1. Arslan Khalid December 2016
IFRS 9 - NEW ACCOUNTING MODEL FOR FINANCIAL INSTRUMENTS (To Replace IAS-39)
Arslan Khalid
December 2016

2. Agenda Reasons for replacement of IAS-39
IFRS-9 – Classification and Measurement of financial instruments
IFRS 9 Impairment Model for Financial Assets
Basel III- Regulatory treatment of accounting provisions
IFRS 9 Governance and Implementation - Challenges and Guidance

3. Reasons for replacement of IAS-39- Cont…
The criticism on IAS-39, in brief :
Fair value accounting was said to have created cycles of accounting write downs and distressed selling of assets during the Crisis
The application of IAS-39 impairment model for loan loss provisions results in delayed recognition of credit losses
The over complexity of IAS-39 such as mixed valuation models, multiple impairment approaches, complicated category transfer rules and hedge accounting requirements.

4. Reasons for replacement of IAS-39- Cont…
In view of above criticism, IASB received calls to reduce the complexity of accounting standards for financial instruments from G-20, the Financial Stability Board, the European Union and regulators and other stakeholders from around the world.
The work on IFRS 9 started in 2009 and after 5 years of extensive technical work and stakeholders consultations, the final standard was issued in July 2014.

5. Scope of IFRS 9 Classification and measurement of financial instrument
Impairment of credit exposures (expected credit losses)
Hedge accounting
IFRS 9 is effective for annual periods beginning on or after 1 January 2018, with early application permitted
Formating to done

6. IFRS-9 – Classification and Measurement of financial instruments

7. IFRS-9 Conceptual Foundation
In developing IFRS-9, the IASB was faced with a challenge to reduce complexity of IAS-39 and at the same time maintain a technically sound basis for the standard
Many believe that the primary source of complexity in IAS-39 is the diverse methods used to measure financial instruments and perhaps the solution may be to move towards full Fair Value approach
The IASB noted that there is still widespread support for the mixed attribute measurement approach (Fair value and Amortized cost). Therefore, IFRS-9 is build on a Mixed Measurement Model.

8. IFRS-9 Conceptual Foundation- Cont…
The standard draws distinction between:
Those instruments that have highly variable cashflows (Equity investments and derivatives) ; and
Those instruments that have cashflows which are either fixed or vary only with market interest rates (loan ,bonds ,simple debt instruments)
For the first category ,IASB believe that Fair value is the most appropriate measurement basis.
For the second category, the IASB accepts that a cost-based approach would be feasible especially when they are held to collect contractual cashflows rather then for selling.

9. IFRS-9 Classification and Measurement - Equity Instruments
Equity Investments
Trading Investments
Non-Trading
Investments
Irrevocable
Option
Fair Value through
profit and loss
Fair Value through
OCI

10. IFRS-9 Classification and Measurement - Equity Instruments (Cont…)
Held for Trading investments continue to be measured at fair value through profit and loss as presently under IAS-39 and SBP Regulations
Non-Trading investment that are presently classified an AFS under IAS-39 and SBP Regulations are subject to option i.e. Fair Value through profit and loss (FVTPL) or Fair Value through Other Comprehensive Income (FVTOCI)

11. IFRS-9 Classification and Measurement - Equity Instruments (Cont…)
In case of non-trading investments classified under FVTOCI category, all fair value changes in there investments will be recognized as Other Comprehensive income/expense without any transfer of gains and losses to P& L account on:
Disposal ;or
Impairment
Therefore, impairment of AFS equity investment will no longer be an issue.

