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International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards

Page 742

by International GAAP 2019 (pdf)


  on a PD approach

  On 31 December 2018, Bank A originates a 10 year bullet loan with a gross carrying amount of $1,000,000, with

  interest being due at the end of each year and the principal due at maturity. In line with IFRS 9, Bank A must

  recognise an impairment allowance for the ECLs, considering current and forward looking credit risk information.

  The ECLs are a probability-weighted estimate of the present value of estimated cash shortfalls – i.e. the

  weighted average of credit losses, with the respective risks of a default occurring used as the weights. For

  this purpose, the following parameters must be estimated:

  • Probability of Default (‘PD’) – Estimate of the likelihood of default over a given time horizon (e.g. from ti–1

  to ti). A default may only happen at a ti horizon if the facility has not been previously derecognized and is

  still in the portfolio. An early exit (‘EE’) may occur in case of default unless the facility reverts to performing

  without significant modification of the contractual terms. The marginal probability of default for the period

  ti–1 to ti is then adjusted from the probability that an early exit occurred during the previous periods:

  J=j–1

  PD

  (1 – EE )

  t ×

  t

  i

  J=1

  j

  We note that, for simplicity, Bank A may decide to model EE within the PD component.

  • Loss Given Default (‘LGD’) – Estimate of the loss arising in case a default occurs at a given time (e.g. ti). It

  is based on the difference between the contractual cash flows due and those that the lender would expect to

  receive, including from the realisation of any collateral. It is usually expressed as a percentage of the EAD.

  • Exposure at Default (‘EAD’) – Estimate of the exposure at a future default date, taking into account

  expected changes in the exposure after the reporting date, including repayments of principal and interest,

  whether scheduled by contract or otherwise, expected drawdowns on committed facilities, and accrued

  interest from missed payments.

  • Discount Rate (‘r’) – Rate used to discount an expected loss to a present value at the reporting date.

  Based on these parameters, an ECL can be computed for any horizon – typically for each due date of an

  exposure. The computation formula can be expressed as follows:

  t = t

  i

  n

  J=j–1

  PD

  (1 – EE ) × LGD × EAD

  t ×

  t

  t

  t

  i

  J=1

  j

  i

  i

  ECL tn =

  (1 + r ti

  i )

  t = t

  i

  1

  Where:

  i

  = each future payment

  ti

  = maturity of the payment i

  tn

  = horizon considered (either 12-month or lifetime)

  Note that the figures in the tables below have been rounded to one or two decimal points.

  3754 Chapter 47

  Stage 1: 12-month ECLs of $422

  At origination, the loan is in stage 1. Thus a corresponding 12-month ECL allowance is recognised, i.e. the

  portion of the lifetime ECLs that result from default events that are possible within 12 months after the

  reporting date.

  Based on statistical and qualitative information, Bank A has computed the following ECL parameters at origination.

  As interest is paid on a yearly basis, ECLs are calculated using annual periods.

  Each year EAD equals the outstanding principal plus accrued interest due at the end of the year. This bullet

  loan does not allow any prepayment, therefore the EAD is constant.

  The effective interest rate of the loan is assumed to be the contractual rate, which is 3%.

  Bank A sets EE = PDn–1 × 0.8, on the basis that a proportion of the loans which default are expected to cure

  and will once again be at risk of default.

  Based on provided guarantees and collateral, LGD is estimated at 25% of EAD, whatever the date of default.

  Cumulative

  Cumulative

  Discount

  PD @

  Marginal

  EE t–1 @

  Marginal

  Year EAD rate

  origination

  PD

  origination LGD

  ECL

  2018 1,000,000

  2019 1,030,000

  3%

  0.17%

  0.17%

  0.00% 25%

  $422

  12m ECL

  2020 1,030,000

  3%

  0.49%

  0.32%

  0.14% 25%

  $775

  2021 1,030,000

  3%

  0.86%

  0.37%

  0.39% 25%

  $877

  2022 1,030,000

  3%

  1.38%

  0.53%

  0.69% 25%

  $1,196

  2023 1,030,000

  3%

  1.84%

  0.47%

  1.11% 25%

  $1,027

  2024 1,030,000

  3%

  2.37%

  0.54%

  1.47% 25%

  $1,141

  2025 1,030,000

  3%

  2.85%

  0.49%

  1.90% 25%

  $1,014

  2026 1,030,000

  3%

  3.30%

  0.46%

  2.28% 25%

  $912

  2027 1,030,000

  3%

  3.84%

  0.56%

  2.64% 25%

  $1,073

  2028 1,030,000

  3%

  4.50%

  0.69%

  3.07% 25%

  $1,280

  Lifetime

  $9,717

  ECL

  1 – Cum PDi

  Marginal PDi = 1 –

  1 – Cum PDi–1

  PDi × (1 – Cum EEi–1) × LGDi × EADi

  Marginal ECLi =

  (1 + ri)i

  Financial instruments: Impairment 3755

  Stage 2: lifetime ECLs of $50,285

  On 31 December 2021 – 3 years after origination, the loan shows signs of significant deterioration in credit

  quality based on the creditworthiness of the obligor and forward looking information, and Bank A moves it

  to stage 2. Example 47.10 below shows the calculation underlying this assessment.

