International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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future, which is expected to have a further negative impact on Company Y’s ability to generate cash
flows and to de-leverage.
(b) Company Y is closer to breaching its covenants, which may result in a need to restructure the loan or
reset the covenants.
(c) Bank X’s assessment that the trading prices for Company Y’s bonds have decreased and that the credit
margin on newly originated loans have increased reflecting the increase in credit risk, and that these
changes are not explained by changes in the market environment (for example, benchmark interest rates
have remained unchanged). A further comparison with the pricing of Company Y’s peers shows that
reductions in the price of Company Y’s bonds and increases in credit margin on its loans have probably
been caused by company-specific factors.
(d) Bank X has reassessed its internal risk grading of the loan on the basis of the information that it has
available to reflect the increase in credit risk.
Bank X determines that there has been a significant increase in credit risk since initial recognition of the loan
in accordance with paragraph 5.5.3 of IFRS 9. Consequently, Bank X recognises lifetime ECLs on its senior
secured loan to Company Y. Even if Bank X has not yet changed the internal risk grading of the loan it could
still reach this conclusion – the absence or presence of a change in risk grading in itself is not determinative
of whether credit risk has increased significantly since initial recognition.
Example 47.9: No significant increase in credit risk
Company C is the holding company of a group that operates in a cyclical production industry. Bank B
provided a loan to Company C. At that time, the prospects for the industry were positive, because of
expectations of further increases in global demand. However, input prices were volatile and given the point
in the cycle, a potential decrease in sales was anticipated.
In addition, in the past Company C has been focused on external growth, acquiring majority stakes in
companies in related sectors. As a result, the group structure is complex and has been subject to change,
making it difficult for investors to analyse the expected performance of the group and to forecast the cash that
will be available at the holding company level. Even though leverage is at a level that is considered acceptable
by Company C’s creditors at the time that Bank B originates the loan, its creditors are concerned about
Company C’s ability to refinance its debt because of the short remaining life until the maturity of the current
financing. There is also concern about Company C’s ability to continue to service interest using the dividends
it receives from its operating subsidiaries.
At the time of the origination of the loan by Bank B, Company C’s leverage was in line with that of other
customers with similar credit risk and based on projections over the expected life of the loan, the available
capacity (i.e. headroom) on its coverage ratios before triggering a default event, was high. Bank B applies its
own internal rating methods to determine credit risk and allocates a specific internal rating score to its loans.
Bank B’s internal rating categories are based on historical, current and forward-looking information and
reflect the credit risk for the tenor of the loans. On initial recognition, Bank B determines that the loan is
subject to considerable credit risk, has speculative elements and that the uncertainties affecting Company C,
including the group’s uncertain prospects for cash generation, could lead to default. However, Bank B does
not consider the loan to be originated credit-impaired.
Subsequent to initial recognition, Company C has announced that three of its five key subsidiaries had a
significant reduction in sales volume because of deteriorated market conditions but sales volumes are
expected to improve in line with the anticipated cycle for the industry in the following months. The sales of
the other two subsidiaries were stable. Company C has also announced a corporate restructure to streamline
Financial instruments: Impairment 3793
its operating subsidiaries. This restructuring will increase the flexibility to refinance existing debt and the
ability of the operating subsidiaries to pay dividends to Company C.
Despite the expected continuing deterioration in market conditions, Bank B determines, in accordance with
paragraph 5.5.3 of IFRS 9, that there has not been a significant increase in the credit risk on the loan to
Company C since initial recognition. This is demonstrated by factors that include:
(a) Although current sale volumes have fallen, this was as anticipated by Bank B at initial recognition.
Furthermore, sales volumes are expected to improve, in the following months.
(b) Given the increased flexibility to refinance the existing debt at the operating subsidiary level and the
increased availability of dividends to Company C, Bank B views the corporate restructure as being credit
enhancing. This is despite some continued concern about the ability to refinance the existing debt at the
holding company level.
(c) Bank B’s credit risk department, which monitors Company C, has determined that the latest
developments are not significant enough to justify a change in its internal credit risk rating.
As a consequence, Bank B does not recognise a loss allowance at an amount equal to lifetime ECLs on the loan.
However, it updates its measurement of the 12-month ECLs for the increased risk of a default occurring in the
next 12 months and for current expectations of the credit losses that would arise if a default were to occur.
A numerical illustration of how a significant increase in credit risk might be assessed is
shown in Example 47.10 below.
