Does paragraph 5.5.20 of IFRS 9, which that requires that expected credit losses on certain revolving credit facilities be measured over a longer period than the maximum contractual period, apply only to retail credit cards and retail overdrafts?
No. Though often discussed in the context of retail credit cards and retail overdrafts provided to individual customers, IFRS 9 does not state that paragraph 5.5.20 only applies to these types of products. Therefore, the individual characteristics of all revolving credit facilities (‘RCFs’) that might fall within the scope of paragraph 5.5.20 need to be considered, including those provided to wholesale and corporate customers, to assess whether or not they fall within its scope. Where an entity such as a bank has many RCFs, it may be appropriate to group RCFs with suitably similar characteristics together when performing this assessment.
Paragraph 5.5.20 of IFRS 9 describes the financial instruments that fall within its scope, and paragraph B5.5.39 of IFRS 9 sets out three characteristics (a)-(c) that are generally associated with such financial instruments. Key considerations in assessing these general characteristics, as well as the overall principle and relevant disclosure requirements, are discussed below.
The ‘exception’ in paragraph 5.5.20 to the more general IFRS 9 requirement that the period over which ECL is measured be limited to the maximum contractual period, only applies to those financial instruments where1:
- The instrument has the ability to have both a loan and undrawn commitment component;
- The entity has the contractual ability to demand repayment of the loan component and to cancel the undrawn commitment component; and
- The entity’s exposure to credit losses is not limited to the contractual notice period.
As a result, not all RCFs with a contractual ability to demand repayment of the loan component and to cancel the undrawn commitment component fall in the scope of paragraph 5.5.20. Judgement is required, in particular in determining which wholesale and corporate RCFs fall in the scope of this paragraph.
The December 2015 meeting of the IFRS Transition Resource Group for Impairment of Financial Instruments (‘ITG’) also noted that ‘…the exception was intended to be limited in nature and that it was introduced in order to address specific concerns raised by respondents in relation to RCFs that were managed on a collective basis’. This importance of managing collectively versus individually is further discussed within general characteristics (b) and (c) below. Therefore where it is concluded that a financial instrument is managed individually, rather than on a collective basis, it would generally be expected that the financial instrument would not fall within the scope of paragraph 5.5.20 and instead the ECL would be measured over the maximum contractual period in accordance with paragraph 5.5.19.
Paragraph B5.5.39 of IFRS 9 provides general characteristics of financial instruments that fall in the scope of paragraph 5.5.20 which are helpful in interpreting paragraph 5.5.20, in particular what is meant by ‘the entity’s exposure to credit losses is not limited to the contractual notice period’. However, these general characteristics are not determinative and therefore, do not all need to be met in order for paragraph 5.5.20 to apply. Where some, but not all, of the general characteristics set out in paragraph B5.5.39 are present an entity should consider the principle in paragraph 5.5.20, that is, ‘…financial instruments include both a loan and an undrawn commitment component and the entity’s contractual ability to demand repayment and cancel the undrawn commitment does not limit the entity’s exposure to credit losses to the contractual notice period’. If the overall principle is not met, the requirement in paragraph 5.5.20 should not be applied.
The three general characteristics in B5.5.39
B5.5.39(a) The financial instruments do not have a fixed term or repayment structure and usually have a short contractual cancellation period (for example, one day)
As highlighted by the December 2015 ITG, all the terms of the financial instrument should be considered. For example, if when an RCF is drawn the resulting drawn loan has a fixed maturity of 5 years and the lender does not have the contractual ability to demand repayment of the drawn exposure, this would not be consistent with the RCFs described in paragraph 5.5.20, where repayment of drawn amounts can be demanded. But if the fixed maturity were only 1 month, rather than 5 years, then judgement would be required to determine if this would prevent the instrument from falling within the scope of paragraph 5.5.20.
However, as noted above just because this general characteristic is not met does not prevent a financial instrument being within the scope of paragraph 5.5.20, if the overall principle is met. This is illustrated by the immediately revocable revolving credit facility with a fixed maturity of 5 years that was also considered by the December 2015 ITG. In this case, the ITG concluded that the facility would not seem inconsistent with the type of facility described in paragraph 5.5.20, despite the facility having a fixed maturity, because the lender has the contractual ability to cancel the entire facility including both the drawn amount and the undrawn commitment at any point2.