  Consistent with the significant increase in credit risk, the PD of the obligor has increased. In consequence, the

  probability of an early exist has also increased, because of the higher level of default. For the purposes of this

  example, we assume that there are no significant fluctuations in collateral values and the LGD remains constant.

  Discount

  Cumulative

  Marginal

  Cumulative

  Marginal

  Year EAD rate

  PD

  PD

  EE t–1

  LGD

  ECL

  2021 1,000,000

  0.00%

  2022 1,030,000

  3%

  1.40%

  1.40%

  0.00%

  25% $3,495

  12m ECL

  2023 1,030,000

  3%

  3.87%

  2.51%

  1.12% 25% $6,017

  2024 1,030,000

  3%

  8.82%

  5.15%

  3.10% 25% $11,7
56

  2025

  1,030,000 3% 12.84%

  4.40% 7.06%

  25%

  $9,366

  2026

  1,030,000 3% 16.04%

  3.67% 10.27%

  25%

  $7,322

  2027

  1,030,000 3% 18.98%

  3.50% 12.83%

  25%

  $6,585

  2028

  1,030,000 3% 21.60%

  3.23% 15.18%

  25%

  $5,745

  Lifetime

  $50,285

  ECL

  Stage 3: lifetime ECLs of $262,850

  In the following year, on 31 December 2022, the obligor does not pay the amount due. Based on credit

  information available, it is already considered to be in default and is moved to stage 3 – credit-impaired. At

  this time, the exposure is $1,030,000.

  Once a facility becomes credit-impaired, impairment must still represent ECLs. Therefore, it must be

  probability-based. At the reporting date, Bank A updates the appraisal value of the collateral and considers 3

  probable scenarios:

  • Scenario 1 – Cure: the obligor eventually pays past dues and the loan reverts to performing. In this case,

  ECL corresponds to lifetime losses expected from loans that have recently defaulted. Based on its

  historical data and using the methodology described above, Bank A expects an ECL of $130,000.

  • Scenario 2 – Restructure: Bank A comes to a restructuring agreement with the obligor. After 6 months

  of negotiation, the loan is written off and a new loan is initiated with a net present value of $800,000.

  • Scenario 3 – Liquidation: The loan is written off and the bank starts the collection of the contractual

  collateral. Bank A expects to sell the collateral within a year and to collect $700,000 net of recovery costs.

  3756 Chapter 47

  The ECL of each scenario can be calculated as follows:

  t = t

  i

  n

  CFt – RC

  i

  ti

  ECL = EAD –

  (1 + r ti

  i )

  t = t

  i

  1

  Where:

  CF

  = expected future cash flows

  RC

  = expected recovery costs

  Expected net

  Expected

  ECL of

  Probable

  Discount

  Weighted

  Probability EAD

  future cash

  recovery

  each

  scenarios

  rate

  ECL

  flows

  time

  scenario

  Scenario 1:

  20% 1,030,000

  3%

  900,000

  0.0 $130,000

  $26,000

  Cure

  Scenario 2:

  40% 1,030,000

  3%

  800,000

  0.5 $241,737

  $96,695

  Restructure

  Scenario 3:

  40% 1,030,000

  3%

  700,000

  1.0 $350,388 $140,155

  Liquidation

  Weighted

  Lifetime

  $262,850

  average ECL

  ECL

  % of

  26%

  EAD:

  ECL = EAD − Exp. net future CF

  (1+r)exp recovery time

  Most sophisticated banks have developed their IFRS 9 solutions by adjusting and

  extending their Basel models. This is true for all types of model component: PD, LGD

  and EAD. This is perhaps unsurprising given the historical investment large banks have

  made in their Basel models, and the fact that IFRS 9 shares fundamental similarities in

  expected loss modelling. But, for many banks, creating lifetime estimates and altering

  models to satisfy the complex and detailed IFRS 9 requirements will still require

  significant work.

