ESRB published a report that examines the concerns about procyclicality from the expected credit loss (ECL) model in IFRS 9, including the possible sources of procyclicality and its relevance from a financial stability perspective. The report also incorporates the recent information on the implementation of IFRS 9 by EU banks.
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
Previous ArticleSAMA Publishes Financial Entities Ethical Red Teaming Framework
A Consultative Group on Risk Management (CGRM) at the Bank for International Settlements (BIS) published a report that examines incorporation of climate risks into the international reserve management framework.
The European Banking Authority (EBA) published the final guidelines on liquidity requirements exemption for investment firms, updated version of its 5.2 filing rules document for supervisory reporting, and Single Rulebook Question and Answer (Q&A) updates in July 2022.
The Australian Prudential Regulation Authority (APRA) is seeking comments, until October 21, 2022, on the introduction of CPS 230, which is the new cross-industry prudential standard on operational risk management.
The European Commission published a Delegated Regulation 2022/1301 on the information to be provided in accordance with the simple, transparent, and standardized (STS) notification requirements for on-balance-sheet synthetic securitizations.
The Australian Prudential Regulation Authority (APRA) is announced revisions to the capital framework for authorized deposit-taking institutions to implement the "unquestionably strong" capital ratios and the Basel III reforms.
The European Banking Authority (EBA) published a report that examines the use of certain exemptions included in the large exposures regime under the Capital Requirements Regulation (CRR).
The Bank of England (BoE), the Prudential Regulation Authority (PRA), and the Financial Conduct Authority (FCA) published a joint discussion paper that sets out potential measures to oversee and strengthen the resilience of services provided by critical third parties to the financial sector in UK.
The Bank of England (BoE) issued a communication to firms to provide an update on the progress of the joint data transformation program—which is being led by BoE, the Financial Conduct Authority (FCA), and the industry—for the financial sector in UK.
The European Banking Authority (EBA) published the draft methodology, templates, and template guidance for the European Union-wide stress test in 2023.
The European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) jointly published the final guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP) for investment firms.