Some options for evaluating significant deterioration under IFRS 9

Gaurav Chawla, Lawrence Forest Jr and Scott Aguais

Abstract

ABSTRACT

According to International Financial Reporting Standard 9 (IFRS 9), if the credit risk on an instrument has increased "significantly" since the instrument's original recognition, and the resulting credit risk is more than "low credit risk", then the institution would recognize a loss allowance on the instrument in the amount of lifetime expected credit losses (ECLs). Alternatively, at original recognition, and thereafter in the absence of significant deterioration in credit risk, the institution would recognize an allowance in the amount of twelve months of ECLs (or a lifetime, if the instrument matures in less than twelve months). In clarifying this aspect of IFRS 9, the International Accounting Standards Board (IASB) has specified that, in evaluating whether an instrument has suffered significant deterioration, an institution should consider only lifetime default risk, excluding consideration of possible changes in the exposure at default (EAD) and loss given default (LGD) components of ECLs. The authorities have also stated that the triggering of a lifetime allowance would reflect circumstances under which the spread inherent in contractual pricing no longer fully compensates for credit risk.

Further, in its analysis of IFRS 9, the Bank for International Settlements has presented a view that any deterioration in credit risk should be considered significant. But how, precisely, does an institution determine whether an instrument has suffered a significant deterioration in its credit risk to a point in excess of low credit risk? Beyond the unspecific guidance mentioned above, the authorities have said little about this. As a result, many institutions appear to be unclear on this matter and remain provisional in their planning for full implementation of IFRS 9. In this paper, we present some implementation options that, for corporate and commercial portfolios of instruments evaluated individually, seem compatible with the IASB's limited guidance to date. As a leading candidate for a decision measure, we introduce the levelized forward probability of default (LFPD). The LFPD translates a PD term structure into a spread equivalent. If this spread measure increases, one can conclude that the (real not risk-neutral) PD component of the instrument's par spread has increased, and so, on the basis of default risk information alone, one would have evidence that the initial contract pricing was insufficient to cover prospective credit risk.

We present this default risk measure along with a couple of others; these similarly reduce an instrument's PD term structure at original recognition and at a later reporting date to summary numbers, which one can rank and use in determining whether significant deterioration has occurred. Not all institutions will be able to calculate such PD-spread measures, at least initially, so we also review some alternative decision rules. We compare various options and suggest the use of a hierarchical structure based on an institution's data availability, with the use of PD-spread measures at the top of the hierarchy. We describe ways to simplify the assessment of point-in-time (PIT) PD term structures. We explore ways of designing a threshold for stage 2 allocation and suggest combining a percentage-change threshold for significant deterioration together with an absolute threshold (on annualized default risk) for low credit risk. Last, we provide some perspective on implementation requirements for this standard.