- For loans that are in stage 2 or 3, a lifetime expected credit loss is recognised.
- In measuring the expected credit loss, all reasonable and supportable information that is available without undue cost or effort should be considered. This includes both internal and external information, and information about past events, current conditions and forecasts of future economic conditions.
- The effect of credit enhancements such as collateral, guarantees and letters of support should also be included. Guarantees that are contractually enforceable have a greater effect than letters of support that are not.
For intercompany loans that fall within ‘stage 2 or 3’, a lifetime expected credit loss is recognised. Also, as explained within the Appendix, if an entity cannot determine at the date of transition to IFRS 9 whether there has been a significant increase in credit risk since the loan was originated without undue cost or effort, lifetime expected credit losses should be recognised.
Using the approach described within the Appendix will require a PD to be applied that considers the likelihood of default over the whole life of the loan. Since lifetime PDs are higher than 12-month PDs, it is more likely that the intercompany loan will have a material expected credit loss. However, irrespective of the ‘stage’ at which the intercompany loan sits within the model, collateral and other credit enhancements can result in a lower LGD, which in turn reduces the expected credit loss.
How can an entity establish the PD of the loan?
The lender should take a holistic approach to establish the PD of the loan, taking into account all reasonable and supportable information that it is able to obtain without undue cost or effort relating to the loan. This includes information about past events, current conditions and forecasts of future economic conditions.
The starting point for the lender will generally be to consider the internal information that it holds about the borrower and the loan, which should be supplemented by external information.
Internal information: If the group is sophisticated, it might have developed its own internal credit ratings as part of its credit risk management that can be used to establish the PD of the loan. In any event, the lender should consider any information that it has about the borrower’s historical arrears. IFRS 9 contains rebuttable presumptions that a loan that is 30 days past due has had a significant increase in credit risk (at para 5.5.11), and that a loan that is 90 days past due is credit-impaired (at para B5.5.37).
Management of the lender is expected to consider its intercompany arrangements with the borrower holistically. For example, if the borrower has been granted multiple loans by the lender and is overdue on one loan, it might be more likely that it will default on another intercompany loan, and hence that the other intercompany loan now has a higher PD.
The lender could also consider the interest rates/credit spreads used for transfer pricing on loans to the borrower, which might give an indication of its credit rating.
If the borrower is a lessee needing to calculate an incremental borrowing rate (that is, the rate of interest that a lessee would have to pay to borrow over a similar term, and with similar security, as the lease) for its leases under the new leasing accounting standard, IFRS 16, this might also give an indication of the borrower’s PD, although entities considering IFRS 16’s implementation will be aware that calculating the incremental borrowing rate brings its own challenges.
The lender can also consider the overall financial health of the borrower in developing a PD. For example, if the borrower has positive liquid net assets (that is, excluding goodwill, deferred tax assets, contingent consideration etc.) and a low gearing ratio, the PD might be lower than if the borrower has negative liquid net assets and a high gearing ratio.
Management should ensure that the information used to generate PD estimates is consistent with other internal information, such as that used in cash flow forecasts to assess impairment, deferred tax asset recovery, internal budgets and incremental borrowing rates of leases, where applicable.
External information: If the borrower has any external loans, or is the counterparty to any other instruments such as interest rate swaps, there might be external credit rating information about that entity. As explained in Section C above, external credit ratings are likely to be a useful point of comparison for an intercompany loan’s credit rating only where the external loan has the same seniority and terms as the intercompany loan. In addition, if any intercompany loan arrangements have previously been established at a market rate of interest, the entity should have information available on how this assessment was made.
External credit ratings agencies (such as Standard & Poor’s, Moody’s and Fitch), analytics agencies (such as Thomson Reuters and Bloomberg) and credit bureaux (such as Experian and Equifax) might directly provide related PD percentages.
External credit ratings are historical, and sometimes lagging, indicators. The lender should carefully consider their relevance and whether the PD should be changed based on forecasts of future economic conditions the wider economic environment. This might require consideration of factors such as changes in the unemployment rate, interest rates or economic growth, and how this would be expected to flow through to the PD, as discussed further below.
Management of HP has identified another intercompany financing transaction within the Downstream business unit between HP Aviation Limited and HP Aviation (Overseas) Limited, a fuel supply company. This is a mid-term (three-year) loan of €300m to expand operations. The loan was at a market rate of interest, floating at EURIBOR+2.0%. This rate was broadly consistent with quotes received at the time (December 2016) from external financial institutions for a similar loan directly to HP Aviation (Overseas) Limited.
Management has gathered the following information to establish a PD:
- HP Aviation (Overseas) Limited has a history of defaulting on external and intercompany loans. Of its four external and 20 intercompany loans, it has defaulted on two of them in the past 12 months.
