The estimate for the LGD on the credit cards in the sub-portfolio is 90 per cent. That results in lifetime ECLs
of £661,500 and 12-month ECLs of £330,750 (see calculation for ECLs in the table below).
For the presentation in the statement of financial position, the ECLs against the drawn amount of £607,500
would be recognised as an allowance against the credit card receivables and the remainder of the ECLs that
relates to the undrawn facilities of £384,750 would be recognised as a liability (see table below).
Determination made at facility level
Drawn
Undrawn
Total
Facility
£6,000,000 £4,000,000
£10,000,000
Exposure
Subject to lifetime ECLs (25% of the
25% £1,500,000
£1,000,000
£2,500,000
facility has been determined to have
significantly increased in credit risk)
Subject to 12-month ECLs (the 75%
£4,500,000
£3,000,000 £7,500,000
remaining 75% of the facility)
Financial instruments: Impairment 3849
Credit conversion factor (CCF)
95%
A uniform CCF is used irrespective of
deterioration, which reflects that the
CCF is contingent on default which is
the same reference point for a 12-month
and lifetime ECL calculation
EAD
EAD for undrawn balances is calculated
as exposure × CCF
Subject to lifetime ECLs
£1,500,000
£950,000
£2,450,000
Subject to 12-month ECLs
£4,500,000
£2,850,000 £7,350,000
PD
Exposures subject to lifetime ECLs
30%
Exposures subject to 12-month ECLs
5%
LGD
90%
ECLs
(EAD × PD × LGD)
Exposures subject to lifetime ECLs
£405,000
£256,500
£661,500
Exposures subject to 12-month ECLs
£202,500
£128,250 £330,750
£607,500
presented as loss
£384,750 presented as
£992,250
allowance against assets
provision
In the above calculations, we have used the same credit conversion factor, of 95%, for
calculating the EAD, irrespective of whether it is an input for 12-month or lifetime ECLs.
This is based on an assumption that the extent of future draw-downs in the event that the
customer defaults does not differ depending on whether at the reporting date there had
been a significant increase in credit risk. In practice, for many credit cards, the exposure
in the event of default reaches close to the credit limit and may even exceed it. However,
as discussed further below, the standard does not permit the use of a credit conversion
factor of more than 100%. For this reason, the use of a conventional credit conversion
factor model for estimating the EAD may need to be adjusted to comply with the standard.
It should be noted that:
• Example 10 of the standard (on which our Example 47.23 above is based), does not
explain how the entity has concluded that 25% of the portfolio has significantly
increased in credit risk. Collective assessment is discussed at 6.5 above.
• Example 10 in the standard also does not show how the 30-month period
was calculated.
3850 Chapter 47
12.2.2
Guidance provided by the ITG
The ITG in April 2015, discussed how to determine the appropriate period when
measuring ECLs for a portfolio of revolving credit card exposures in stages 1, 2 and 3
and commented that:
• An entity’s ability to segment and stratify the portfolio into different sections of
exposures in accordance with how those exposures are being managed will be relevant.
For example, an entity may be able to identify exposures with specific attributes that
are considered more likely to default and consequently would have shorter average
lives than those that are expected to continue performing (see 6.5 above).
• While IFRS 9 requires a period in excess of the maximum contractual period to be
used when measuring ECLs, the fundamental aim was still to determine the period
over which the entity is exposed to credit risk and an entity must consider all three
factors set out in paragraph B5.5.40. Consequently, expected defaults or potential
credit risk management actions such as reduction or removal of undrawn limits
could result in a shorter period of exposure than that indicated by the historical
behavioural life of the facility. That is, the time horizon is not the period over
which the lender expects the facility to be used, but the period over which the
lender is, in practice, exposed to credit risk.
At its December 2015 meeting, the ITG continued the discussion on how an entity
should determine the maximum period to consider when measuring ECLs for revolving
credit facilities. This divided into two sub-questions: when does this period start and
when does it end?
With respect to the starting-point, the ITG members observed that the requirements of
paragraph B5.5.40 of IFRS 9 do not alter the starting-point of the maximum period to
consider when measuring ECLs and consequently, the appropriate starting-point should
be the reporting date.
