IFRS 9 And Credit Unions – Part 3
A Firstline Securities Limited Blog by: Mike
1. The Credit Risk Management Process
It follows from what has been written in our first two blog entries that credit unions must have a system in place to rate customers and unique portfolio segments.
If we look at just retail products, then the credit union would need to consider all of the following:
- When the loan is originated it would be placed in Stage 1 (unless the loan is considered impaired at the time it was granted).
- The credit union must consider the criteria for subsequent movements between the three possible stages under IFRS 9.
- The credit union must consider what movement between the internal risk rating system it has adopted would indicate a significant increase in credit risk. IFRS 9 does not define what is considered to be a significant change and so the credit union is left to decide this for itself. As explained in our second blog entry, there is a rebuttable presumption that 30 days past due would be cause for transferring a loan from Stage 1 to Stage 2.
- Because credit unions maintain a portfolio of many loans it may be challenging to review all loans on an individual basis. A sensible approach might be to consider that a loan being placed on a watch list or a delinquency list is sufficient enough to trigger a review of that individual loan.
- If a loan that is in Stage 1 becomes delinquent or is placed on a watch list, then those two scenarios would probably warrant the loan moving from Stage 1 to Stage 2.
- A loan that is considered to be impaired (past 90 days) would `automatically be placed into Stage 3.
2. Arriving at a definition for default
As explained in our first two blog entries, IFRS 9 does not provide a definition of default and so credit unions are responsible for defining the term themselves. The definition the credit union adopts should be based upon the definition of default they use in their own internal risk management processes.
While a simple approach might be to define default as the failure to meet a scheduled payment, the definition that the credit union uses must also consider qualitative factors such as breach of covenants. Inability to pay may also be considered in making the qualitative assessment of default.
IFRS 9 provides a rebuttable presumption that default occurs once a loan is more than 90 days past due. This can be rebutted if the credit union has supportable evidence to the contrary.
3. The use of forward looking information and macro-economic forecasts
IFRS 9 requires the credit union to estimate expected credit losses (ECL’s). The estimate of ECL’s must reflect reasonable and supportable information that is available without undue cost or effort. This would include information in respect of:
- Past events.
- Current conditions.
- Forecasts of future economic conditions.
4. Practical implication considerations
Under IFRS 9 the measure of expected credit losses is based on an unbiased probability weighted amount that is determined by evaluating a range of possible outcomes and using reasonable and supportable information that is available without undue cost or effort. As noted above, this includes information in respect of past events, current conditions and forecasts of future economic conditions.
In respect of forward looking information, IFRS 9 does not prescribe the number of factors that must be taken into account, but it does provide examples of potential data sources.
These potential sources include:
- The credit unions internal credit loss experience.
- Internal and external ratings.
- The credit loss experience of other entities.
- External reports and statistics.
One problem most credit unions will face is that they won’t have all the forecasted information available at the time IFRS 9 must be implemented (applicable for accounting period starting on or after the 1st January 2018).
Factors credit unions would need to consider include forecasts of:
- Unemployment rates: since there is usually a positive correlation between a rise in the unemployment rate and a rise in default rates.
- Interest rates: since a rise in the interest rate is usually associated with an increase in default rates experienced on variable rate loans.
- Inflation rate: since a rise in the rate of inflation reduces the purchasing power of money and makes it harder for people to “make ends meet.”
- The Gross Domestic Product Rate (GDP): since the GDP rate in broad terms gives an estimate of the movement of the size of the economy. If a contracting GDP/economy is forecast then businesses may experience reduced revenue, increased costs, are less likely to re-invest and are more likely to cut-back operations or economic activity.
- Industry factors and trends: Credit Unions could use estimates of the trends for industries over a defined period.
- Construction forecasts: In theory credit unions could use the forecast of commercial real estate construction to determine the probability of default on commercial lending products they offer.
- Commodity prices: This is particularly relevant in Trinidad and Tobago because the economy is dominated by the energy sector. Therefore, a fall in oil and gas prices could be used as a factor to determine the probability of default for commercial lending products that credit unions may offer within Trinidad and Tobago.
- Property and land values: these could be used to determine the amount of loss given default especially in relation to the loss of principal.
- The current calculation of the Loan to Value Ratio: A higher loan to value ratio means a greater risk to the credit union.
5. Subsequent blog entries in this series
In the fourth blog entry in this series published tomorrow we look at loss given default and collateral and provide a worked example of how IFRS 9 might be applied by a credit union in practice.
Closing thoughts – a time to chill and a time to invest?
Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers many unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@firstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.