Example 47.10: Assessment of a significant increase in credit risk based on a PD
approach
This example is based on the same loan presented in Example 47.3 above.
On 31 December 2018, Bank A originates a 10-year bullet loan with a gross carrying amount of $1,000,000,
interest being due at the end of each year. Based on statistical and qualitative information – including forward
looking, Bank A has estimated a BBB rating for the loan.
Based on this rating, Bank A has computed a PD term structure at origination. Bank A’s PD term structure is
estimated with the annual PD expected for each future period. The lifetime PD is the product of each marginal
PD during the considered period:
n
lifetime PDk = 1 −
(1 − marginal PD )
i
k=i
Finally, based on the marginal PD computed for each future period, Bank A is able to compute the forward
lifetime PD as follows:
Cumulative
Remaining
PD at
Marginal 12-
Remaining
annualised
Year
origination
month PD
lifetime PD
lifetime PD
2018
2019 0.17% 0.17% 4.50% 0.46%
2020 0.49% 0.32% 4.34% 0.49%
2021 0.86% 0.37% 4.03%
0.51%
2022 1.38% 0.53% 3.67%
0.53%
2023 1.84% 0.47% 3.16% 0.53%
2024 2.37% 0.54% 2.71% 0.55%
2025 2.85% 0.49% 2.18% 0.55%
2026 3.30% 0.46% 1.70% 0.57%
2027 3.84% 0.56% 1.24% 0.62%
2028 4.50% 0.69% 0.69% 0.69%
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For the first year, the remaining lifetime PD is the cumulative PD at origination. Then, after a year, it starts
decreasing, considering that the remaining period is shorter. After 2 years it is 4.03% and after 3 years it is
only 3.67%. At the end of the loan, the remaining lifetime PD ends up at 0%.
In common with many institutions, Bank A chooses to compare an annualised lifetime PD instead of a
cumulative PD. This has the advantage that business lines and risk analysts can easily map an annualised PD
onto a rating scale. It also enables an absolute change in annualised lifetime PD, e.g. 20bp, to be set as a
‘filter’, to exclude small changes in lifetime PD from being assessed as significant that are considered to be
‘noise’. For this purpose, Bank A calculates an annualised PD, using the residual cumulative curve. The
annualised lifetime PD is calculated as follows:
annualised lifetime PDk = 1 – (1 – lifetime PDk)1/t
when t = horizon of the lifetime PD expressed in years
2020: no significant increase in credit risk: Stage 1
On 31 December 2020 – 2 years after origination, Bank A updates the rating of its obligor. The rating is now BB+.
A new PD term structure is estimated based on this information:
Year
Cumulative lifetime PD
2021 0.67%
2022 1.53%
2023 3.70%
2024 5.58%
2025 5.89%
2026 6.51%
2027 7.45%
2028 8.70%
Remaining annualised
1.13%
lifetime PD
Forecast at origination
0.51%
Increase (multiple)
2.20
In this example, Bank A uses a significant increase in credit risk threshold of a 2.5 multiple of PD. For
simplicity we ignore any qualitative or other indicators that a bank might use to make this assessment.
Comparing the remaining annualised PD estimated at origination (0.51%) with the remaining annualised PD
at the reporting date (1.13%), the increase is still only ×2.2. We note that, had Bank A used a cumulative
lifetime PD approach, it would compare 8.70% to 4.03%, which would also be a multiple of 2.2. The
significant deterioration threshold set by Bank A is not met and therefore the loan remains in stage 1.
2021: significant increase in credit risk: stage 2
On 31 December 2021 – 3 years after origination, Bank A updates the rating of its obligor. Its rating is now
BB–. Then Bank A updates its historical information for current economic conditions as well as reasonable
and supportable forecasts of future economic conditions.
Financial instruments: Impairment 3795
Year
Cumulative lifetime PD
2022 1.40%
2023 3.87%
2024 8.82%
2025 12.84%
2026 16.04%
2027 18.98%
2028 21.60%
Remaining annualised
3.42%
lifetime PD
Forecast at origination
0.53%
Increase (multiple)
6.41
As before, Bank A compares the remaining annualised PD estimated at origination (0.53%) with the
remaining annualised PD at the reporting date (3.42%), an increase of 6.45 times the original PD. Had Bank A
used a cumulative lifetime PD approach the comparison would be of 21.6% to 3.67%, a 6.41 fold increase.
This time, the threshold of significant deterioration is met and the loan is moved to stage 2.