B5.5.39(b) The contractual ability to cancel the contract is not enforced in the normal day-to-day management of the financial instrument and the contract may only be cancelled when the entity becomes aware of an increase in credit risk at the facility level
IFRS 9 BC5.255 notes that ‘…the use of the contractual period was of particular concern for some types of loan commitments that are managed on a collective basis, and for which an entity usually has no practical ability to withdraw the commitment before a loss event occurs and to limit the exposure to credit losses to the contractual period over which it is committed to extend the credit’ [emphasis added].
The key factor to consider is therefore what information the lender has available which it could use so as to have the practical ability to cancel the contract before a loss event occurs. This means that if in practice, as a result of how a lender manages its portfolio, it will not become aware of an increase in credit risk of a particular borrower until after it has occurred, either because relevant information to identify this cannot be obtained or as the lender chooses not to obtain such information, then that facility would be expected to meet this general characteristic. This would generally be the case for a financial instrument that is collectively managed (also refer to general characteristic (c) below). Conversely, if a lender could reasonably be expected to obtain relevant information giving them the practical ability to act earlier, then the facility would not be expected to meet this general characteristic. This would generally be the case for a financial instrument that is individually managed.
As the availability of information is the key factor, a facility would still not meet this general characteristic if a lender obtains the relevant information but then chooses not to act upon it, for example to maintain what was considered to be a valuable customer relationship. This is because the lender would have had the practical ability to withdraw the commitment before a loss event occurred and so limit its exposure to credit losses to the contractual period over which it was committed to extend credit, but chose not to.
B5.5.39(c) The financial instruments are managed on a collective basis
The term ‘managed on a collective basis’ is not defined within IFRS 9. However, IFRS 9 paragraph B5.5.1 states ‘…it may be necessary to perform the assessment of significant increases in credit risk on a collective basis by considering information that is indicative of significant increases in credit risk on, for example, a group or sub-group of financial instruments’ [emphasis added]. Furthermore, IFRS 9 paragraph B5.5.3 notes that there are ‘financial instruments such as retail loans for which there is little or no updated credit risk information that is routinely obtained and monitored on an individual instrument until a customer breaches the contractual terms’. This reinforces the principle outlined above, that the key factor to consider is the availability of information that can be used to take credit risk management actions before it is ‘too late’.
As a result, the term ‘managed on a collective basis’ refers to portfolios where the information used to manage the credit risk of the exposures is obtained primarily at an aggregated level.
As IFRS 9 provides no further guidance on the term ‘collective’, judgement will be required in assessing whether or not a financial instrument is managed on a collective basis and where in the spectrum of available information the ‘dividing line’ is drawn between collective and individual management. This will depend on individual facts and circumstances, in particular how a bank manages its credit risk. For some exposures, the bank may have more information than for others and so be more able to take action earlier. In particular, in practice it will likely vary with type and size of client (for example, between the biggest listed corporates and the smallest ‘SME’ customers). However, examples of credit risk information that might be obtained and monitored individually for a particular financial instrument, demonstrating that it is managed on an individual rather than collective basis, would include regular covenant reporting, management accounts information or updates on financial performance obtained from regular contact with the borrower as well as credit risk information about the borrower obtained from publicly available sources.
Other indicators that may be relevant in judging whether a financial instrument is managed collectively or individually include:
- Availability of public information – For example, there is more likely to be publicly available information about an individual borrower if it is a large or listed company;
- Frequency of information – For example, if information on the individual customer is regularly obtained then it is more likely the facility would be considered individually monitored;
- Nature and extent of credit officer monitoring – For example, a single customer where monitoring is the sole duty of an individual credit officer would be considered individually monitored, whereas a facility with a customer monitored by a credit officer also responsible for 999 other lending relationships would generally not be; and
- Historic practice – For example, whether for similarly managed financial instruments there is past evidence of proactive decisions being made on individual borrowers to take credit risk management action ahead of a loss event occurring.
Monitoring account utilisation at the individual RCF level, which can be performed for any RCF using the information readily available from the lender’s own records, would not be a differentiating factor in assessing whether a financial instrument is managed collectively or individually.
Entities should make appropriate disclosure of the judgements they have made in determining the scope of paragraph 5.5.20 of IFRS 9 and applying paragraph B5.5.39, given that paragraph 35G of IFRS 7 requires an entity to explain the assumptions used to measure expected credit losses.
In addition, disclosure explaining how RCFs are managed will be relevant to the requirement in paragraph 35B of IFRS 7 to provide information about the entity’s credit risk management practices and how they relate to the recognition and measurement of expected credit losses.
1 Refer to paragraph 27 of the IASB summary of the December 2015 ITG meeting.
2 Refer to paragraph 31 of the IASB summary of the December 2015 ITG meeting.