ESRB Report Examines Cyclical Behavior of ECL Model in IFRS 9

Given the limited experience with IFRS 9 to date, this report focuses on describing the aspects of the ECL model under IFRS 9 that could potentially contribute to procyclical bank behavior, along with the conditions under which such behavior would be more likely to arise. The report is focused on the impact at the onset of a downturn because it is a crucial time for the exacerbation of the depth and duration of a financial crisis. The report concludes that a substantial degree of uncertainty exists about the cyclical behavior of the ECL model in IFRS 9 and its impact on bank behavior. Stress tests and targeted and harmonized disclosures are effective tools to improve the understanding of this cyclical behavior. So far, experience of IFRS 9 is limited but points to the following three factors that are important in shaping the cyclical behavior of ECL approach in IFRS 9 and, therefore, may warrant closer monitoring and review going forward:

• The principles-based nature of IFRS 9, with particular reference to the conditions and criteria that trigger the transfer of exposures from stage 1 (12 month expectation) to stage 2 (lifetime expectation) and further into stage 3, which, in turn, could facilitate a delay in loss recognition.
• The ability of, and incentives for, banks to promptly incorporate into their ECL models all new information available on the expected trend of the economic cycle and to recognize losses in a timely manner under IFRS 9 (if recognition of credit losses is delayed because of inadequate modeling or improper incentives).
• The use of point-in-time (PIT) estimates for expected credit losses should generate more volatile outcomes than through-the-cycle estimates, although that volatility should not be judged as negative per se and becomes less relevant if a bank has anticipated the downturn.

The report also concludes that the policy analysis should focus on how the requirements of IFRS 9 are being applied and whether banks have appropriate incentives to recognize credit losses in a timely manner. As IFRS 9 has only been applied since January 01 2018 and in a period of benign macroeconomic conditions, it is still too early to say whether IFRS 9 poses a real risk to financial stability and, therefore, requires prompt regulatory intervention. However, early evidence points to issues that regulators and supervisors may want to monitor closely going forward. These issues, which relate to the quality of foresight in banks’ ECL models, concern lack of information (for example, due to insufficient data or inherent behavioral biases to overweight more recent conditions or not consider tail events) and perverse incentives (that is, management incentives to avoid excessive volatility or adverse market perceptions rather than to build sufficient foresight into ECL estimates). The development of best practices or enhanced guidelines could make a positive contribution to ensuring that the financial stability benefits of IFRS 9 are reaped.

Related Link: Report (PDF)

Keywords: Europe, EU, Accounting, Banking, Procyclicality, ECL, IFRS 9, Credit Risk, Financial Stability, ESRB