- The financial health of HP Aviation (Overseas) Limited – it has a high gearing ratio.
- Aviation industry average credit ratings (global), which give a PD of 5%.
- Peer aviation fuel supply company credit ratings (global), which give a PD of 4%.
Management has determined that the global industry average and peer company credit ratings give a PD which is too low for the intercompany loan, given the historical defaults by HP Aviation (Overseas) Limited and its high gearing ratio.
Management has noted that, of HP Aviation (Overseas) Limited’s 24 long-term borrowings, it has defaulted on two of them in the past 12 months (that is, it has defaulted on 8.3% of its external and intercompany loans in the last year). The intercompany loan to HP Aviation Limited has two years of its life remaining, so management has calculated a lifetime PD, initially based only on this historical information, by calculating the PD for each of the remaining two years as follows:
Year 1 (2018): Apply the historical PD of 8.3% to the intercompany loan under consideration.
Year 2 (2019): Calculate the marginal PD (that is, the probability that the loan will default in year 2 if it has not already defaulted in year 1). The probability that the loan will not default in year 1 is 91.7% (that is, 100% less 8.3%). Accordingly, the marginal PD for year 2 is 8.3% x 91.7% = 7.6%.
Lifetime PD (based on historical information) is the sum of the PDs for years 1 and 2 (that is, 8.3% + 7.6% = 15.9%).
Management now needs to consider the impact of forward-looking expectations on the PD.
How can an entity incorporate forward-looking information into the PD?
Management will need to do an assessment, based on its historic experience and understanding of the industry/customer base of the borrower, to determine what factors are likely to have the greatest impact on the recoverability of the intercompany loan.
These factors could be general trends and changes in the economy, such as inflation/growth rates, unemployment rates, interest rates, FX rates, etc. In addition, there could be further industry or geography-specific indicators that might have a significant impact on future default levels. These indicators might differ for each intercompany loan/group of intercompany loans, depending on the industry and geography in which the borrowers operate.
One approach might be to look for historical correlation between macro-economic rates (such as unemployment rates) and losses experienced on intercompany loans. If there is such a correlation and unemployment is forecast to be higher or lower than the historical average over the period in which losses have been observed, an adjustment would then be made to the historical amounts (for example, expected higher unemployment might mean that the provision applied to intercompany loans needs to be increased). Under IFRS 9, entities are expected to consider alternative scenarios to develop a probability-weighted outcome. An entity could use scenario analysis to reflect different possible future outcomes. This need not consider every single possible scenario that could occur, but must consider at least one scenario where a loss occurs. This is illustrated within the Appendix under ‘How should expected credit losses be measured?’.
In establishing a link to economic data, further complexities might arise due to ‘lag’. Consider an electricity provider that has been granted a loan by another entity within its group. A rise in unemployment might not trigger an immediate increase in defaults, because customers prioritise paying electricity bills over other discretionary expenditures. The increase in unemployment might only trigger a rise in PD for the intercompany loan if, for example, it is sustained for a six-month period.
Management of HP has considered the customers of HP Aviation (Overseas) Limited and the wider economic factors that might impact HP Aviation (Overseas) Limited’s sales and profitability and, consequently, its ability to repay its intercompany loan as follows:
- Oil price. For most airlines, the cost of oil has a direct impact on their profitability, because it is usually one of their largest costs. In times of high oil prices, HP has experienced higher levels of default from customers in their aviation fuel business.
- US Dollar. Since oil is priced in dollars, not only the underlying movement in the oil price but also the strength of the US Dollar when compared to other currencies has an impact on sales to customers.
- Inflation. Rising prices and costs of doing business overseas will impact both customers of HP Aviation (Overseas) Limited and HP Aviation (Overseas) Limited’s own ability to meet financial obligations.
- The International Air Transport Association (‘IATA’) publishes monthly data on load factors (that is, the number of seats occupied on flights). In times or areas where load factors are low, this could suggest an over-supply of flights or lack of demand, and it could therefore impact airline profitability and the ability of customers to pay their debts to HP Aviation (Overseas) Limited.
Management considered each of the above factors and how they have moved when compared to the period of the historical data available. It has established that, in previous reporting periods, on average, when inflation has increased by 2%, overall losses have increased by 0.5%; and when the oil price has increased by 5%, losses have increased by 2%. Management has performed such an analysis for all factors. Management has obtained external economic outlook reports to understand how each variable might improve or worsen over the remaining life of the intercompany loan.
Management has determined, after performing the analysis described above for each factor, that an additional expected credit loss for forward-looking information of €3m needs to be recognised. The €3m represents the total expected impact of the economic outlook on the intercompany loan for each of the factors above. Management has provided a detailed breakdown of the €3m additional expected credit loss, and all of the related inputs and assumptions.
