EU Banks under IFRS were required to apply IFRS 9 as of the starting date of the bank’s first financial year, beginning on or after January 1, 2018. A key concern was that the application of IFRS 9 could lead to a sudden increase in expected credit loss (ECL) provisions, provoking an abrupt significant decrease in Common Equity Tier 1 (CET1) capital and ratios for many EU banks. The main impact seems to be driven by the estimation of lifetime ECL for stage 2 exposures. Smaller banks estimated a larger impact on own funds ratios than larger banks .
Author: Samuel Da-Rocha-Lopes | Reading time: 9 minutos
Banks should not underestimate the challenges of implementing IFRS 9. Future transversal review of the implementation of the ECL across banks (benchmarking exercises) may help to ensure the quality of IFRS 9 implementation and the regular monitoring of the key elements of the ECL models. Furthermore, the possible impact on lending behavior needs to be assessed.
Benefits and Challenges Ahead
The benefits of the new accounting regime are several. The incentives to improve the credit appraisal processes, the monitoring of under-performing exposures and credit impairments, as well as the capital and business planning were improved. Transparency and the enhancement of market disclosures to the stakeholders were also promoted. A key aspect to embrace the benefits of the new accounting regime is the high-quality implementation of the process.
The variation in provisions across banks will be influenced not only by underlying risks but also by modelling assumptions. Banking supervisors and market participants need to be able to disentangle both. The main concern is to ensure a proper interaction of the capital framework with the expected credit loss model in accounting.
Transitional Arrangements of Five Years
In May 2017, the EU adopted a five-year transitional period for mitigating the impact on own funds of the implementation of IFRS 9. These created the conditions for a phase-in of the impact of IFRS 9 impairment requirements on capital and leverage ratios. The portion of ECL provisions included in CET1 capital decreases over time with full implementation due by the end of 2022.
Table: Evolution of “excess” provisioning included in CET1 capital between 2018 and 2022
Source: EU (European Parliament and Council)
For the banks that decide to apply IFRS 9 transitional arrangements, the disclosure of such effects on own funds, risk-based-capital, and leverage ratios is required. The improvement of the information available to market participants will ensure consistency and comparability, further fostering market discipline.
In 2017, the average estimated impact of IFRS 9 on CET1 ratio for the EU was a 45 basis points (bps) decrease, without taking into consideration any possible transitional arrangements . In 2018, the actual negative day-one impact on CET1 (51 bps on simple average) and increase in provisions (9% on simple average) broadly confirm the previous estimations. In relation to the use of transitional arrangements mitigating the impact of IFRS9 on CET1 capital, the average CET1 impact resulting from the add-back of provisions for all the banks in the sample applying these transitional arrangements corresponds to 118 bps .
Figure: Impact on CET1 ratio without application of transitional arrangements (reference date: 1 January 2018)
Source: EBA - European Banking Authority
The total estimated impact of IFRS 9 on banks’ own funds is driven mainly by the impairment requirements, namely the estimation of lifetime ECL for stage 2 exposures (i.e., exposures that have experienced a significant increase in credit risk but are not defaulted). The main instruments and portfolios for the impacts are loans and advances to households and nonfinancial corporations. The impacts are different between G-SIBs and smaller banks (for example, with total financial assets below €100 billion and which tend to use the SA for measuring credit risk). Smaller banks estimated a larger impact on own funds ratios than larger banks (with higher use of the internal ratings-based IRB approach).
Regarding the change in classification and measurement requirements, the impact would be limited for most banks. However, the operationalization of the classification and measurement requirements means resources are needed. In this context, banks should not underestimate the challenges of implementing those classification and measurement requirements. Moreover, several banks anticipated that IFRS 9 impairment requirements would increase volatility in profit or loss. This is mainly due to the expected “cliff effect,” from moving exposures from stage 1 to stage 2 (i.e., from 12-month ECL to lifetime ECL) and the practical use of forward-looking information. In principle, this reduces the surprises and delays in the recognition of losses.
Robust Validation Process and Governance Framework for the ECL Measurement
In the implementation of the IFRS 9, banks are using, some of them for the first time, various processes, data, systems, and models in order to provide sound estimations of expected credit losses. Factors such as data quality, availability of historical data, and the assessment of “significant increase in credit risk” (as required under IFRS 9), are the most significant challenges for EU banks. Therefore, a robust validation process for ECL measurement is paramount and needs to be well defined and implemented in order to ensure a regular monitoring of the key elements of the ECL models.
