Zambian Banks to record Higher Provisions in 2018, additional Capitalisation may be required as IFRS 9 is Implemented
• Credit impairments reported expected to rise • FSPs need investment in systems and bid data compatible models
• More rigor in determining futuristic forecasts
It also prescribes principles for derecognizing financial instruments and for hedge accounting. The presentation and the disclosure of financial instruments are the subjects of IAS 32 and IFRS 7 respectively.
During the financial crisis it was discovered that a lot of assets went bad earlier than the world realized. Why was this so? Well it was because of either lack of a model that could forecast so or methodologies that out rightly understated the provision numbers for bad assets. It’s for this reason that global accounting bodies responded by redesigning the old International Accounting Standard IAS (39), made additions to seal its gaps and then renamed it IFRS-9. In layman’s language IFRS (9) is the International Accounting Standards Board’s (IASB) response to the financial crisis, aimed at improving the accounting and reporting of financial assets and liabilities. It replaces IAS 39 with a unified standard. In July 2014, The International Accounting Standards Board - IASB finalized the impairment methodology for financial assets and commitments.
IFRS 9 introduces changes across (3) areas with profound implications for financial institutions namely classification and measurement of financial assets, introduction of a new expected-loss impairment framework and the overhaul of hedge accounting models to better align the accounting treatment with risk management activities.
Previously IAS 39 triggered provision raising only when there was an actual default which resulted in over conservative - “too little, too late” - provisions and clearly did not reflect the underlying economics of the transaction. i.e. There are instances when even when it is known that an industry exhibited sign ns of potential stress, banks went on to treat the assets as though all was in good stead. But it was just a matter of time that these would go bad. IFRS (9) will require that forward looking views are adopted to ensure that provisions are taken early for expected future outcomes. To this effect judgement is very key in determination of provision numbers. The current standard in force aligns the measurement of financial assets with the bank’s business model, contractual cash flow characteristics of instruments, and future economic scenarios. Banks may have to take a “forward-looking provision” for the portion of the loan that is likely to default, as soon as it is originated.
Bank of Zambia’s role in IFRS 9 roll out
As a regulator, the Bank of Zambia has championed the successful roll out of IFRS 9 to ensure Financial Service Providers – FSPs are well equipped and well prepared for the changes in regulatory reporting requirements starting 2018. The BOZ has successfully issued a circular that provides guidance notes on how banks should report. The Bank of Zambia has issued a circular number 11/2017 which provides guidance notes on how provision under IFRS 9 will be treated for regulatory purposes. The guidance also includes an outline of transitional arrangements to ensure that the negative impact of anticipated higher provisions at the time of adoption of the standard are moderated. The Bank of Zambia has urged Financial Service Providers – FSPs ensure that their risk management systems are aligned to requirements of the standards. It has urged banks to develop new robust and resilient internal controls, systems, models and governance infrastructure to ensure full compliance of the requirements of IFRS 9.
What IFRS (9) means for banks financial statements
The global financial crises perpetrated the need to revisit IAS-39 for loop holes hence tightening all gaps with IFRS – 9 which provides a more stringent approach to provisioning. IFRS 9 is more forward-looking and requires a higher degree of judgement. Banks will need to sharpen their forecasting models to make economic predictions of direction interest and exchange rates will take.
IFRS 9 will affect the business models, processes, analytics, data, and systems across several dimensions. These are listed below:
Expected increase in credit impairments and the need for additional capital issuances
A general rise in credit impairments under IFRS 9 will be expected due to the rigor in economic forecasting and the cash flow potential of assets. Under the previous standard it was discovered that credit provisions were deeply understated. Capital is held to cushion against the level of risk and as such credit impairments reflect the credit risk a commercial bank is running because it is expected that IFRS 9 will result in higher provisions than IAS 39, additional capital reserves will be required to cushion for a higher credit risk profile. Additional counter cyclical capital issuances will be required triggered by changes in economic factors and counterparty behaviour on underlying assets. The counter cyclical capital requirement aligns with the new Banking Financial Services Act of 2017. Banks will have to estimate and book an upfront, forward-looking expected loss over the life of the financial facility and monitor for ongoing credit-quality deterioration. Credit rating models will have to be updated often.
Big Data and system upgrades will be required for reporting
The new credit loss impairment engine requires more data to enable forecasting in addition to upgraded systems to deal with the sophisticated nature of the reporting standard. There will be more reconciliation requirements with regulatory requirements which will require the right systems which will need to change significantly to calculate and record changes requested by IFRS 9 in a cost-effective, scalable way.
Banks without state of the art accounting systems or without systems that can’t integrate with big data requirements will have to fork out some investments to make IFRS9 a success. There has never been a better time than now for investment in cloud based packages.
The credit impairment exercise will be a collaborative cross functional effort
Previously the provisions exercise was done between finance and credit. IFRS 9 emphasizes the need for cross functional collaboration and brings business functions to the party. The business should have a better understanding of the behaviours counterparty’s and their objectivity will be a key driver in the success of the model.
Banks will proactively provision calculate at deal inception
A behavioural change in mind set is that banks will evaluate at origination how economic changes will potentially impact their business models, capital rationing and ultimately provisioning levels. With a forward looking model and much rigor in understanding the business environment. Banks will need to internally develop models or methodologies to calculate a forward-looking measurements and additionally cash flow valuation analysis must be scenario-driven. As with IAS -39 these provisions would only be taken when assets started to show signs of stress.
The need for asset reclassification, recognition and measurement will arise
Banks will need to reclassify assets and reconcile them with IAS. They will also need to map products that can be categorized before the calculation (contractual cash flow test) or create a workflow to capture the purpose ( business model test). An additional effort could be required to identify those products that can be considered out of scope (e.g., short-term cash facilities and/or covenant-like facilities).