The Guidance notes that the timely determination of whether there has been a significant increase in credit risk is crucial. Banks should have processes in place to achieve this, combined with strong governance, systems and controls, which are able to handle and assess large amounts of information.
IFRS 9 requires that when making the assessment of significant increases in credit risk since initial recognition an entity shall use the change in the risk of default occurring over the expected life of the financial instrument instead of the change in the amount of expected credit losses. In other words, this assessment is made in terms of the risk of a default occurring and not expected credit loss (ie before the consideration of the effects of credit risk mitigants such as collateral or guarantees).
Definition of default
IFRS 9 does not define default, but requires entities to apply a default definition that is consistent with the definition used for internal credit risk management purposes and considers qualitative indicators (for example, financial covenants) when appropriate. However, there is a rebuttable presumption in IFRS 9 that default does not occur later than when a financial asset is 90 days past due. To rebut this presumption an entity needs reasonable and supportable information that demonstrates that a more lagging default criterion is more appropriate.
The Committee recommends that the definition of default used for IFRS 9 be ‘guided by’ the definition used for regulatory purposes. The default definition in the Basel capital framework combines a qualitative ‘unlikeliness to pay’ criterion with an objective ’90 days past due’ criterion. The ‘unlikeliness to pay’ criterion permits identification of default before the exposure becomes delinquent, with the ’90 days past due’ criterion acting as a backstop.
For regulatory purposes a supervisor may substitute a figure up to 180 days past due for different products. However the Guidance notes that this possibility should not be read as an exemption from the application of the 90 days past due rebuttable presumption in IFRS 9.
It is not entirely clear what is meant by being ‘guided by’ the default definition used for regulatory purposes. However, it is clear from IFRS 9 that the 90 days past due rebuttable presumption cannot be rebutted solely on the grounds that more than 90 days past due (eg 180 days past due) is used for regulatory purposes. A key point is that banks should be able to justify, with appropriate analysis and evidence:
- using a different definition of default for accounting purposes than that used for regulatory purposes; and
- rebutting the IFRS 9 90 days past due presumption, even when 180 days past due is used for regulatory purposes.
Use of PDs and movements in credit grading systems
IFRS 9 states that the significance of a change in credit risk since initial recognition should be assessed against the risk of a default occurring at initial recognition. The guidance notes that where a bank uses changes in PD as a means of identifying changes in the risk of a default occurring, the significance of a given change in PD can be expressed as a ratio (or the rate of fluctuation) proportionate to the PD at initial recognition, as follows:
S (ΔCR) =
where S (ΔCR) is the significance of a change in credit risk; ΔPD the change in PD since initial recognition (ie the PD at the reporting date less the PD at initial recogition); and PDo is the PD at initial recognition of a particular lending exposure.
However, the Committee also acknowledges that the “width” of the change in PD itself (ie PD at the reporting date minus PD at initial recognition) should also be taken into consideration.
The IFRS 9 impairment model is based on an assessment of relative increases in credit risk since initial recognition. Provided that this objective is met, IFRS 9 does not specify particular methods for assessing significant increases in credit risk.
The Committee’s acknowledgement that the width of the change in PD should be taken into consideration as well as the proportionate change, since initial recognition, is helpful. This is because it shows some sympathy for the use of alternative approaches where the objectives of IFRS 9 are still met, as appropriate depending upon the particular facts and circumstances.
The Guidance notes that, as illustrated in IFRS 9, it is possible to set a maximum credit risk for particular portfolios upon initial recognition that would lead to assets within that portfolio moving to lifetime ECL when credit risk increases beyond that maximum level. However this is an example of the application of the principle of a relative increase in credit risk in the Standard, rather than an exception to that principle. The Committee notes that this simplification is only relevant when exposures are segmented on a sufficiently granular basis such that the bank can demonstrate that a significant increase in credit risk had not occurred for items in the portfolio before the maximum credit grade was reached.
The guidance emphasises that banks need to look beyond how many ‘notches’ or ‘grades’ a rating downgrade entails. Particular attention has to be paid to internal or external rating systems and their granularity, as a change in PD for a one-notch movement may not be linear and a significant increase in credit risk could occur prior a movement in the credit grade.
It may be appropriate to use movements between internal credit risk grades as a means of identifying significant increases in credit risk when an entity derives internal credit risk grades by taking into account all reasonable and supportable information, the grades are sufficiently granular and the portfolios of lending exposures appropriately segmented. However, not all movements between credit risk grades will carry the same weight when evaluating whether there has been a significant increase in credit risk since initial recognition.
The Guidance observes that ‘significant’ should not be equated with statistical significance and should not be based solely on quantitative analysis. For portfolios which have a large number of individually small credits and a rich set of historical data, it may be possible to identify significant increases in credit risk in part by using formal statistical techniques. However for other exposures, that may not be feasible.
In addition the Guidance notes that ‘significant’ should not be judged in terms of the extent of impact on a bank’s primary financial statements. This is because the identification and disclosure of increases in credit risk are likely to be as important to users seeking to understand trends in the intrinsic credit risk of a bank’s loans, even when there is no impact on the allowance made, for example, because the exposure is fully collateralised.
Renegotiated or modified loans
For modified loans that do not result in derecognition, IFRS 9 requires that a bank must assess whether there has been a significant increase in credit risk by comparing the risk of default occurring at the reporting date based on the modified contractual terms with the risk of default occurring at initial recognition based on the original, unmodified, contractual terms.
The Guidance notes that modifications or renegotiations can mask increases in credit risk. Modified or renegotiated loans that have not been derecognised should not move back to stage 1 unless there is sufficient evidence that the credit risk over the life of the exposure has not increased significantly compared with that at initial recognition. The Committee emphasises that typically a customer would need to demonstrate consistently good payment behaviour over a period of time on the revised terms before credit risk is considered to have decreased. For example, a history of missed or incomplete payments would not typically be erased by simply making one payment on time following a modification of the contractual terms.
The Guidance implies that a track record of payments is needed to move modified or renegotiated loans from stage 2 to stage 1. We observe that individual regulators may have differing views as to what a ‘reasonable period of time’ may be.
In contrast, a modified or renegotiated loan that is derecognised is treated as a new loan. Such modified loans would be in stage 1 (unless it is credit-impaired on origination), until there was a further significant increase in credit risk from the date of the modification or renegotiation. This distinction highlights the importance of appropriately determining whether a modification or renegotiation results in the derecognition of the loan.