6.2.4
Use of behavioural factors
At its meeting on 16 September 2015, the ITG (see 1.5 above) discussed whether the
following behavioural indicators of credit risk could be used, on their own, as a proxy
to determine if there has been a significant increase in credit risk:
• where a customer has made only the minimum monthly repayment for a specified
number of months;
• where a customer has failed to make a payment on a loan with a different lender; or
• where a customer has failed to make a specified number of minimum monthly
repayments.
The ITG members noted that:
• When assessing whether there has been a significant increase in credit risk,
entities are required to consider a range of indicators rather than focussing on
only one. Furthermore, while behavioural indicators have a role to play, the
above behavioural indicators are often lagging indicators of increases in credit
risk. Consequently, they should be considered in conjunction with other, more
forward-looking information. In this regard, an entity must consider how to
source and incorporate forward-looking information into the assessment of
significant increases in credit risk and may need to do this on a collective basis
if forward-looking information is not available at an individual financial
instrument level.
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• When considering the use of behavioural indicators, an entity should:
(a) focus on identifying pre-delinquency behavioural indicators of increases in
credit risk, e.g. increased utilisation rates or increased cash drawings on
specific products;
(b) only use indicators that are relevant to the risk of default occurring;
(c) establish a link between the behavioural indicators of credit risk and changes
in the risk of default occurring since initial recognition;
(d) be mindful that while behavioural indicators are often predictive of defaults
in the short term, they are often less predictive of defaults in the longer term,
and, hence, might be lagging. Consequently they may not, on their own, signal
significant increases in credit risk in a timely manner; and
(e) consider whether the use of behavioural indicators is appropriate for the type
of product being assessed, e.g. if a loan has only back-ended payments,
behavioural indicators based on timeliness of payment will not be appropriate.
• An entity is required to consider all information available without undue cost and
effort and it should not be limited by the information that is available internally.
For example, an entity should consider using third-party information from sources
such as credit bureaus. However, information that is available to entities will vary
across jurisdictions.
• When making the assessment of significant increases in credit risk, an entity should
consider the possibility of segmenting the portfolio into groups of financial
instruments with shared credit characteristics in such a way that similar indicators of
credit risk could be used to identify increases in credit risk for specific sub-portfolios.
• It would not be appropriate to use the above behavioural indicators for the
purposes of identifying low credit risk assets in accordance with paragraph 5.5.10
of IFRS 9 (see 6.4.1 below), on the basis that such measures would not constitute a
globally accepted definition of low credit risk as required by IFRS 9.
Other behavioural indicators, beyond those mentioned above, including items such as
the level of cash advances, changes in expected payment patterns (e.g. moving from full
payment to something less than full payment), and higher-than-expected utilisation of
the facility, were raised at the meeting. Individually, these kinds of behaviours may not
be determinative of a significa
nt increase in credit risk but, when observed together,
they may prove to be more indicative. By combining these indicators, an entity has the
potential to transfer assets between stage 1 and stage 2 more meaningfully.
We also note that that one of the challenges with using behavioural information is that
it depends on the starting point. That is, if the obligor’s risk of default initially is
consistent with a super-prime rating, the kind of deteriorating behaviour noted above
would likely signal a significant shift. However, if the obligor originally had a sub-prime
rating, then such behaviour might not indicate a significant increase in risk.
As noted by the ITG, while indicators that are more lagging may show a greater
correlation with subsequent default, they are also likely to be less forward-looking.
Although a probability of default approach may seem more sophisticated and forward
looking, it is still generally fed by behavioural information, even if it is combined,
Financial instruments: Impairment 3797
segmented and modelled in a more sophisticated way. If the only borrower-specific
information is his behaviour, a forward looking portfolio overlay will generally be
required, whether a PD or a behavioural approach is used.
6.3
What is significant?
The assessment of whether credit risk has significantly increased depends, critically, on
an interpretation of the word ‘significant’. Some constituents who commented on the
2013 Exposure Draft requested the IASB to quantify the term significant, however, the
IASB decided not to do so, for the following reasons: [IFRS 9.BC5.171, BC5.172]
• specifying a fixed percentage change in the risk of default would require all entities
to use the risk of default approach. As not all entities (apart from regulated financial
institutions) use PDs as an explicit input, this would have increased the costs and
effort for those entities that do not use such an approach; and
• defining the amount of change in the risk of a default occurring would be arbitrary
and this would depend on the type of products, maturities and initial credit risk.
The standard emphasises that the determination of the significance of the change in the