One of Kenya’s biggest lenders has recently announced it was weighing the prospect of cutting back on disbursement of personal loans guaranteed by salaries.
This impending change in lending strategy is apparently being driven by expected coming into force of International Financial Reporting Standards (IFRS) 9, a new accounting guideline for financial instruments in January 2018.
IFRS 9 is expected to significantly alter the accounting treatment of financial instruments — these being contracts that give rise to a financial asset of one entity and equity instrument of another entity and includes cash and derivative instruments.
It increases levels of required disclosures and has a bearing on firms in financial markets, legal approach to corporate transactions as well as taxation.
Mckinsey & Company, a strategy consulting firm, has predicted that the standard will specifically trigger a silent revolution in the banking industry and banks’ models.
Indeed, the revolution in banking has started as seen from the considerations of the Kenyan bank.
As a background, the accounting treatment for financial instruments such as collateralised debts, derivatives, has been blamed for triggering the financial crisis of 2007/08.
The instruments were recognised in financial statements through their fair value, ordinarily determined in accordance with the intention of the company.
Such intention would be holding the instruments to maturity, for sale, recognising them through profit and loss, or having them as loans and receivables.
In the event the instruments are held for sale, the practice was that a company would always value them at market value. Where a firm intends to hold them to maturity, they would carry the instruments at cost, adjusting for impairment.
This accounting practice is messy. It results into a company having different values for one instrument depending on the intention.
Thus, companies kept on marking the instruments to market, sometimes on wishful valuations. Where panic hits the market as happened in 2007, firms rush to dispose of the instruments marked to market in rapid fire-sale, resulting to decline in prices that trigger collapse of the markets.
For these reasons, the International Accounting Standards Board decided to change the practice of financial instruments.
The board introduced IFRS 9, which generally introduces three issues. First, is the classification and measurement of financial instruments. Second, hedge accounting and third, impairment of financial instruments.
On classification, the standard requires financial liabilities to be categories either at “fair value” or at “amortised cost.” The latter is where amortisation loss has been factored into the value of the instrument.
However, a rider is, a financial instrument will only be categorised at amortised cost where the business model of an entity is to hold that instrument until its maturity for the purpose of collecting contractual cash flows, which should constitute “solely payment of principal and interest.”
Such a treatment will impact more on classifying instruments such as exchange traded derivatives that have historically been used for trade speculation.
On hedge accounting, the standard has streamlined how hedge instruments are accounted for. This is geared to reduce volatility caused by marking-to-market of instruments such as derivatives, which result to large to price fluctuations.
The standard aims at aligning entities’ hedging practice with their risk management activities. It further improves hedge effectiveness on account of enhanced disclosures.
Entities such as Kenya Airways #ticker:KQ, which recently suffered the wrath of hedging instruments on oil forward contracts, will take note of this development.
On impairment, the standard has changed the practice where firms account for loss on credit exposures only when such loss has been incurred.
Firms will now adopt “expected loss model” which involves approximating expected credit loss for the whole life of the exposure of the instrument.
The requirement of approximating “expected loss” on credit exposures is one proving to be a hard pill to swallow for banks. For instance, on loans, banks must approximate anticipated losses from their lending.
With such a requirement, Kenyan banks will generally have the following options:
One, for loans not backed by sound collateral, banks could lend at high interest rates to limit credit default exposures. Due to interest rates caps, this may not be tenable. In such case, banks may reduce lending periods for high-risk borrowers to limit probability of default.
Second, banks may increase the provisioning or increase the insurance cover for approximated defaults on unsecured loans. This will certainly increase expenses and reduce recognised profits. StanChart #ticker:SCBK seems to have taken this option.
Third, banks would abandon extending personal loans or on collaterals that cannot be foreclosed on default. Equity Bank #ticker:EQTY seems to moving towards this strategy.
Further, IFRS 9’s introduction of a universal way of classifying financial instruments should help in combatting international tax avoidance by multinationals.
This will help to reduce hybrid mismatches, which arise where firms classify financial instrument differently, either as a debt in one jurisdiction and as equity in another.
This exacerbates the problem of base erosion and profit shifting, especially in countries where instruments are classified as debt, which is tax deductible.
Banks and other firms operating in financial markets will need to review their operating framework and rethink strategies in line with this new accounting standard.