In our first blog entry we introduced IFRS 9 and defined some of the key terms of that standard. In this second blog entry we look further at the application of that standard and the assessment of credit risk.
Under IFRS 9 credit unions are expected to assess whether the credit risk on a financial instrument has increased significantly since the financial instrument was first recognised or the last reporting date (year-end).
To assess whether there has been a significant increase in credit risk the credit union is expected to consider reasonable and supportable credit risk relevant information that is available without undue cost or effort on the part of the credit union.
Where the credit union concludes that there has been a significant increase in credit risk since the financial instrument was first recognised it must recognise lifetime expected credit losses on that financial instrument in its financial statements.
Lifetime credit losses do not need to be recognised if the credit union considers that the credit risk on the financial instrument is low at the reporting date. As guidance a financial instrument with an external credit rating of “investment grade” is considered to be a useful benchmark for a financial instrument that has low credit risk.
Credit unions should consider three main elements in assessing whether there has been a significant increase in credit risk for the purpose of placing a financial instrument in either stage 1,2, or 3.
The three main indicators that need to be considered are:
Under IFRS 9 we must recognise stage 1 impairment losses when a new financial instrument is issued.
At each reporting date after the financial instrument has been issued, the credit union must assess whether credit risk in respect of the financial instrument has increased significantly.
If the credit risk has not increased significantly, the credit union continues to recognise only 12-month expected credit losses. However, if the credit risk has increased significantly then lifetime expected credit losses are recognised.
Once a financial instrument is in default it should be transferred to stage 3 and a loss allowance equal to the lifetime expected credit losses recognised.
With the use of an internal scorecard or risk rating process the credit union can assess significant increases in credit risk in their portfolios. By definition, this would involve setting thresholds for determining what constitutes a significant increase in credit risk as the facility granted to the customer moves along the rating scale.
If a scorecard system exists, the credit union can then determine the probability of default associated with the ratings achieved at that point in time on the scorecard system.
As noted in our first blog entry, two types of probability of default have to be considered by the credit union under IFRS 9.
The quantitative assessment of significant increases in credit risk for most credit unions could be derived using an internal scorecard or a defined risk rating process.
The following is an example that is given just for guidance as a starting point for each credit
union considering the need to create their own relevant scorecard.