Effective January 1, 2018, Asian economies that follow International Financial Reporting Standards (IFRS) will implement IFRS 9: Financial Instruments. Promulgated by the International Accounting Standards Board (IASB), IFRS 9 focuses on three main areas: classification and measurement of financial instruments, hedge accounting, and impairment.
The most significant change is how impairment is calculated. The new standard will fundamentally change how banks determine loan loss allowances. Under IFRS 9, banks will transition from the existing “incurred loss” approach to an “expected loss” approach. Simply put, under the incurred loss approach, banks only recognize losses that have occurred in their loan portfolio. However, under the expected loss model, banks will have to recognize not only credit losses that have already occurred but also losses that they expect to incur in the future through the life of the loan. This significant change in methodology will likely require that many banks increase loan loss provisions, resulting in lower reported earnings.
Why the shift to this new impairment approach?
After the global financial crisis, the G20, Financial Stability Board, and other international bodies urged global accounting standard setters to reconsider the standard for determining loan loss allowances. In particular, the existing incurred loss model limits the recognition of loan losses to current events and prevents factoring in future forecasted conditions. This approach typically delays the recognition of credit losses on loans and results in loan loss allowances that are “too little, too late.” As a result, these organizations called for a more forward looking approach to loan loss provisioning. Since then, both the IASB and the Financial Accounting Standards Board (FASB)1 in the United States have taken on the project and issued new standards in 2014 and 2016, respectively. While some differences exist, both sets of standards require adoption of the expected loss concept. The implementation timeline is 2018 for the IFRS standard and 2020 for the FASB standard.
What is the impact of this change on Asia?
Many of the major Asian jurisdictions follow IFRS. Asian banks adopting IFRS 9 will likely experience higher loan loss provisions due to the forward looking nature of the lifetime expected loss approach. Therefore, some banks may see lower reported earnings and dividend payouts. However, the magnitude of the impact on individual banks will depend on many factors, including the current point in the credit cycle, anticipated changes in economic conditions, existing levels of loan loss allowances, as well as the underlying characteristics of the loan portfolio.
In a recent survey of risk officers from leading Asian banks at the 2016 FICO CRO Forum, 88 percent of respondents anticipated that the new impairment methodology could result in up to 30 percent of their retained earnings being set aside for future losses. Another Deloitte survey indicated that loan loss provisions for global banks may increase by as much as 50 percent upon implementing the new standard.
The potential impact will also vary from jurisdiction to jurisdiction in Asia. Some jurisdictions including South Korea and China have minimum provisioning requirements set by their regulators. As a result, banks in these economies may currently have an additional buffer on their existing loan loss allowances. For example, preliminary analysis conducted by some Chinese banks indicated that their current loan loss allowances would be sufficient even with a shift to the expected loss model. Currently, Chinese banks are required by their regulators to set aside loan loss allowances in an amount greater than 150 percent of their reported problem loans. This additional buffer may allow some Chinese banks to conclude that the current level of allowances will be sufficient for the expected loss model.
Are Asian banks ready?
The shift to a different approach would require banks to implement changes, including collecting new data and upgrading existing internal systems and processes. Based on recent surveys, it appears that most Asian banks are not quite prepared for the change. For example, a Wolters Kluwer survey of Asian banks found that 66 percent of respondents have not even begun the IFRS 9 implementation process. Furthermore, only 56 percent of FICO CRO Forum respondents believe that Asian banks will be able to meet the IFRS 9 implementation timeline of January 1, 2018.
Summary
IFRS 9’s rule on impairment is a major step towards addressing an identified weakness in financial reporting in the aftermath of the 2008 global financial crisis. For those Asian economies that follow IFRS 9 and its stated timeline, implementation is less than 18 months away. Given the looming deadline, implementing the new standard will be a daunting task for many Asian banks. However, the transition to a more appropriate accounting methodology will ultimately enhance the credibility and transparency of reported financial statements.
1. The Financial Accounting Standards Board establishes financial accounting and reporting standards for companies that follow Generally Accepted Accounting Principles (GAAP).
The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.