Need to know
- Under international accounting rules, banks have to treat loans issued with environmental, social and governance criteria as derivatives. In the US, the loan’s ESG element has to be treated as a free-standing derivative.
- Many banks have been able to argue that the ESG elements of such loans, which have the potential to change the products’ cash flows, are inconsequential. This has enabled banks to account for the loans at amortised cost.
- Most borrowers benefit from a reduction in interest rates of between five and 10 basis points if they meet pre-determined ESG-related targets.
- However, as the market for ESG-linked loans and the monetary benefit from hitting ESG targets both increase, the lack of clarity over how accounting rules should apply to these products could soon become a problem.
- Banks are concerned that accounting rules are not being applied consistently across the market and have asked standards boards to provide clearer guidance.
Like a driver at night struggling to make out faraway shapes with their headlights, accounting standards boards have always tried to predict the financial products that will be coming down the road.
Over recent decades, the Financial Accounting Standards Board (FASB) in the US and the International Accounting Standards Board (IASB) have devised standards that they felt could apply to a broad range of products. However, they did not foresee the rise of loans linked to environmental, social and governance issues.
ESG-linked debt instruments have become popular in recent years among corporates and investors that want to show that they are trying to make the world a better and healthier place. Banks are under increasing pressure to understand how the current accounting rules and principles apply to these products – and the task is far from clear.
They fear the problem will get worse over the coming months as the demand for ESG products increases, and they are looking to the standards boards to make things clearer.
“The banks are not waiting until the IASB makes some decisions,” says the head of accounting at a European bank. “They’re going a little bit ahead. And it’s not only the banks – it’s the whole industry. But a lot of things are unclear. From my point of view, we have divergence in practice.”
The crux of the issue is the fluctuation in interest payments built into ESG loans. If a corporate hits certain ESG targets, it can be rewarded with a small reduction in the rate of interest it needs to pay; if it fails to meet the targets, it can be forced to pay more.
FASB, which oversees the Generally Accepted Accounting Principles (GAAP) in the US, and the IASB, which oversees the International Financial Reporting Standards (IFRS, and specifically IFRS 9), are working to provide the market with greater clarity.
They are trying to establish whether cash flows on ESG loans should be classified solely as principal and interest, and what can be characterised as interest. This includes establishing whether any variation in cash flow resulting from the ESG-linked element of the interest should be considered part of the interest on the underlying principal.
If the ESG element were to be considered part of the interest on the underlying principal, the loan could be subject to the same accounting standards as a normal lending facility at amortised cost– which enables adjustments such as depreciation, amortisation or impairment to be reflected in the loan’s value over time. However, if the ESG element were to be viewed as distinct from the rest of the interest and not clearly linked to the underlying principal, under IFRS 9 the entire loan would have to be classified as a derivative at fair value – which reflects the market price of an asset at any one point in time – for accounting purposes, or the ESG element would have to be accounted for as a separate derivative under US GAAP rules.
At the moment, corporates are generally receiving benefits of between five and 10 basis points from hitting their ESG-related targets. However, many banks expect these benefits to increase as demand for ESG-linked loans grows and competition among banks to supply the products intensifies. Between 2018 and 2021, the value of ESG-linked loans issued grew steadily from around $2.9 trillion to just over $3 trillion in the US, and from $740 billion to $795 billion in the EU.
“We are starting to see new instruments with an ESG feature that relates to between 15 and 25 basis points,” says Vincent Guillard, a partner at consultancy and audit firm Mazars. “Saying that 25 basis points is de minimis – it’s complicated, because sometimes it’s a significant part of the cash flow of the instruments. So saying that it is so little that we can disregard it, it’s not possible anymore.”
Traffic diverted
De minimis refers to one of the two workarounds available under the current standards. At present, banks can bypass the need to account for an ESG loan at fair value if the ESG-related element of the interest is deemed too small to be taken into consideration on a trade-by-trade basis, as under IFRS 9, or as part of the bank’s overall activity under GAAP.
This allows banks to have their ESG-linked loans accounted for at amortised cost. The IASB has said amortised cost is for products with simple contractual cash flows.
Accounting for the instruments at fair value might result in the application of mark-to-market derivatives accounting. This in turn could lead to higher profit-and-loss volatility, which would make banks reluctant to offer ESG loans.
Under the second workaround, a bank can argue that the ESG feature has a direct link to the asset’s credit risk and should therefore be included as a component of the interest of a basic lending agreement. The loan could thus be classified as “solely payments of principal and interest on principal outstanding” (SPPI) and be accounted for as amortised cost.
“What we also see is actually that the margins under ESG clauses are very limited,” says the head of accounting at the European bank. “We’re talking a range of up to five basis points, so you can argue it’s de minimis. If I have four or five basis points and I have a normal credit margin, then it’s not material. It does not alter the revenues, which are the same as you’d get from a basic lending contract.”