12. IFRS-9 Classification and Measurement – Un-quoted Equity Instruments
No cost exemption for unquoted equity instruments  all equities at fair value
Cost may be used as a proxy for fair value in certain circumstances
Indicators of when cost might not represent fair value
A significant change in the performance of the investee
Changes in expectation that technical milestones will be achieved
A significant change in the market for the investee company or its products
A significant change in the global economy or the economic environment
A significant change in the observable performance of comparable companies, or in the valuations implied by the overall market.
Internal matters such as fraud, commercial disputes, or litigation, or changes in management or strategy.
Evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties.
To be confirmed with IFRS

13. IFRS-9 Classification and Measurement – Debt Instruments
Under IAS-39, debt instrument may be classified in the following 4 categories:
Fair Value Through Profit and Loss
Held For Trading
Designated as FVTPL (not allowed under SBP Regulation)
Held to Maturity
Available for Sale

14. DEBT INSTRUMENTS
Cash flows are solely payment of Principal and Interest
(time value of money plus credit risk plus admin cost)
Arrangement that are not basic lending arrangements
(such as exposures linked to commodity, equity prices)

15. IFRS-9 Classification and Measurement – Debt Instruments (Cont…)
Cash flows are solely payment of Principal and Interest
Business model at portfolio level
Held to collect contractual cash flows
BM to collect cash flows and selling financial assets
BM is trading of financial assets
Amortized Cost
Fair Value through OCI (with recycling)
Fair value through P&L
Fair value through P&L option available on initial recognition

16. IFRS-9 Classification and Measurement – Debt Instruments (Cont…)
Arrangement that are not basic lending arrangements
(such as exposures linked to commodity, equity prices)
Examples
Bonds convertible into equity
Deferred interest without additional compensation (such as cumulative preference shares)
Derivative contracts and instrument with embedded derivatives
Fair value through P&L

17. IFRS-9 Classification and Measurement – Debt Instruments (Cont…)
Business Model Test
In some cases, an entity may have more than one business model, in which case, the assessment would be made at a portfolio level rather than an entity level.
Is a matter of fact and not management intention.
Not an instrument-by-instrument approach like IAS-39.
Reclassifications of portfolio is not allowed unless there is a change in business model

18. Impact of IFRS-9 on the measurement of Debt Instruments accounted for under SBP Regulations
Considering the stringent (Nature of Asset Test) of IFRS-9, non-basic instruments will not qualify for ‘Amortized cost’ measurement.
Held-for-trading, Available-for-sale and Held-to-maturity debt securities are expected to be accounted for the same way as currently being treated under SBP Regulations.
Instrument will be classified on the basis of business model rather than management intent
Reclassifications will be infrequent
Fair value through P&L option will be available for all investments on initial recognition

19. Impairment of Financial Assets
Under IFRS 9

20. Background
In response to the reporting issues highlighted by the Global Financial Crisis, a Financial Crisis Advisory Group (FCAG) was setup in October 2008
The objective of FCAG was to advice IASB and US FASB to bring improvements in the financial reporting standards that could enhance investor confidence in the financial markets
The FCAG, in its report published in July 2009, identified delayed recognition of loan losses as one of the primary weaknesses in the accounting standards and recommended to explore alternatives model which is more forward looking

21. Incurred Loan Model under IAS-39
Interest income is recognized over the period of the loan on the basis of contractual cashflows (Effective interest method)
Impairment is recognized only when there is a objective evidence of impairment i.e. when a loss event has occurred
It may argued that interest income is overstated in periods before a loss event occurs because it is inherent in the nature of assets that certain credit losses will occur

22. Expected Loss Model of IFRS 9
The impairment requirements applies to debt instruments such as loans, debt securities, bank deposits, lease receivables, loan commitments and financial guarantee contracts.
Under the expected loss model impairment is recognized over the life of assets on the basis of future expected loss events
In other words, impairment allowance is made even before there any objective evidence of impairment or occurrence of default event
The scope of impairment requirements, therefore is much broader and are designed to result in earlier recognition of credit losses
This model will potentially address the concerns about IAS 39 incurred loss model i.e. too little and too late

23. Overview of Expected Loss Model of IFRS 9
3 stage model which recognizes impairment over time based on changes in credit quality since origination of loans
Stage 1
Stage 2
Stage 3
Performing
Under-performing
Non-performing
Loans with low credit risk and with no significant increase in credit risk since origination
Loans for which credit risk has increased significantly since initial recognition
Loans with objective evidence of impairment
Font should be black

