Why IFRS 9 is unlikely to have the hyped effect

The banking fraternity globally is halfway through the implementation of the International Financial Reporting Standards version nine (or commonly referred to as IFRS 9). As you may be aware, IFRS 9 is an accounting standard that instituted a number of changes when it comes to treatment of financial instruments.

Key among the changes is the migration of financial assets impairment loss recognition from incurred (rear view) to expected (front view). What is impairment loss?

The concept of impairment of an asset was first introduced in the 36th version of International Accounting Standards (or IAS 36) and broadly refers to the amount by which the carrying amount of a cash generating asset(s) exceeds its recoverable value.

Some sort of economic devaluation of a cash-generating asset. At the point of recognition, the entity carrying such an asset is required to recognise the difference by passing it through the income statement as a loss, hence impairment loss.

However, passing of this loss through the income statement doesn’t equate to loan loss provisions. While the concept of provisions is different altogether, it’s application in the recognition and measurement of financial instruments (and in this article as well), strictly speaking, is more of a prudential invention, rather than accounting.

Talking about impairments losses, Kenyan banks’ migration to the front view (expected) impairment loss model seems to have had minimal impacts on their capital positions. Commercial banks’ results for the first quarter of 2018 (Q1 2018) show that banks only took a 172 basis points (1.72 per cent) haircut on their core capital after absorbing additional impairment losses as a result of the migration.

This is at odds with the street expectations — including some doomsday-like balance sheet annihilation projections that flew around. I expected this minimal balance sheet impact, for two reasons.

First, in the Kenyan context, IFRS 9 was basically a convergence of prudential and accounting standards. The old bankers will tell you that before exhaustive adoption of International Accounting Standards 39 (or IAS 39), the chief propagator of the old rearview model, there was always some form of blanket recognition of potential impairment losses to cushion against future unforeseen credit risks.

For that reason, some money was always set aside. Prudential guidelines made the same recognition and, in addition to specific provisions, created a general provisions’ pool—which is currently set at one per cent of a bank’s total risk-weighted assets.

The general pool is a classic representation of front-view approach to credit risks. Similarly, IFRS 9 demands of financial institutions to take a front view approach to quantifying factors that might affect the performance of a financial asset.

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This is such a classic ‘Stanley meets Dr Livingstone’ (Prudential, I presume). The only difference has been that the prudential approach has never explicitly brought out its scientific underbelly, while the latter does.

Indeed, as part of the migration, financial institutions have had to develop statistical models populated with historical credit-risk performance for the different client segments as well as in-built price points. The model then calculates a probability of default score that is used to bucketise borrowers as well as the segment.

This convergence of prudential and IFRS 9 allowed banks to offset the additional impairment losses using the general provisions pool—which helped limit the extent of the haircut.

Secondly, the Central Bank of Kenya (CBK) established a five-year window for commercial banks to stagger the recognition of the additional impairment losses under IFRS 9, to allow their balance sheets gradually absorb any large haircut.

Broadly, for any prudential regulatory regime that had established some form of general provisioning, Kenya and Uganda being the leading lights, IFRS 9 is simply a convergence.