How does the Discounted Cash Flow (DCF) method apply to the calculation of ECL under IFRS 9, especially for instruments with a long maturity profile?
Under IFRS 9, expected credit losses (ECL) are measured as the present value of the difference between the cash flows the lender is contractually entitled to receive and the cash flows that are expected to be received in the event of default. The discounted cash flow (DCF) approach is central to this measurement, as it adjusts for both the timing and the risk of future losses. This becomes especially critical for instruments with long maturities, where uncertainty about future cash flows and credit risk is higher.
Conceptual Overview
a. Expected Credit Loss under IFRS 9
• ECL Framework: IFRS 9 requires entities to recognize ECL on financial instruments. For instruments where credit risk has significantly increased, a lifetime ECL (i.e., losses expected over the remaining life of the asset) must be recognized.
• Components: The key components are:
• Probability of Default (PD): The likelihood that a borrower will default in a given period.
• Loss Given Default (LGD): The percentage of the exposure that is lost if a default occurs.
• Exposure at Default (EAD): The outstanding amount when the default happens.
b. Role of the DCF Method
• Time Value of Money: The DCF method discounts future expected losses to their present value using an appropriate discount rate (often the asset’s effective interest rate). This reflects the fact that a loss incurred in the future is worth less today.
• Long Maturity Challenges: For instruments with long maturities, cash flows forecasted far into the future carry more uncertainty. Discounting ensures that losses occurring later have less impact on today’s ECL, while still capturing the overall risk.
Calculation Steps
a. Step 1: Forecast Future Cash Flows
Determine the contractual cash flows over the life of the instrument (interest, principal repayments, etc.). For example, a loan might have level interest payments with a bullet repayment of principal at maturity.
b. Step 2: Estimate PD, LGD, and EAD
For each future period:
• PD: Estimate the probability that the borrower defaults in that period.
• LGD: Estimate the proportion of the exposure that will be lost if default occurs.
• EAD: Determine the outstanding balance (this may be constant or declining, depending on the repayment structure).
c. Step 3: Calculate the Expected Loss for Each Period
Expected Loss = PD(Probability of default * LGD (Loss Given Default) *EAD (Exposure at Default)
d. Step 4: Discount Each Period’s Expected Loss
Implications for Long Maturity Instruments
• Higher Uncertainty: Forecasting over long periods increases uncertainty around future PDs, LGDs, and EADs. Therefore, the assumptions need to be robust and frequently updated.
• Discounting Effect: Because losses far in the future are heavily discounted, the impact of potential long-term losses on today’s ECL is moderated. However, even small changes in the discount rate can have a significant effect on the calculated ECL.
• Model Complexity: For long maturity instruments, the estimation model must carefully consider macroeconomic forecasts and trends, as these will influence the long-term PD and LGD estimates.
• Risk Sensitivity: The DCF approach ensures that the timing of cash flow shortfalls is reflected accurately, providing a more risk-sensitive measure of credit losses compared to a simple aggregation without discounting.
Conclusion
The DCF method under IFRS 9 involves forecasting period-by-period expected losses—by incorporating PD, LGD, and EAD—and then discounting these expected losses to present value. For instruments with a long maturity profile, discounting plays a vital role in ensuring that distant, uncertain losses are appropriately weighted, thereby providing a realistic and timely measure of credit risk. This comprehensive, DCF-based approach is essential for capturing both the timing and the magnitude of expected credit losses in a dynamic economic environment.
In the context of IFRS 9 transition, how should a financial institution address the reclassification of assets when moving from the incurred loss model (IAS 39) to the expected credit loss model (IFRS 9)?
When transitioning from IAS 39 to IFRS 9, financial institutions must reclassify their financial assets in line with the new, principle-based requirements. Under IAS 39, asset classification—and especially impairment—was based on an incurred loss model. IFRS 9 replaces that with an expected credit loss (ECL) approach and also introduces a new framework for asset classification that hinges on both the business model for managing the assets and the contractual cash flow characteristics.
