significant change in the borrower’s ability to meet its debt obligations.

Next step 4: Define low credit risk Step 3 Define significant increase in credit risk

Or jump to:

Step 1 Define DefaultStep 2 Decide to use the general or simplified approach, Step 5 Allocate receivables to high and low credit riskStep 6 Apply the provision matrixStep 7 Measure expected credit losses

Step 3 Define significant increase in credit risk

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