Covid exposes one weakness of IFRS 9 accounting standard

Commercial banks saw their net profits in the second quarter of 2020 plunge by half, quarter-on-quarter as a surge in loan impairment losses chewed into their earnings.

The premise of impairing financial assets such as loans (or cash-generating units or group of assets) is based on recognising the fact that the carrying amount of an asset exceeds its recoverable amount; a difference that is recognised as a loss.

During the quarter, impairment losses surged by 79 percent quarter-on-quarter; as economic activities remained frozen during the period due to the Covid-19 pandemic and related restrictions.

Larger tier-one banks recorded the highest impairment losses, which literally gobbled half of their net earnings during the quarter. Perhaps this is down to their larger portfolios.

KCB Group #ticker:KCB, which has the largest balance sheet in East Africa, saw its net earnings plunge by more than half during the three-month period, while Equity Group’s #ticker:EQTY net earnings declined by a third.

Co-operative Bank #ticker:COOP, on the other hand, reported strong earnings. However, Absa was the only bank in the tier-one group to record a quarterly loss (of Sh0.25 per share) during the period.

Medium-sized tier-two banks and the smaller tier-three lenders didn’t do much recognition during the quarter and both saw their loan impairments surprisingly decline by 39 percent quarter-on-quarter.

Tier-two banks’ net earnings softened slightly to Sh6.8 billion during the quarter.

However, tier-three banks recorded a combined net loss largely on slowdown in revenues (and not impairment recognitions). But you may ask yourself a question: do some these results really reflect the risk environment?

It is common knowledge that Covid-19 has negatively impacted the global economy to a very significant extent. Domestically, production has slumped (we await official figures to know the extent).

Latest statistics from the Kenya National Bureau of Statistics (KNBS) show that 1.7 million jobs were wiped out in the second quarter of the year.

Of course, that came with several businesses, especially larger ones, cutting down capacity, while small and medium ones closing shop.

The country’s public finances, which were already in disarray before the pandemic, have never looked weaker.

When it comes to financial reporting, International Financial Reporting Standards version nine (or IFRS 9), provides guidelines on how a financial institution assesses and treats its credit risks in a truthful and fair manner.

Management has to look into the front-view mirror and make judgments whether an asset or group of assets it is holding is capable of generating enough cash to pay for itself and, preferably, produce some profit given the risk(s).

If the asset were unable to pay for itself, then its carrying amount would have to be reduced to reflect the loss of capability to produce cash and profit.

To achieve this, commercial banks have built various price points that help them assign a credit-risk rating to borrowers, which then determines their probability of default.

BIG BANKS

To answer the question, perhaps the pandemic has also laid bare some of the weaknesses of IFRS 9.

It doesn’t cure the risk-subjectivity disease; a disease that gives too much discretion to management to make judgments.

In the advanced world, impairment losses during the quarter wiped out earnings for big banks.

South Africa’s Absa Group announced that its net earnings for the first half of the year had plunged by 82 percent after impairment losses grew four-fold and the group’s management opted for a decisive action to increase coverage against future credit losses.

In essence, the extent to which a bank recognises the pandemic on its books is probably down to judgment (for which they have enough discretion).

@GeorgeBodo