IFRS 9 and Credit Unions – Part 1

August 6, 2018

A Firstline Securities Limited Blog by: Mike

Over the next 5 days we look at IFRS 9 and Credit Unions. Commentators suggest that Credit Unions will struggle to implement this standard which is applicable for the accounting period commencing on or after the 1st January 2018. Will you be ready or do you need help?

1 . Background

The implementation of IFRS 9 creates many challenges for credit unions operating in Trinidad and Tobago. This series of blog entries is designed to assist our credit union clients to identify implementation issues relevant to them which in turn will allow them to design appropriate responses to address these.

These blog entries should not be considered as a definitive guide. Each credit union will have its own unique characteristics and these blog entries should not be considered to be a substitute for each individual credit union seeking its own independent advice (where considered necessary) and then applying the impairment principles contained in IFRS 9 to their own unique pool of financial assets.

2. Understanding IFRS 9’s key definitions and concepts

In order to understand how to implement IFRS 9 the reader must have an understanding of a number of that standards key definitions and concepts:

2.1 Financial instrument

A financial instrument is a loan or credit facility granted by the credit union to a third party.

2.2 Default

IFRS 9 does not provide a definition of default. In practice each individual credit union – if it doesn’t already have an established definition – will have to create its own definition of default. The definition that the credit union uses should be based upon its own internal credit risk management practices and policies, and the definition used must be consistent with the definition used to measure what is referred to as the “probability of default” (discussed in detail below).

In accordance with IFRS 9 the definition of default must consider qualitative indicators such as financial covenants when appropriate.

All credit unions should be aware that there is a rebuttable presumption that default takes place no later than 90 days past due.

2.3 Forward looking information and factors

In assessing impairment issues credit unions are expected to include forward looking information and forecasts particularly macro-economic forecasts in assessing which of the 3 stages under IFRS 9 a financial instrument or portfolio of financial instruments resides.

2.4 Probability of default

The probability of default is an estimate of the likelihood of default over a given period of time.

Two types of probability of default are used for calculating expected credit losses (defined below):

12 Month Probability of Default: This is the estimated probability of default occurring within the next 12 months (or over the remaining life of the financial instrument in the event that this is a period of less than 12 months). The 12-month probability of default is used to calculate 12-months expected credit losses. 12-months expected credit losses are recognised under IFRS 9 as stage 1 impairment losses.
Lifetime Probability of Default: This is the estimated probability of a default occurring over the remaining life of the financial instrument. Under IFRS 9, lifetime probability of default is used to calculate lifetime expected credit losses recognised in both stage 2 and stage 3 impairment losses.

2.5 Expected credit losses

Expected credit losses (ECL’s) are the difference between the present value of the expected cash flows that are contractually due (usually this would be the repayment of principal together with any interest due) and the present value of the cashflows that the credit union expects to receive taking into account the estimate of probability of default.

2.6 Exposure at default

Exposure at default (EAD) is an estimate of the loan exposure value at a future default date. Exposure at default takes into account expected changes in the exposure after the credit unions reporting date (the credit unions financial year-end), including any repayments of principal and payments of interest, any prepayments made or liquidation of collateral, or further expected drawdowns in the event that a credit union has granted a facility to a borrower.

2.7 Expected life

Expected life is the maximum period over which expected credit losses are measured. Expected life should not exceed the contractual term of the loan or facility granted.

2.8 Loss given default

Loss given default (LGD) is an estimate of the loss arising on default. It is based on the difference between contractual cash flows due under a loan or facility and those that the credit union expects to receive, including any that would be received from the liquidation of any collateral due on the loan or facility. Loss given default is usually expressed as a percentage of exposure at default.

2.9 Discount rate

The discount rate is the applicable discount rate used to discount an expected credit loss to a present value at the credit unions reporting date (year-end) using the effective interest rate at the point of initial recognition of the loan or facility. The effective interest rate takes the stated rate on the original loan and factors in any fees, transaction costs, expected prepayments and discounts on premiums.

3. Subsequent blog entries in this series

In the second blog entry in this series published tomorrow we look at how credit unions should assess whether there has been a significant increase in credit risk in respect of a financial instrument.

Closing thoughts – a time to chill and a time to invest?

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