Management could have developed a detailed statistical model that considered large number of detailed simulations to estimate the quantitative impact of the above factors on the historical PD (that is, how the 15.9% PD should be adjusted to reflect forward-looking information). However, HP has determined that it is unable to do this without undue cost and effort, so it has used the simpler analysis outlined above.
Therefore, instead of adjusting the PD directly, once management has calculated an expected credit loss based on historical information (using a PD of 15.9% determined previously), it will recognise an additional expected credit loss as calculated above.
How can an entity establish the LGD of the loan?
LGD is affected by collateral and other credit enhancements, some examples of which are explored below. As for the PD, the LGD should incorporate appropriate forward-looking information. For example, if the collateral backing an intercompany loan was a head office property, expectations about how the Commercial Property Price Index in the relevant geographical area might perform should be factored into the realisable value of the property. A similar approach to that applied above, for calculating the impact of forward-looking information for the PD, could be applied to the LGD.
Collateral: Any collateral pledged to the lender or other security over the loan (for example, the right to seize assets of the entity holding the loan) can reduce the LGD, which could be decreased to an amount that represents the value at which the collateral/asset(s) seized could be sold. Careful consideration should be given as to what drives the value of the assets. If the assets are, by definition, not valuable in the event that the counterparty defaults, those assets would not be effective in decreasing the LGD.
Guarantees: Guarantees are contractually binding and generally come in two different forms. The first type of guarantee would only become effective when a default occurs. This type of guarantee reduces the LGD of the intercompany loan – it does not reduce the likelihood that the borrower will default, and hence it does not affect whether a loan is in stage 1 or stage 2, but it will reduce the loss incurred if the borrower does default. The second type of guarantee becomes effective before a default occurs. Hence, this type of guarantee helps to prevent a default from occurring, and consequently does reduce the PD and can affect whether the loan is in stage 1 or stage 2. If guarantees are present for intercompany loans, either from a bank or another entity within the group, it is therefore important to understand how the guarantee works to appropriately reflect it in the expected credit loss calculation.
Since guarantees are contractually binding, paragraph 5.5.55 of IFRS 9 states that they should be taken into account in determining expected credit losses; their effect is to reduce the PD/LGD of the intercompany loan, as applicable, to that of the entity providing the guarantee (that is, the bank or other group entity). The entity providing the guarantee might need to record a provision itself based on the likelihood of paying out under the guarantee.
Letters of support: Letters of support can be given in varying circumstances between group entities to support the going concern of an entity. Typically, these letters of support are not legally binding, and they create no legal obligation between the provider and entity in question. Management should consider its history of supporting entities and its ability to move cash and liquid assets around the group to settle obligations when taking a holistic view about intercompany arrangements.
Whilst letters of support should be taken into consideration when establishing the PD and LGD for the intercompany loan, they are not contractually binding, and so they do not reduce the PD and LGD of the intercompany loan to the same extent as a contractual guarantee.
Further, letters of support typically have an effective date of up to 12 months from the date when the financial statements are signed. Thus, they might form one of the considerations when taking a holistic view of information about the borrower if 12-month expected credit losses are calculated for the intercompany loan. If there has been a significant increase in credit risk since inception and lifetime expected credit losses need to be determined, they would only be helpful in considering the PD and LGD for the period that the letter covers. (For example, if a letter of support is effective for one year from when the financial statements are signed, and the financial statements are signed nine months after the reporting period, the letter of support could only be considered for the first year and nine months of the loan’s remaining life. If the loan has a remaining life of longer than one year and nine months, the expected credit loss for the period after one year and nine months would not be influenced by the letter of support.)
Letters of credit and credit insurance: Letters of credit and credit insurance might help to reduce the PD of the loan to that of the letter of credit/insurance provider, or reduce the LGD, dependent on whether the letter of credit/insurance reduces the likelihood of a default, or mitigates the loss after a default has occurred (similar to the two types of guarantee described above).
HP Aviation Limited holds a contractually binding guarantee from HP (Hold Co) Ltd, the ultimate parent entity, which guarantees 30% of the loan due from HP Aviation (Overseas) Limited if HP Aviation (Overseas) Limited defaults. HP (Hold Co) Ltd has a strong capacity to pay out under the guarantee in the event of such a default. Management has taken this into account in assessing the LGD, and it has therefore calculated expected losses for this intercompany loan as follows:
- PD – 15.9% (based on historical information);
- LGD – 70% (30% of the loan is guaranteed by the parent); and
- EAD – €300m.
This gives expected credit losses of €33.4m. The overlay for forward-looking information calculated previously (an additional €3m of expected credit losses) did not include the effect of the parent’s guarantee. Consequently, the overlay is now reduced by 30% (that is, to €2.1m). This gives total expected credit losses of €35.5m.