With respect to the ending-point, ITG members focused on which credit risk
management actions an entity should take into account and noted that:
• An entity should consider:
(a) only credit risk management actions that it expects to take rather than all
credit risk management actions that it is legally and operationally able to take;
(b) only those credit risk management actions that serve to mitigate credit risk
and consequently, actions that do not mitigate credit risk such as the
reinstatement of previously curtailed credit limits should not be considered;
and
(c) all credit risk management actions that it expects to take and that serve to
either terminate or limit the credit risk exposure in some way.
Financial instruments: Impairment 3851
• An entity’s expected actions must be based on reasonable and supportable
information. In this regard, consideration should be given to an entity’s normal
credit risk mitigation process, past practice and future intentions.
• The ending-point could be limited by the expected timing of the entity’s next
review process, but only if the entity’s normal business practice is to take credit
risk mitigation actions as part of this review process. Consequently, it may not
always be appropriate to use the timing of the entity’s next review process as a
basis for determining the ending-point.
• In respect of assets in stage 2, the probability of assets curing and defaulting would
need to be taken into account when determining the maximum period to consider
when measuring ECLs.
• It was noted that a distinction should be made between credit risk management
actions such as the reinstatement of a previously curtailed credit limit (that
should not be taken into account) and consider
ing how a particular stage 2
exposure that has not yet been subject to any credit risk mitigation actions will
develop. For example, an entity may have determined that there has been a
significant increase in credit risk since initial recognition in respect of a
particular exposure but may not yet have taken any specific credit risk
mitigation actions such as the curtailment or termination of the credit limit. In
this case, consideration should be given to the possibility that the exposure may
cure rather than default. In contrast, if an entity had taken credit risk mitigation
action in respect of that exposure such as the curtailment of the credit limit, it
would not be appropriate to take into consideration the possibility that the
exposure may subsequently cure, resulting in a reinstatement of the previously
curtailed credit limit when determining the maximum exposure period. In this
regard, appropriate portfolio segmentation is crucial, in particular in relation to
financial assets in stage 2.
• There is only one maximum exposure period to consider, which applies equally to
both the drawn and undrawn components of a revolving credit facility, which is
consistent with the way in which the facility is managed. Nevertheless, in measuring
ECLs, credit risk mitigation actions may affect the drawn and undrawn components
differently. For example, when an entity cancels the undrawn component, the
possibility of any future drawdowns is removed, whereas when an entity demands
repayment of the drawn component the recovery period associated with that drawn
exposure still needs to be considered in measuring ECLs.
• Ultimately, the estimation of the maximum period to consider would require
judgement and consequently the disclosure requirements of IFRS 7 (such as those
explaining inputs, assumptions and estimation techniques in relation to ECLs)
would be important (see 15 below and Chapter 50 at 5.3).
3852 Chapter 47
12.2.3
Guidance provided by the IASB webcast
In May 2017 the IASB issued a webcast titled IFRS 9 Impairment: The expected life
of revolving facilities. Like other IASB webcasts, this sets out the views of the
speakers rather than the Board, but it will nevertheless be regarded as important
educational material.
This webcast used the example of a portfolio of 100 similar facilities, 30 of which are
expected to significantly increase in credit risk by the next credit review and, at the next
credit review, based on past experience, 5 of these facilities will be cut. The key
messages provided were:
• The entity should assume that the expected life of the portfolio will be limited by
the period to the next credit review only for those 5 facilities. This is because the
expected life can only be reduced to the next review date to the extent that
mitigation actions are expected to occur.
• It is not necessary to know in advance which 5 facilities will be cut.
• The expected life of the other 95 facilities will be bounded by when they are expected
to default or the point at which the facility is no longer used by the customer.
• Meanwhile, the expected life for the 5 facilities may be shorter than the time to the
next review if they are expected to default.
• As discussed at the ITG, it will be necessary to segment the portfolio appropriately
into groups of loans with similar credit and payment expectations in order to
determine its expected life. If a facility is more likely to default then it is also more
likely to be subject to risk mitigation action.