24. Impairment Approach – Stage 1 Loans
Performing
Under-performing
Non-performing
Stage 1 loans represent high quality loans without any indication for increase in credit risk since origination
IFRS 9 requires that portion of the credit losses expected within next 12 months of the reporting date should be recognized on stage 1 credit exposures
12 months ECL are defined as portion of total lifetime expected credit losses that will result if defaults occurs in next 12 months
12 ECL = Lifetime Expected Credit Losses X Probability of
Default within 12 Months

25. Impairment Approach - Stage 1 Loans
Performing
Under-performing
Non-performing
Interest income of Stage 1 Portfolio is recognized on ‘Gross Loan Amount’ using effective interest rate method
For banks which are expending their credit portfolios, the Stage 1 loans provisioning may adversely impact the profitability

26. Impairment Approach - Stage 2 Loans
Performing
Under-performing
Non-performing
Stage 2 loans represent credit exposures with significant increase in credit risk since the origination of loans
It is critical therefore to determine the point at which credit risk of certain loans or a portfolio of loans has increased significantly
While various banks have systems to continuously assess credit risk, IFRS 9 provide guidance about the mix of quantitative and qualitative factors that an entity should consider in order to determine whether credit risk has changed significantly

27. Impairment Approach - Stage 2 Loans (Cont…)
Information to take into account for assessment of increased credit risk
Internal watch-list accounts
Changes in external market indicators – price of borrower debt or equity
Adverse changes in business or economic conditions
Changes in the value of collaterals and repayment behaviour
Changes in internal price indicators and credit ratings downgrade
30 days past due rebuttable presumption
Changes in external credit ratings
Changes in operating results
However….

28. Impairment Approach - Stage 2 Loans (Cont…)
Performing
Under-performing
Non-performing
For Stage 2 loans, IFRS 9 requires an entity to recognize full lifetime expected credit losses based on the present value of the cash shortfalls expected over the life of the asset
Banks therefore, would need to estimate the risk of default occurring on loan portfolios over life of loans and the cash shortfalls or credit losses resulting from such default events
IFRS 9 does not prescribe any specific method to estimate expected credit losses, however, the approach used should comply with certain principles

29. Impairment Approach - Stage 2 Loans (Cont…)
Performing
Under-performing
Non-performing
An entity’s estimate of expected credit losses must reflect:
the best available information – historical and forward looking
an unbiased and probability-weighted estimate of cash flows associated with a range of possible outcomes (including at least the possibility that a credit loss occurs and the possibility that no credit loss occurs).
the time value of money
Various approaches can be used
Formating to be done

30. Impairment Approach - Stage 2 Loans (Cont…)
Performing
Under-performing
Non-performing
In practice, estimate of ECL will involve using of simple to advanced models depending on the complexity of the portfolio
Base case using historical information
Adjustment for microeconomic and portfolio level forward looking information
Impact on possible defaults
Expected Credit Loss

31. Impairment Approach - Stage 2 Loans (Cont…)
Performing
Under-performing
Non-performing
For the purposes of estimating ECL, credit exposure may be grouped based on shared credit risk characteristics such as industry, collateral type, nature of facility, credit risk ratings etc. This collective assessment is particularly relevant for retail portfolios
Interest income of Stage 2 Portfolio is recognized on ‘Gross Loan Amount’ using effective interest rate method

32. Impairment Approach - Stage 3 Loans
Performing
Under-performing
Non-performing
Represents impaired loans for which the default event has already occurred
IFRS 9 requires lifetime ECL to be recognized for such portfolios like stage 2 loans
The credit provision in Stage 3 will therefore, represents the incremental provision after Stage 2 based on changes in ECL estimates
Interest income should be recognized by reference to the net carrying value (after provisions) of impaired portfolio