The question is how long accounting departments at banks will be able to rely on the current exemptions. They may be coming to an end sooner rather than later.
“These concerns are very much real,” says Silvie Koppes, associate partner at KPMG in the UK. “I think, maybe this year, banks are still able to argue that it might be not material, and are working on their de minimis policy. And hopefully, the standard setters can come up with something that banks, auditors and regulators consider appropriate.”
Detour ahead
Standard setters have adopted different approaches to ESG-linked loans, in keeping with their diverging accounting standards.
The IASB is looking into the topic as part of its review of the implementation of IFRS 9. The board introduced the principles-based standard – for measuring and classifying financial assets and liabilities – in 2014, long before any ESG loans had been created. It is in the process of developing further guidance to determine whether a financial asset’s contractual cash flows should be deemed SPPI – and, specifically, what is considered to be interest.
It hopes to publish clarifying guidance in the coming months on the test to determine what can be considered SPPI. The SPPI test will ultimately determine what can be accounted for at amortised cost or at fair value.
FASB only decided at its meeting on the subject on May 11 which aspects it needed to look into. Risk.net understands that the board’s slower movement on discussing the topic was a consequence of the less rapid development of ESG-related instruments in the US.
Many banks say the accounting standards are unclear about what a lender should do when one of its instruments fails the SPPI test.
“Here we have very little guidance under IFRS on that topic,” says Mazars’ Guillard. “The ESG feature did not exist at the time when the IASB board wrote the IFRS 9 guidelines around the SPPI concept.”
As part of its IFRS 9 implementation review, the IASB consulted market participants on how ESG-linked instruments should be accounted. Its respondents expressed a range of views on how the SPPI test should be applied to these instruments.
In the US, FASB views the issue slightly differently. Under GAAP’s rules-based approach, anything that could influence the timing or amount of cashflows is determined to be an embedded derivative of the loan. The ESG element therefore has to be bifurcated from the underlying loan and treated as a freestanding derivative. The ESG element is accounted for at fair value, with changes in the market price reflected in the P&L.
Under GAAP, three criteria need to be met for a loan to require bifurcation: the embedded derivative and underlying loan must not be closely linked; the underlying loan must not be measured at fair value; and if the terms of the embedded derivative were applied to a separate instrument, that instrument would have to be considered a derivative.
FASB also held consultations with banks to understand how they were navigating the current accounting rules. Its respondents agreed that largely ESG-linked instruments met all the criteria for bifurcation, and expressed concerns around a divergence in the application of the rules. Despite bifurcation of the ESG element and the underlying loan being required under GAAP rules, most respondents felt it would be “costly and complex”.
It is understood that FASB and the IASB have no set figure for when an ESG feature of a loan is considered de minimis, and that the figure will instead be dependent on individual banks and the products they choose to provide.
“Nobody is in a hurry to set the number around [the de minimis] concept,” says Mazars’ Guillard. “We are convinced that it is important to continue to hold a large proportion of those assets at amortised cost because it’s more consistent with a business model of the entity. So probably 25 basis points is not de minimis – probably two basis points is de minimis.”
At the junction, continue straight on
While standards boards conduct further research, banks are eagerly awaiting a solution and hoping they can continue to rely on exemptions in the meantime. However, there are concerns that a failure to deal with the problem in a timely manner could have a lasting impact on the development of the ESG loans market.
“This is really topical and worries many,” says KPMG’s Koppes. “Maybe in the future, because we see this growth now, it could be therefore that banks may not be able to provide as many of these loans as they had wanted to or with the features that they actually want to include. It could somehow hold some development back.”
Many of the respondents to the IASB’s consultation said that although ESG-linked loans might not pass the SPPI test, there should be a specific exemption allowing them to be accounted for at amortised cost. They reasoned that this approach, rather than fair value, provides more valuable information on future cash flows and aligns the accounting of a product on both the lender’s and the borrower’s side.
IASB has decided that no fundamental changes are required to IFRS 9 and that no ESG-related exemptions are needed. Instead, it is undertaking a standard-setting project on SPPI requirements. Its aim is to provide greater clarity on the definition of a basic lending agreement and how to determine if a trigger – such as a failure to meet ESG targets – is relevant in determining whether a loan’s cash flows are SPPI. It hopes to have draft rules ready for market feedback by the first quarter of 2023.
Respondents to FASB’s consultation suggested a rule whereby ESG-linked instruments would not require bifurcation or for the board to provide guidance around the implementation of bifurcation. At its May meeting, FASB’s board agreed to conduct further research before deciding whether to dedicate time and resources to a project as part of its technical agenda.
As the song says: the road is long, with many a winding turn.
Editing by Daniel Blackburn
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