The relationship between a bank and its customers has changed a great deal in the past few years. From the time when paperwork and bureaucracy was the order of the day to when technology is driving faster, more focused transactions, the business of banking has changed in a big way and mostly to the benefit of the customer.
The customer is no longer just an anonymous number. Banking is nearly at a stage where products and services are tailored for the individual customer. Banks are close to create products, price them, and offer them to customers at an individual level.
Yet, the growing complexity of financial products, and the entire financial industry, has meant that regulation has had to follow suit. Even as new products and new ways of selling them are being developed, banking still needs to be as solid, trustworthy and safe as it has always been, perhaps even more so.
Lessons the world painfully absorbed in the aftermath of the 2007-08 financial crisis brought home the fact that regulation as it were prior to the crisis had not served customers, banks, the economy and society as well as it should have. In the decade since, this realisation has led to the review of accounting standards to create a more resilient and stable banking sector.
One of the most significant changes in this arsenal is a new reporting standard that is due to come into effect on January 1, 2018 across the globe. International Financial Reporting Standard 9, or IFRS 9, was developed in response to the global financial crisis to help ensure financial institutions recognise and account for risk more prudently. The standard was issued by the International Accounting Standard Board (IASB), and for which compliance is a regulatory requirement in the Kenyan Companies Act, 2015.
IFRS 9 deals with accounting for financial instruments such as loans and advances, customer deposits, government securities, cash, borrowings, other debtors and creditors. The standard guides the classification and measurement, impairment and hedging of these financial instruments.
While IFRS 9 may sound complicated and esoteric, it is at its core, very simple, the fundamental change being recognition of credit risk losses. Credit risk is the risk that a borrower will default on their contractual obligation to repay a loan. Traditionally, a bank (or any other financial institution offering credit products) has recognised a loan’s risk at the point of default.
Under IFRS 9, banks will be expected to provide for things that are expected to happen in future. IFRS 9 now requires that these institutions recognise this risk at the beginning and during the entire loan’s credit life cycle.
In this case, a better understanding of the borrower’s credit profile, industry, the current and expected macro-economic environment will be important determinants of how to score, measure and price for risk.
Impairment is a measure of risk attributable to the cash flows that an entity may fail to realise in the event of a default. It is a factor of the customer’s probability of default over a specified time horizon, the expected exposure at default and the loss given default for the cash flows not recovered.
Additionally, IFRS 9 introduces a new requirement of calculating credit risk associated with undrawn or unutilised but committed credit facilities reported as off balance sheet exposures. These include credit and overdraft limits, letters of credit, performance and financial guarantees.
Further, the standard introduces a requirement to hold credit allowances for government securities previously not in scope for impairment. This comes in the wake of sovereign risk default witnessed during the 2007-2008 financial crisis.
By analysing, recognising and allocating this risk throughout the life cycle of the loan, financial institutions will be able to tell, at a glance, how much risk their loan books carry, and allocate their resources accordingly.
IFRS 9 substantially changes the rules on provisions for impairment, which will in turn mean significant changes for the customer. The one that the consumer will notice the most will be the introduction of cross-product default.
Instead of looking at each facility the customer has — credit card, mortgage, personal loan — in isolation, IFRS 9 will mean that we will have one customer, and default on one product will mean banks have to impair the other products the customer has.
So why does IFRS 9 matter to you? It goes back to what we started with, and the revolution in the information and data, pricing and customer engagement we manage with you. IFRS 9’s demands on the risk modelling and pricing of credit products bring these revolutions full-circle.
Banks and other institutions will now have to know their customers and their financial profiles a lot better, in order to more efficiently allocate risks and minimise forward looking expected impairment and provisioning.
Theoretically, IFRS 9 should mean better pricing for lower-risk customers, as the bank will have a far greater amount of information on each customer, and will have the ability to create a big data analysis model around that customer.
However, the introduction of the interest rate caps in the Kenyan market forces the same price on customers, regardless of risk, and it means that we are thus unable to segment the market and offer better pricing for less risky customers. The net result is that we are potentially looking at a further contraction to private sector lending which will impact economic growth.
It is therefore important for the government and industry players to come together and review the impact of the Banking Amendment Act (2016) in light of the impending IFRS 9 rules and make the necessary adjustments to the law so as to release much-needed capital flow to deserving businesses in order to stimulate economic growth.
IFRS 9 also demands a different relationship between banks and regulators. The first and most obvious is that with the body mandated to maintain accounting standards in Kenya, the Institute for Certified Public Accountants in Kenya (ICPAK). ICPAK is working with relevant industry players to translate the varied requirements under IFRS 9 to the Kenyan situation.
The Central Bank of Kenya is also reviewing its position in view of the requirements under IFRS 9. Issues including capital ratio requirements, which are directly under the CBK’s purview, are part of this review and we expect the CBK to communicate its view in due course.
Other institutions such as the Kenya Revenue Authority (KRA) are also crucial to this. Since the core of IFRS 9 – the recognition and allocation of risk – does mean changes to a bank’s balance sheet as well as profit and loss position. How the KRA translates its reporting requirements to the industry will be key to the success of the rollout of IFRS from January.
Ultimately, the introduction of IFRS 9 on 1 January, 2018 will change the global banking landscape and introduce a new normal for the sector.
Awori is the Managing Director, Barclays Bank of Kenya