  5.4.2

  Loss rate approach

  Not every entity calculates a separate risk of a default occurring and an LGD, but instead

  uses a loss rate approach. Using this approach, the entity develops loss-rate statistics on

  the basis of the amount written off over the life of the financial assets. It must then adjust

  these historical credit loss trends for current conditions and expectations about the

  future. The following Illustrative Example 9 from IFRS 9 is designed to illustrate how

  an entity measures 12-month ECLs using a loss rate approach. [IFRS 9 IG Example 9, IE53-IE57].

  Example 47.4: 12-month expected credit losses measurement based on a loss

  rate approach

  Bank A originates 2,000 bullet loans with a total gross carrying amount of $500,000. Bank A segments its

  portfolio into borrower groups (Groups X and Y) on the basis of shared credit risk characteristics at initial

  recognition. Group X comprises 1,000 loans with a gross carrying amount per client of $200, for a total

  gross carrying amount of $200,000. Group Y comprises 1,000 loans with a gross carrying amount per

  client of $300, for a total gross carrying amount of $300,000. There are no transaction costs and the loan

  Financial instruments: Impairment 3757

  contracts include no options (for example, prepayment or call options), premiums or discounts, points paid,

  or other fees.

  Bank A measures ECLs on the basis of a loss rate approach for Groups X and Y. In order to develop its loss

  rates, Bank A considers samples of its own historical default and loss experience for those types of loans. In

  addition, Bank A considers forward-looking information, and updates its historical information for current

  economic conditions as well as reasonable and supportable forecasts of future economic conditions.

  Historically, for a population of 1,000 loans in each group, Group X’s loss rates are 0.3 per cent, based on

  four defaults, and historical loss rates for Group Y are 0.15 per cent, based on two defaults.

  Number

  of

  Estimated

  Total

  Historic

  Estimated

  Present

  Loss rate

  clients in

  per client

  estimated

  per

  total gross

  value of

  sample

  gross

  gross

  annum

  carrying

  observed

  carrying

  carrying

  average

  amount at

  loss (a)

  amount at

  amount at

  defaults

  default

  default

  default

  Group

  A

  B

  C = A × B

  D

  E = B × D

  F

  G = F ÷ C

  X 1,000 $200 $200,000

  4

  $800

  $600 0.3%

  Y 1,000 $300 $300,000

  2

  $600

  $450 0.15%

  (a) ECLs should be discounted using the EIR. However, for purposes of this example, the present value of the observed loss is assumed. [IFRS 9.5.5.17(b)].

  At the reporting date, Bank A expects an increase in defaults over the next 12 months compared to the

  historical rate. As a result, Bank A estimates five defaults in the next 12 months for loans in Group X and

  three for loans in Group Y. It estimates that the present value of the observed credit loss per client will remain<
br />
  consistent with the historical loss per client.

  On the basis of the expected life of the loans, Bank A determines that the expected increase in defaults does

  not represent a significant increase in credit risk since initial recognition for the portfolios. On the basis of its

  forecasts, Bank A measures the loss allowance at an amount equal to 12-month ECLs on the 1,000 loans in

  each group amounting to $750 and $675 respectively. This equates to a loss rate in the first year of 0.375 per

  cent for Group X and 0.225 per cent for Group Y.

  Number

  of

  Estimated

  Total

  Expected

  Estimated

  Present

  Loss rate

  clients in

  per client

  estimated

  defaults

  total gross

  value of

  sample

  gross

  gross

  carrying

  observed

  carrying

  carrying

  amount at

  loss

  amount at

  amount at

  default

  default

  default

  Group

  A

  B

  C = A × B

  D

  E = B × D

  F

  G = F ÷ C

  X 1,000 $200 $200,000

  5

  $1,000

  $750

  0.375%

  Y 1,000 $300 $300,000

  3

  $900

  $675

  0.225%

  Bank A uses the loss rates of 0.375 per cent and 0.225 per cent respectively to estimate 12-month ECLs on

  new loans in Group X and Group Y originated during the year and for which credit risk has not increased

  significantly since initial recognition.

  The example above illustrates that under the loss rate approach, an entity would

  compute its loss rates by segmenting its portfolio into appropriate groupings (or

  sub-portfolios) based on shared credit risk characteristics and then updating its

  historical loss information with more forward-looking information. The loss rate

  was derived simply by computing the ratio between the present value of

  observed losses (the numerator) and the gross carrying amount of the loans

  3758 Chapter 47

  (the denominator). Although the loss rate approach does not require an explicit risk

  of a default occurring, there has to be an estimate of the number of defaults in order

 

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