33. Impairment Approach - Summary
The credit risk has increased significantly since initial recognition
improvement deterioration
Stage 1
Stage 2
Stage 3
Performing
Under-performing
Non-performing
12 month expected
credit losses
(Expected credit losses that result from default events that are possible within 12 months)
Lifetime expected
credit losses
(Lifetime expected credit losses that result from possible default events over
the life of the financial instrument)
Lifetime expected
credit losses
(100% PD)
(Defaulted loans that result from possible default events over the life of
the financial instrument)
Portfolio impairments
Portfolio impairments
Specific impairments
Effective interest on gross carrying amount
Effective interest on gross carrying amount
Effective interest on
net carrying amount
(i.e. net of credit allowance)

34. Comparison with the SBP Prudential Regulations
Category
IFRS 9
SBP Regulations
Performing
12 months ECL
Interest income to recognize
No credit provision
Interest income to recognize
Under
Performing
Provision and interest suspension based on subjective evaluation in certain cases
Lifetime ECL
Interest income to recognize
Non-
Performing
Lifetime ECL
Interest income to recognize on net basis
Time based provisions
Interest income suspension

35. Implementation Challenges
Components
Implementation challenges
Portfolio segmentation
Determine segmentation criteria
Consider existing models and data availability for various portfolios
Criteria for low credit risk
Transfer criteria
Definition of trigger events
Significant deterioration in credit
Expected loss modeling
Determination of models for 12 month and lifetime expected loss
Discount rate
Sources of information
Internal data (internal credit ratings, historical loss experiences)
External data – Macro economic statistics and credit ratings
Update of internal data used for credit risk management regularly

36. Expected Loss Model Implementation Guidance
IASB has set up an IFRS transition resource group with a aim to support stakeholders on implementation issues
The Basel Committee on Banking Supervision issued guidance which sets out supervisory expectations from banks related to implementation of IFRS 9 impairment model
European Banking Authority has also issued draft guidelines on credit risk management and accounting for Expected Credit Losses
Central banks in many other countries are expected to issue regulatory guidelines to provide a sound governance framework for implementation of IFRS 9 impairment model

37. Governance Considerations
A bank’s public reporting should promote transparency and comparability by providing timely, relevant and decision- useful information
Adopt, document and adhere to sound methodologies that address policies, procedures and controls for assessing and measuring the level of credit risk on all lending exposures.
Establish process to appropriately group lending exposures on the basis of shared credit risk characteristics.
Adequacy of aggregate amount of allowances consistent with the objectives of the relevant accounting requirements
Policies and procedures and controls in place to appropriately validate its internal ECL models
Formating to be done

38. Basel III – Regulatory Treatment of Accounting Provisions
The IRB regulatory EL estimates use a 12 month ECL. IFRS 9 uses a 12 month ECL in Stage 1 and a lifetime ECL in Stages 2 and 3
The Basel loss estimates are based on loss severity experienced during economic downturn conditions while accounting models represent a neutral estimate based on expected economic conditions
Given the above differences, it is possible that accounting ECL could be higher or lower than regulatory EL
Formating to be done

39. Basel III – Regulatory Treatment of Accounting Provisions (Cont…)
The Basel Committee is supportive of the ECL provisioning approach and has considered implications on regulatory capital
The Basel Committee intends to harmonize regulatory treatment of accounting provisions for capital adequacy purposes, which may result in Standardized EL component under the Standard Credit Risk Approach
The Basel Committee has recently released a consultative document on the policy considerations related to the regulatory treatment of accounting provisions under the Basel III capital framework
Formating to be done

40. Global Banks – State of Readiness for IFRS 9
EY conducted IFRS 9 Banking Survey to identify emerging trends in the implementation of new Standard
Participants included 36 top tier financial institutions worldwide including 14 global systematically important banks
Findings
Banks have made significant developments with a focus on identifying data and system requirements
Most banks expect to start parallel run in quarter one of 2017
Banks expects to disclose first quantitative impact assessments to the markets during 2017

41. Business Impact Aim to reduce volatility in profits, however, may
Reduce profitability for expanding loan booked in earlier year.
Result in larger losses in periods with significant changes in future credit loss expectations (may be more pro- cyclical)
Significant system changes required due to:
Complexity in computing effective credit losses on a continuous basis
Extensive disclosures require data and analysis and hence a need to gather such data through the accounting system

42. THANK YOU