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

by International GAAP 2019 (pdf)

  consistent with the impairment of loans for which risk premiums are also received over the life of the loan.

  Normal loan commitments issued at market interest rates are excluded from the scope

  of IFRS 9 except for impairment and derecognition. [IFRS 9.2.1(g), 2.3]. Unlike off-market

  loan commitments, i.e. loan commitments provided at below-market interest rates,

  normal loan commitments are not subject to the ‘higher of’ test for subsequent

  measurement. [IFRS 9.2.3(c), 4.2.1(d)]. The consequence is that an ECL is required for all

  normal loan commitments, whether or not any fees are paid upfront. This is consistent

  with the general requirement to provide for 12-month ECLs for any new loans that have

  not experienced significant increases in credit risk since initial recognition.

  Another question that arises in practice is whether loan commitments and financial

  guarantee contracts can ever be accounted for as purchased or originated credit-

  impaired. The definition of ‘purchased or originated credit-impaired’ in IFRS 9 refers

  only to financial assets, not financial instruments (consistent with the definition of

  credit-impaired) but loan commitments and financial guarantees are not financial assets.

  So, if such an instrument is entered into when default is highly likely or has already

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  occurred, and the potential loss is reflected in the price, how should the ECLs be

  measured, so as to avoid double counting the loss? This issue could be particularly

  relevant in the context of business combinations, where an entity may acquire loan

  commitments or financial guarantee contracts that are already credit-impaired. For

  financial guarantees, the ‘higher of’ test avoids the double-counting, as the fair value of

  the guarantee recognised as a liability on initial recognition will be higher than lifetime

  expected losses. For loan commitments, one view could be to consider they are at

  below-market interest rates on initial recognition (as the terms were fixed at a time

  where the loan commitment was not credit-impaired) and apply the higher of test;

  alternatively, one may consider that the guidance for financial assets may be applied by

  analogy to loans commitments. This would make sense as the standard treats loans that

  are drawn from a loan commitment as a continuation of the same financial instrument.

  For disclosure purposes, we believe such loan commitments and financial guarantees

  should also be reported as credit-impaired.

  12

  REVOLVING CREDIT FACILITIES

  The 2013 Exposure Draft specified that the maximum period over which ECLs are to

  be calculated should be limited to the contractual period over which the entity is

  exposed to credit risk.37 This would mean that the allowance for commitments that can

  be withdrawn at short notice by a lender, such as overdrafts and credit card facilities,

  would be limited to the ECLs that would arise over the notice period, which might be

  only one day. However, banks will not normally exercise their right to cancel the

  commitment until there is already evidence of significant deterioration, which exposes

  them to risk over a considerably longer period. Banks and banking regulators raised

  concerns on this issue and the IASB responded by introducing an exception for

  revolving credit facilities and setting out further guidance as well as an example

  addressing such arrangements.

  In outline, the revolving facility exception requires the issuer of such a facility to

  calculate ECLs based on the period over which they expect, in practice, to be

  exposed to credit risk. However, the words of the exception are not very clear and it

  has been discussed at all three ITG meetings. The IASB staff have also produced a

  webcast on the topic.

  12.1 Scope of the exception

  The guidance relates to financial instruments that ‘include both a loan and an undrawn

  commitment component and for which the entity’s contractual ability to demand

  repayment and cancel the commitment does not limit the entity’s exposure to credit

  losses to the contractual notice period’. [IFRS 9.5.5.20]. Despite the use of the word ‘both’,

  the ITG agreed, in April 2015, that this guidance applies even if the facility has yet to be

  drawn down. It also applies if the facility has been completely drawn down, as it is the

  nature of revolving facilities that the drawn down component is periodically paid off

  before further amounts will be drawn down again in future.

  The standard also describes three characteristics generally associated with such

  instruments: [IFRS 9.B5.5.39]

  Financial instruments: Impairment 3845

  • they usually have no fixed term or repayment structure and usually have a short

  contractual cancellation period;

  • the contractual ability to cancel the contract is not enforced in day-to-day

  management, but only when the lender is aware of an increase in credit risk at the

  facility level; and

  • they are managed on a collective basis.

  Products that are generally agreed to be in the scope of the exception include most

  credit card facilities and most retail overdrafts. However, even with these some caution

  needs to be applied, since we understand that there are credit card facilities which do

  not enable the issuer to demand repayment and cancel the facility, and which would

  therefore be out of scope.