• If the entity expects, based on past experience, to cut the facility only in part, by
reducing the limit, then the life of the facility will be cut only for the portion of the
facility that is expected to be withdrawn.
This example only looks forward to what it expects to happen by the time of the next
credit review. Presumably it would be appropriate to extend the analysis, to look
beyond this to subsequent reviews and further reductions in facilities expected in the
future, to help determine the expected life of the remaining 95 facilities in the portfolio.
This is illustrated by Example 47.24 below.
A second example in the webcast compared two entities: entity A only cancels undrawn
facilities that deteriorate to a risk classification of 20, while entity B cancels any facility
as soon as it deteriorates to a classification of 15 (and so lower risk than grade 20). It was
concluded that, all else being equal, the expected life for entity A’s portfolio will be
longer than for entity B’s portfolio.
It should be stressed that estimating the expected life of a revolving facility is of relevance
mostly for those facilities that are measured using lifetime credit losses. The allowance for
those assets in stage 1 will be calculated based only on losses associated with default in the
next twelve months, which is likely to be the period used to measure ECLs unless the
entity’s risk mitigation activities indicate that a shorter period should be used.
To recap, it would seem that a periodic credit review should normally be taken into
account when assessing the period over which to measure losses to the extent that it is
expected to result in actual limits reduction or withdrawal. Hence, for example, if
Financial instruments: Impairment 3853
normally 20% of facilities are withdrawn based on an annual review, then for 20% of the
outstanding facilities the period to measure losses should be limited by the timing of this
next review. For the other 80% of the facilities, three things may happen: they may
someday default, the facility may someday be reduced or withdrawn, or the borrower
may someday cease to use the card. For the 80% it is necessary to model each of these
possibilities, which means that the period over which to measure ECLs may extend for
a number of years into the future. Under this view the standard’s requirement for any
facilities measured using lifetime ECLs can be simply summarised as ‘how much do you
expect to lose’? The length of the period over which losses are measured is of secondary
importance except that it is necessary to know when defaults are expected to occur, in
order to determine the appropriate discounting. The application of this approach is
illustrated in the following example.
Example 47.24: Estimating the life of revolving credit facilities
Of 1,000 facilities in stage 2 the entity estimates that each year:
• 10% will default every year in the first three years, but this reduces to 2% thereafter, as those facilities
that do not default in the first three years are expected to have become significantly lower risk.
• 8% of holders will cease to use their card every year in the first three years but this increases to 15%
thereafter once their financial position has improved.
• 15% of facilities will be withdrawn each year, as credit risk mitigation, over the first three years. After that
period it is assumed that the credit risk is significantly reduced and none of the facilities are reduced thereafter.
No of
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
facilities
in Stage 2
Balance
brought
forward 1,000 670 448 301 250 207 172
Defaults (100) (67) (45) (6) (5) (4) (3)
Cease to
use
card (80) (54) (35) (45) (38) (31) (26)
Facility
withdrawn
(150)
(101)
(67) – – – –
Balance
carried
forward 670 448 301 250 207 172 143
In this example it is apparent that while the level of defaults quickly declines, a small
portion of the portfolio has a very long life. The consequence is that the ECL could be
very significant. However, the example does not take account of the time value of
money. Given the high interest rate charged on credit cards, the manner in which
interest is included in the estimation of cash flows and losses are discounted will have a
major impact upon the ECL measurement (see 12.4 below).
One method that we have observed being applied to make this calculation is to track a
portfolio of stage 2 facilities over a number of years and note how long it takes for the
default rate to reduce to an immaterial level.
3854 Chapter 47
12.2.4 Interaction
with
derecognition
A further issue is the extent to which the period over which to measure ECLs is restricted
by the normal derecognition principles of IFRS 9 and what could constitute a
derecognition of the facility. In particular, it is unclear whether the existence of a
contractual life and/or the lender’s ability to revise the terms and conditions of the facility
based on periodic credit reviews as thorough as that on origination, would be regarded as
triggers for derecognition and so would also limit the life for ECL measurement.
In April 2015, the ITG discussed how to determine the date of initial recognition of a
revolving credit facility for the purposes of the assessment of significant increases in
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