New rules shake banking industry

By Phillimon Mhlanga

The local banking industry will next year be required to adopt a new version of the International Financial Reporting Standard 9 (IFRS 9) issued by the International Accounting Standards Board (IASB).

This requires all financial institutions to estimate future credit losses, a move which is likely to significantly impact on banks and other financial institutions.

The changes to financial instruments accounting for banks will come into effect in January next year, although sector players can choose to apply the new standards earlier. Other countries around the world have already embraced the transformation.

The new rules under IFRS 9 replace the International Accounting Standard 39 (IAS 39), currently the primary accounting standard that deals with impairment of financial instruments.

The Reserve Bank of Zimbabwe (RBZ) also prescribed how banks should account for non-performing loans and advances using the Basil 2 requirements and also the banking regulations such as Statutory Instrument 205 of 2000.

What it means is that the new rules will supersede all previous versions of IFRS 9.

It will require banks to estimate the credit loss allowances, a situation which may be challenging and will involve a high degree of judgment.

Analysts said IFRS 9 model uses a dual measurement approach that requires recognition of either a 12 months expected credit loss for assets that are likely not to suffer a significant increase in credit risk or provide for allowance for lifetime expected losses if there is a significant increase in credit risk.

As a result, reported credit losses are expected to increase and become more volatile under the new credit loss model.

According to paragraph 59 of IAS 39, banks have been determining loan loss provisions through useful factors that are considered when testing for impairment performance of a financial instrument such as significant financial difficulty, breach of contract, decline in future expected cash flows by the borrower, among other things.

But now, banks will be required to make expected credit losses.

This effectively means that financial institutions will move away from the traditional incurred loss model to an expected credit loss (ECL) which, by any means, requires more judgment in considering information related not only to the past and present but also to the future economic conditions.

This measure of loan loss allowance will again demand use of data and information not previously used under IAS 39.

The challenge, however, will be around the accurateness and reliability of such data given that some will not have been used for accounting purposes but for credit risk management or regulatory reporting.

There are, therefore, growing concerns that the rules on credit exposure could result in the amount of loan loss provisions significantly increasing.

The changes will affect how impairments are recognised and measured, and these changes may impact business decisions.

Financial experts last week told the Financial Gazette’s Companies & Markets that the change will materially impact on banks, with impairment calculations affected most.

Samuel Matsekete, Barclays Bank of Zimbabwe’s chief finance officer, said there would be an increase in provisions for impairment in the banking sector.

Matsekete, who is a member of the Institute of Chartered Accountants of Zimbabwe (ICAZ), said: “What it means is that we will be doing more predictions than history. Basically, we will be predicting the quality of loan books (taking into account) a loan that has already been incurred or a provision that you need to make for losses that would have occurred but you had not identified them.

“Now, the implication is that we are obviously now needing to be more conservative, modern driven, vigilant. We are required to do predictions as opposed to accounting for history or using historical events directly. We do make projections based on some history but we are looking forward.

“There is an element which is a bit more technical which says if your book is clean, and you are supposed to provide for certain losses for the next 12 months on that book, provide for it now. But if you doubt your book, you now need to provide expected losses over a life time of that facility. So, if it’s a five-year loan and you have had that loan facility deteriorating, you now need to look at how much you can provide now.

“So, we generally expect that there will be an increase in provision levels. What we need to do is to be prudent and do what we should do as proper banks.

“Provisions would be higher if the loans are not secured. But, we believe that we should be able to respond to that and cope as an industry by ensuring that we don’t compromise on our lending practices. That’s some of the dynamics we should employ as an industry ahead of the effective date.”

The new rules come at a time when the local banking industry is faced with challenging economic conditions, a situation which has resulted in borrowers’ repayment capacity getting more constrained.

The economic hardships have negatively impacted business, leading to an unprecedented number of companies collapsing, with some being placed under judicial management or receivership.

These challenges have resulted in significant credit risk in the financial services sector, with high non performing loans (NPLs) having been reported. This has resulted in poorly performing loan books in the banking sector.

Due to the significance of credit risk and high amounts of NPLs housed by the banks, banks had to rely on IAS 39 to account for NPLs and the old IFRS 9.

Elles Mukunyudze, a director at Chartered Accountants Academy who is also a technical advisor at ICAZ, concurred with Matsekete.

He said: “IFRS 9 will have serious effects particularly for banks and other financial services entities. The major change that IFRS 9 brings is that it will require banks to account for impairments on loans and advances on an expected loss model instead of the traditional incurred loss model.

“What this means is that when a bank gives a loan, it will need to assess and impair the loan based on the expected loss and not when they have evidence that the counterparty is impaired.

“This treatment will likely increase the impairment that banks have in their books. Some financial service entities in the United Kingdom who tested this model based on their 2015 numbers have indicated that their impairments have increased by over 200 percent.”

Mukunyudze added: “Other changes in the standard are that it replaces the classification categories of financial assets that were in IAS 39 with new categories under IFRS 9.

“IAS 39 had four major classes of financial assets, namely loans and receivables, available for sale assets, fair value through profit and loss and held to maturity investments.

“These have been replaced with a new classification category under IFRS 9. IFRS 9 mainly bases classification criteria on the subsequent measurement method of an asset.”

As a result of the changes, credit loss provisions are expected to exceed those being calculated under Basel and RBZ prescribed rules largely due to the requirement to provide for lifetime expected losses.

This could have a more significant effect on the banks’ ability to grow their loan books.

This also impacts on profit or loss and also has the impact of reduced net assets.

The fact that financial assets classification becomes more judgmental may affect how capital resources and requirements are calculated.

The new model relies on banks being able to make robust estimates to ECL. To trigger earlier recognition of impairment losses, banks will have to establish new and appropriate systems and processes needed to meet the ECL model’s extensive new data and calculation requirements.

This is particularly problematic as banks are increasingly concerned about costs to implement the new changes.

The proposals may, resultantly, potentially increase the credit loss allowance or provision recorded by many financial institutions.

The extent of the increase, however, will very much depend on the nature of the credit exposures and current IAS 39 practices.

Due to these changes, banks will now be required to change the way they do business by managing the quality of loans and provisions at origination.

They now face modelling, data, reporting and infrastructure challenges.

But, if these challenges are addressed, they will enable bank boards and senior management to make better-informed decisions, pro-actively manage provisions and capital plans.

These will also enhance their forward-looking strategic decisions for risk mitigation in the event of actual stressed conditions, and help in understanding the evolving nature of risk in the banking business.

Everything being equal, enhanced and consistent capital planning and impairment analysis should lead to a more sound, lower-risk banking system with more efficient banks and better allocation of capital.Financial Gazette