Below are the key steps and considerations for addressing reclassification during the IFRS 9 transition:
1. Assessing the Business Model
a. Review Management Objectives: Institutions must evaluate how they manage and monitor their financial assets. The business model determines whether assets are held to collect contractual cash flows, held for sale, or managed with a dual objective (both collecting cash flows and selling).
b. Implication for Classification:
i. Assets held solely to collect contractual cash flows and that meet the contractual cash flow test (i.e., cash flows are solely payments of principal and interest) will typically be measured at amortized cost.
ii. Assets held in a mixed business model (for both collecting cash flows and selling) are measured at fair value through other comprehensive income (FVOCI).
iii. Assets that do not meet these criteria are classified as fair value through profit or loss (FVPL).
2.Testing Contractual Cash Flow Characteristics
a. SPPI Test: Under IFRS 9, each financial asset must pass the Solely Payments of Principal and Interest (SPPI) test. This ensures that the contractual cash flows reflect only basic lending risks and time value of money.
b. Reclassification Outcome: If an asset fails the SPPI test or is held in a business model where selling is a key objective, it will be classified differently compared to IAS 39, potentially moving from amortized cost or available-for-sale (AFS) categories to FVPL.
3. Transition Adjustments
a. Retrospective Application: IFRS 9 generally requires retrospective application, meaning that financial assets must be reclassified as if the new standard had always been in place. However, transitional reliefs (such as the modified retrospective approach) may be available.
b. Opening Balances: The cumulative effect of transitioning to IFRS 9—including any reclassification—typically impacts the opening retained earnings or other relevant components of equity. Institutions must adjust historical balances to reflect the new classification and impairment requirements.
c. Expected Credit Loss Measurement: For assets that continue to be recognized under amortized cost or FVOCI, a one-time adjustment for lifetime expected credit losses is made at transition. This is a departure from the incurred loss model used under IAS 39.
4. Practical Implementation Considerations
a. Data and Systems: Institutions need to ensure that systems and processes are updated to capture the required data for assessing both the business model and the SPPI test. This might involve significant changes to risk rating, credit loss forecasting, and reporting systems.
b. Documentation and Controls: Detailed documentation of the rationale for reclassification is critical. This includes justifying why assets are now deemed to be managed under a particular business model and how the contractual cash flow characteristics have been assessed.
c. Communication and Training: Staff, particularly in risk management and finance, must be trained on the new requirements. Clear communication regarding the impact of reclassification on reported earnings and regulatory capital is also essential.
d. Regulatory and Audit Considerations: Given the material impact reclassification can have, financial institutions should work closely with auditors and regulators to ensure that the transition is transparent and consistent with IFRS 9 requirements.
5. Continuous Monitoring
a. Reassessment of Business Model: Post-transition, it is important to periodically reassess the business model. If the strategy for managing financial assets changes over time, further reclassifications might be necessary.
b. Updating Impairment Models: Alongside reclassification, the ECL models must be calibrated to reflect new expectations about credit losses. This is especially crucial for long-dated assets where forecasting uncertainty is higher.
In summary, the transition from IAS 39 to IFRS 9 requires a comprehensive review of asset classification based on the business model and the contractual cash flow characteristics. Financial institutions must:
a. Evaluate their business model and apply the SPPI test,
b. Reclassify assets into the appropriate measurement categories (amortized cost, FVOCI, or FVPL),
c. Make necessary adjustments to opening balances and recognize lifetime ECLs for assets held at amortized cost or FVOCI,
d. Update systems, processes, and documentation to support the new requirements, and
e. Ensure continuous monitoring and periodic reassessment to reflect any changes in the business strategy or market conditions.
This reclassification is a fundamental part of the IFRS 9 transition and not only changes how assets are measured on the balance sheet but also impacts the recognition of credit losses and the overall risk management framework.