A particular concern to banking supervisors is the expected reduced parallel runs of IFRS 9 and IAS 39 decided by banks during the implementation phase, and in some cases the absence of parallel runs. From a banking supervisory perspective, the parallel runs allow a better assessment and testing of banks’ IFRS 9 processes and approaches. Furthermore, the governance framework is key, especially after the financial crisis. Key stakeholders, such as the board of directors and the audit committees, need to be sufficiently involved in the IFRS 9 implementation.
Financial Stability Implications
There is a long debate on the use of fair value or historical cost for the measurement of financial assets and the suitability of these methods for different bank assets. In particular, it is expected that a sound and strict implementation will increase transparency and facilitate the earlier and more comprehensive recognition of impairment losses, which has been found to have positive effects on financial stability. There are two fundamental challenges for banks, micro- and macro-supervisors: the modelling risk and the possible procyclicality implications.
Firstly, the modelling risk for IFRS 9 resembles the discussions on the IRB implementation. As potential main areas for possible improvements in the medium term, a stronger oversight role on internal model validation has been necessary. For these reasons, the importance of the development of benchmarking exercises  conducted by banking supervisors (EBA, BIS, and national authorities) for internal models used for capital requirements and also the industry should be underlined. Benchmarking exercises mean that banking models are measured in comparison with a benchmark. For IRB models, the benchmarking exercises become compulsory at the European level and are useful for the assessment of internal models and reliability of RWA. These benchmarking exercises may also help to ensure the quality of IFRS 9 implementation and the regular monitoring of the key elements of the ECL models. A proper disclosure of such ECL benchmarks would also be useful, as is happening with the IRB approaches, from a market participant perspective.
Secondly, the possible procyclical implications of the ECL approach are an important aspect to consider. A more timely and forward-looking recognition of credit losses addresses the criticism of the “too little, too late” provisioning resulting from the incurred loss approach; therefore, by expediting loss recognition, IFRS 9 may improve financial stability by reducing the build-up of losses before a tardy recognition (lower level of reinforcement of the economic cycle). Assuming that the downturn or its implications can be identified sufficiently early on may, in fact, reduce the severity of procyclicality and the credit contraction in a downturn. It is now expected that the market participants get used to a new behavior based on earlier loss recognitions. If recognized in a timely manner, the cyclical sensitivity of the credit risk parameters used for the estimation of ECLs and from the shifts of exposures between stages will not reinforce the economic cycle, quite the opposite.
Conclusion and Areas of Further Work
The EU banking regulators are contributing to a sound implementation of the IFRS 9. At the same time, it is expected that banks continue improving elements of the implementation of IFRS 9 after its initial application in 2018. From an economic analysis perspective, it is important to have a better understanding of how the differences in the implementation of IFRS 9 may affect the measurement of expected credit losses. Therefore, comparisons and benchmarks will be a very useful and powerful supervisory tool.
Furthermore, the possible impact on lending behavior needs to be assessed and there are several aspects to take into account from an economic analysis perspective. There are several topics that will need further analysis:
How will IFRS 9 continue to influence banks’ capital ratios?
How will banks respond to IFRS 9 changes in capital requirements?
Will banks alter capital, lending, asset mix, and balance sheet size?
The combined impact of all these possible changes is difficult to determine in advance taking into account micro- and macro-prudential concerns. Consequently, these issues, among other topics, will need to be part of the post-implementation review of IFRS 9, for which academic researchers will contribute.
This article is based on the Chapter 6 "The Impact of IFRS 9 On Banks Across The EU And Implementation Challenges" by Professor Samuel Da-Rocha-Lopes, as part of the Book: Institutions and Accounting Practices after the Financial Crisis: International Perspective
 Any views expressed are only those of the author and should not be attributed to the European Banking Authority (EBA), Nova School of Business and Economics (Nova SBE) and Aarhus University.
 EBA Report on Results From the Second EBA Impact Assessment of IFRS 9, July 2017. The figures are based on banks’ estimations as of December 31, 2016.
 EBA Report on First Observations on the Impact and Implementation of IFRS 9 by EU Institutions. Banks’ preliminary observations mainly based on the Q2 2018.
 Paolo Bisio, Samuel Da-Rocha-Lopes, and Aurore Schilte. Europe’s New Supervisory Toolkit (2015: Risk Books).