In just over a year, International Accounting Standards 39 (IAS 39) will be replaced by International Financial Reporting Standards 9 (IFRS 9). This new accounting standard will directly influence the financial statements of banks and other financial institutions all over the world, and compliance is required by January 2018.

Following last decade’s financial crisis, the International Accounting Standards Board (IASB) concluded that some of the accounting practices used in the 2000s were overly optimistic and did not adequately account for future risks. IFRS 9 was introduced to correct some of the accounting wrongs that came to light after the recession to help build a stronger financial industry.

Achieving IFRS 9 compliance: a difficult but essential task

As financial institutions prepare to comply with IFRS 9, they’ll face a number of challenges. The implementation of this standard will affect almost every business area, including but not limited to the Risk, IT, Modelling, Finance, Treasury, and Commercial teams. Senior management will need to ensure that these teams work together effectively during and after IFRS 9 deployment, and that they are all appropriately developing the modelling, reporting, and other business capabilities required for full compliance. Institutions do not have an easy task ahead of them, but it is a necessary one.

Modelling challenges

The first, and most significant, challenge of IFRS 9 deployment relates to modelling. Models developed for Basel compliance provide several of the basic components needed for IFRS 9, including probability of default (PD), exposure at default (EAD), and loss given default (LGD) calculations. However, models built to achieve Basel compliance are not sufficient: IFRS 9 requires lifetime rather than 12-month views of expected loss; accurate point-in-time assessments rather than conservative through-the-cycle or downturn assessments; and consideration for a range of macro-economic forecasts and other forward-looking data.

Further, under IFRS 9 all accounts must be assigned to one of three “stages” based on current credit risk performance vs. original expectations to determine whether impairment will be based on a 12-month or lifetime expected credit loss assessment, andto calculate interest income accurately. IFRS 9 models will, therefore, be significantly more complex than impairment models have been in the past and thus require more development time and modelling expertise.

IFRS 9 stages

Operational hurdles

As well as needing to manage additional modelling complexity to be IFRS 9 compliant, organisations will require high-performance production engines to run such intensive models. This is because provisions will need to be calculated in just a few days to meet month-end reporting requirements (and potentially faster to support BCBS 239 stress/crisis principles).Institutions will need to assess the granularity and quality of their models against the requirements of the IFRS 9 standard. It will also be of the utmost importance to ensure accounts are assigned to stages in a logical and defendable manner that aligns with current risk management practices. Despite this additional complexity, IFRS 9 models will still need to produce accurate results quickly to maintain compliance.

For organisations to successfully deploy IFRS 9, and to be able to overcome the aforementioned challenges, they will need to ensure that they have strong governance in place as well as strict controls to manage changes to data, models, processes, and reports used to perform the calculations. All modelling and operational changes made will need to be clearly auditable. Strict user permissions will be key to ensuring that modifications are recorded in a transparent way and to allow financial institutions to remain compliant during and following implementation. Simply deploying IFRS 9 is not enough –every step of the process needs to be thoroughly and accurately tracked to meet auditor and regulator expectations.

Financial impact

While operational impacts will be most significantly felt during implementation, IFRS 9 will also significantly affect financial planning and ongoing strategies.

The most important change relates to the accounting of impairment. Financial planning is complicated due to the dynamic and comprehensive nature of IFRS 9 impairment calculations. Under IAS 39, accounts become impaired only when they experience incurred loss events such as missed payments. However, with IFRS 9 all accounts will attract an impairment provision based on expected losses, even if there is no evidence of impairment at the reporting date, taking future economic conditions into consideration. Institutions must now also hold provisions against credit exposure, not just drawn balances. Therefore, although IFRS 9 itself will not affect the timing of expected cash flows or write-offs, it will accelerate the recognition of expected losses across all portfolios. This change in timing will significantly impact financial planning and require a deep understanding of model sensitivities and portfolio dynamics under IFRS 9.

Business strategies will also need to be revisited and re-assessed. For example, one clearly affected area will be credit line management, both at origination and throughout accounts’ lives, as unused credit lineswill now attract impairment provision and will need to be managed carefully. Further, certain collections strategies (e.g. re-aging)will impact impairment less immediately and less significantly. Pricing, underwriting, and high risk account management will also be affected.Planning for these changes should start well before the “go-live” date.

IFRS 9: worth the hard work

IFRS 9 will impact the organisation as a whole in the race to meet the hard 2018 deadline. Compliance with IFRS 9 will likely require new models, new skills,new ways of working, new management strategies, and new investments in IT and data. Although the effort is significant, organisations will be better off for being able to centralise data resources and processes, automate reporting, simplify impairment methodologies, and be more consistent and transparent across the business.

To benefit from the experience, organisations need to handle implementation carefully in order to overcome these obstacles and minimise the financial and operational impact of IFRS 9 compliance. A complete solution, such as FICO’s IFRS 9 Impairment Management Solution, will help institutions to overcome any hurdles and meet IFRS 9 goals.

Effectively addressing the challenges of this new standard will enable senior management to make better-informed, forward-looking strategic decisions for risk management and help them to understand the evolving nature of risk in today’s dynamic financial services industry. Getting there, though, won’t be easy.

David Binder is a senior principal consultant at analytic software firm FICO, specialising in regulatory compliance. He previously led Barclaycard’s global impairment, capital demand and stress testing team, and worked on behalf of major financial institutions worldwide for US-based financial services consultancies.