Bank ABC provides mortgages to finance residential real estate in three different regions. The bank sets its acceptance criteria based on credit scores, and loans with a credit score above the ‘acceptance level’ are approved, as these borrowers are considered to be able to meet contractual payment obligations. When new mortgage loans are originated, Bank ABC uses the credit score to determine the risk of a default occurring as at initial recognition.
In Region One, Bank ABC assesses each of its mortgage loans on a monthly basis by means of an automated behavioural scoring process that is based on current and historical past-due statuses, indebtedness, loan-to-value (‘LTV’) measures, customer behaviour on other financial instruments with Bank ABC, the loan size and the time since the origination of the loan. Bank ABC updates LTV measures on a regular basis through an automated process that re-estimates property values using recent sales. Historical data indicates a strong correlation between the value of residential property and default rates for mortgages, which is factored into the behavioural score. Bank ABC is able to identify significant increases in credit risk since initial recognition on individual customers before a mortgage becomes past due if there has been deterioration in the behavioural score.
When the increase in credit risk has been significant, a loss allowance at an amount equal to lifetime ECL is recognised; otherwise, a loss allowance at an amount equal to 12-month ECL continues to be recognised. The loss allowance is measured using LTV measures to estimate the severity of the loss. If Bank ABC is unable to update behavioural scores (for example, to reflect the expected decline in property prices), it uses reasonable and supportable information that is available without undue cost or effort to undertake a portfolio assessment, to determine the loans on which there has been a significant increase in credit risk since initial recognition and recognise lifetime ECL for those loans.
In Regions Two and Three, Bank ABC does not have an automated scoring capability. Instead, for credit risk management purposes, Bank ABC tracks the risk of a default occurring by means of past-due statuses. It recognises a loss allowance at an amount equal to lifetime ECL for all loans that have a past-due status of more than 30 days past due. Although Bank ABC uses past-due status information as the only borrower-specific information, it also considers other reasonable and supportable forward-looking information that is available without undue cost or effort to assess whether lifetime ECL should be recognised on loans that are not more than 30 days past due. This is necessary in order to meet the objective (in para 5.5.4 of IFRS 9) of recognising lifetime ECL for all significant increases in credit risk.
Region Two includes a mining community that is largely dependent on the export of coal and related products. Bank ABC becomes aware of a significant decline in coal exports and anticipates the closure of several coal mines. Because of the expected increase in the unemployment rate, the risk of a default occurring on mortgage loans to borrowers in this area who rely on the coal mines is determined to have increased significantly, even if those customers are not past due at the reporting date. Bank ABC segments its mortgage portfolio, by the industry within which customers are employed, to identify customers that rely on coal mining as the dominant source of employment (that is, the ‘bottom up’ approach). For such groups of mortgages, Bank ABC recognises a loss allowance at an amount equal to lifetime ECL, while it continues to recognise a loss allowance at an amount equal to 12-month ECL for all other mortgages in Region Two. Newly originated loans to borrowers who rely on the coal mines in this community would, however, have a loss allowance at an amount equal to 12-month ECL, as they would not have experienced a significant increase in credit risk since initial recognition.
In Region Three, Bank ABC anticipates the risk of a default occurring, and thus an increase in credit risk, as a result of an expected increase in interest rates during the expected life of the mortgages. Historically, an increase in interest rates has been a lead indicator of future defaults on mortgages in Region Three, especially when customers do not have a fixed interest-rate mortgage. Bank ABC determines that the variable interest-rate portfolio of mortgages in Region Three is homogeneous and that, unlike for Region Two, it is not possible to identify particular sub-portfolios on the basis of shared risk characteristics that represent customers whose credit risk is expected to have increased significantly. However, as a result of the homogeneous nature of the mortgages in Region Three, Bank ABC determines that an assessment can be made of a proportion of the overall portfolio that has significantly increased in credit risk since initial recognition (that is, a ‘top down’ approach can be used). Based on historical information, Bank ABC estimates that an increase in interest rates of 200 basis points will cause a significant increase in credit risk on 20% of the variable interest-rate portfolio. Therefore, as a result of the anticipated increase in interest rates, Bank ABC determines that the credit risk on 20% of mortgages in Region Three has increased significantly since initial recognition. Accordingly, it recognises lifetime ECL on 20% of the variable rate mortgage portfolio, and a loss allowance at an amount equal to 12-month ECL for the remainder of the portfolio.
In this case, where the individual assessment only takes into account past due information, the bank is required to complete an assessment of changes in credit risk at a portfolio level using more forward-looking information. To complete this assessment, the bank has used both the ‘bottom up’ and the ‘top down’ approach, based on the information available for each portfolio. Both approaches are acceptable according to the standard.
In addition, an entity should subdivide a portfolio if it identifies that there has been a significant increase in credit risk that applies only to a portion of a given portfolio. This might indicate that the risk characteristics have become different and therefore it is necessary to subdivide the portfolio.