  What is less clear is the treatment of corporate overdrafts and similar facilities. It is

  relevant that all the ITG discussions as well as the webcast referred to credit cards and

  retail customers and not corporate exposures. The problem is partly that the guidance to

  the standard describes management on a collective basis as a characteristic that revolving

  facilities in the scope of the exception ‘generally have’, rather than a required feature as

  listed in paragraph 5.5.20 of IFRS 9. [IFRS 9.B5.5.39]. Some banks consider this is still a

  determining feature and that many of their corporate facilities are outside the scope of

  the exception because they are managed on an individual basis. Banks normally have a

  closer business relationship with their larger corporate customers than with most retail

  customers, and more data to manage the credit risk, such as access to regular management

  information. Other banks consider that facilities that are individually managed are still in

  the scope of the exception, notably because individual credit reviews are generally

  performed only on an annual basis (unless a significant event occurs). In addition, it is

  unclear exactly what is meant by ‘managed on a collective basis’ and where to draw the

  line between large corporates and smaller entities. It should be noted that if a corporate

  facility is not deemed to be a revolving facility, but can be cancelled at short notice, the

  ECLs will be limited to those that arise over the notice period.

  At its December 2015 meeting, the ITG discussed whether:

  • multi-purpose credit facilities, which have the ability to be drawn down in a

  number of different ways (e.g. as a revolving overdraft, a variable or fixed-rate loan

  (with or without a fixed term) or an amortising loan such as a mortgage) would fall

  within the scope exception;

  • the general characteristics identified in paragraph
B5.5.39 of IFRS 9 should be

  considered to be required characteristics, or merely examples of typical

  characteristics; and

  • the existence of a fixed term of the loan once drawn down would prevent a facility

  from falling within the scope exception.

  The ITG commented that:

  • The supporting application guidance in paragraph B5.5.39 of IFRS 9 reinforces the

  features described in paragraph 5.5.20 of IFRS 9 by setting out general

  characteristics which, while not determinative, are consistent with those features.

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  • The Basis for Conclusions of IFRS 9 provides further context around the type

  of financial instruments that the Board envisaged would fall within the scope

  exception. In particular, the exception was intended to be limited in nature and

  that it was introduced in order to address specific concerns raised by

  respondents in relation to revolving credit facilities that were managed on a

  collective basis. Also, it was understood that these types of financial instruments

  included both a loan and an undrawn commitment component and that they

  were managed, and ECLs were estimated, on a facility level; i.e. the drawn and

  undrawn exposure were viewed as one single cash flow from the borrower.

  [IFRS 9.BC5.254-BC5.261]

  • Consequently, both the drawn and undrawn components of these facilities were

  understood to have similar short contractual maturities, i.e. the lender had both the

  ability to withdraw the undrawn commitment component and demand repayment

  of the drawn component at short notice.

  • An immediately revocable facility which has a fixed maturity (e.g. 5 years) would

  be consistent with the type of facility within the scope exception because the fixed

  term feature does not negate the lender’s contractual right to cancel the undrawn

  component at any time. In contrast, an immediately revocable facility that has no

  fixed maturity but when drawn, can take the form of a loan with a fixed maturity

  (i.e. once it has been drawn, the lender no longer has the right to demand

  immediate repayment at its discretion) would not be consistent with the type of

  facility envisaged to be within the scope exception. This is because the fixed term

  feature does negate the lender’s contractual right to demand repayment of the

  undrawn component. However, regarding this characteristic, the ITG members

  also highlighted the following:

  (a) an entity would first need to establish the unit of account to which the

  requirements of IFRS 9 should be applied. In this regard, they noted that even

  if there was only one legal contract supporting a particular multi-purpose

  credit facility, there might be more than one unit of account to consider; and

  (b) if the fixed-term feature was for a shorter period, judgement would be

  required in order to determine whether such a fixed-term feature would

  prevent a particular financial instrument from falling within the scope

  exception (e.g. whether the borrower could consider the exposure on the

  drawn and undrawn components to be one single cash flow).

  • IFRS 7 requires an entity to explain, among other things, the assumptions used to

  measure ECLs. Within the context of multi-purpose credit facilities, such

  disclosures are likely to be important in order to meet the disclosure objectives

  (see 15 below and Chapter 50 at 5.3).

  While, according to the ITG, the drawn and undrawn exposures are viewed as ‘one

  single cash flow from the borrower’, the standard’s Basis for Conclusions is slightly

  clearer. [IFRS 9.BC5.259]. It states that the loan and undrawn commitment ‘are

  managed, and ECLs are estimated on a facility level. In other words, there is only

  one set of cash flows from the borrower that relates to both components’. Hence,

  the drawn and undrawn elements of a revolving facility within the scope of the

  exception would normally be viewed as only one unit of account. The ITG

  Financial instruments: Impairment 3847

  discussion seems to suggest that a new unit of account would be recognised if a

  borrower chose to draw down on a multi-purpose facility in the form of a term loan,

  because this is the point where this specific drawn portion ceases to share the key

  characteristic of a revolving facility, i.e. the entity’s contractual ability to demand

  repayment and cancel the commitment.

  At its December 2015 meeting, the ITG discussed charge cards and how ECLs on

  future drawdowns should be measured if there is no specified credit limit in the

  contract. The ITG members considered a specific fact pattern where the bank has

  the ability to approve each transaction at the time of sale based on the customer’s

  perceived spending capacity using statistical models and inputs such as spending

  history and known income.

  The ITG members noted that because the bank has the right to refuse each transaction

  at its discretion, and on the assumption that the bank actually exercises that right in

  practice, then:

  • the contractual credit limit should be considered to be zero and consequently

  future drawdowns would not be taken into account; and furthermore,

  • the facility described would not fall within the scope exception because there

  would be no undrawn commitment component (i.e. there is no firm commitment

  to extend credit).

  However, the ITG members noted that their discussions focussed on the very specific

  fact pattern presented and observed that the conclusion could differ in other situations.

  12.2 The period over which to measure ECLs

  12.2.1

  The requirements of the standard

  According to the standard, ‘for such financial instruments, and only those financial

  instruments, the entity shall measure ECLs over the period that the entity is exposed to

  credit risk and ECLs would not be mitigated by credit risk management actions, even if

  that period extends beyond the maximum contractual period’. [IFRS 9.5.5.20]. In order to

  calculate the period for which ECLs are assessed, ‘an entity should consider factors such

  as historical information and experience about:

  (a) the period over which the entity was exposed to credit risk on similar financial

  instruments;

  (b) the length of time for related defaults to occur on similar financial instruments

  following a significant increase in credit risk; and

  (c) the credit risk management actions that an entity expects to take once the credit

  risk on the financial instrument has increased, such as the reduction or removal of

  undrawn limits.’ [IFRS 9.B5.5.40].

  The above wording in the standard is not very easy to interpret or apply.

  This following example illustrates the calculation of impairment for revolving credit

  facilities, based on Illustrative Example 10 in the Implementation Guidance for the

  standard. [IFRS 9 IG Example 10 IE58-IE65]. For the sake of clarity, the assumptions and

  calculations have been adapted from the IASB example as it is not explicit on the source

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  of the parameters and how they are computed. The example has also been expanded to

  show the calculation of the loss allowances. However, to simplify the example, we have

  continued to ignore the need to d
iscount ECLs or whether the credit conversion factor

  would change if an exposure has significantly deteriorated in credit risk.

  Example 47.23: Revolving credit facilities

  Bank A provides credit cards with a one day cancellation right and manages the drawn and undrawn

  commitment on each card together, as a facility. Bank A sub-divides the credit card portfolio by segregating

  those amounts for which a significant increase in credit risk was identified at the individual facility level from

  the remainder of the portfolio. The remainder of this example only illustrates the calculation of ECLs for the

  sub-portfolio for which a significant increase in credit risk was not identified at the individual facility level.

  At the reporting date, the outstanding balance on the sub-portfolio is £6,000,000 and the undrawn facility is

  £4,000,000. The Bank determines the sub-portfolio’s expected life as 30 months (using the guidance set out

  above) and that the credit risk on 25 per cent of the sub-portfolio has increased significantly since initial

  origination, making up £1,500,000 of the outstanding balance and £1,000,000 of the undrawn commitment

  (see the calculation of the exposure in the table below).

  To calculate its EAD, Bank A uses an approach whereby it adds the amounts that are drawn at the reporting

  date and additional draw-downs that are expected in the case that a customer defaults. For those expected

  additional draw-downs, Bank A uses a credit conversion factor that represents the estimate of what percentage

  of that part of committed credit facilities that is unused at the reporting date would be drawn by a customer

  before he defaults. Using its credit models, the bank determines this credit conversion factor as 95 per cent.

  The EAD on the portion of facilities measured on a lifetime ECL basis is therefore £2,450,000, made up of

  the drawn balance of £1,500,000 and £950,000 of expected further draw-downs before the customers default.

  For the remainder of the facilities, the EAD that is measured on a 12-month ECL basis is £7,350,000, being

  the remaining drawn balance of £4,500,000 plus additional expected draw-downs for customers defaulting

  over the next 12 months of £2,850,000 (see the calculation for the EAD in the table below).

  Bank A has estimated that the PD for the next 12 months is 5 per cent, and 30 per cent for the next 30 months.