The estimate of expected credit losses reflects the cashflows expected from collateral (and credit enhancements if they exist) that are part of the contractual term of the financial instrument issued by the credit union.
The Expected credit losses (ECL) on a loan is equal to the Exposure at Default (ED) x Probability of Default (PD) x Loss Given Default (LGD).
If you need reminding what all these terms mean they are all defined in the first blog entry in this series.
To determine the LGD the credit union must consider the cash flows expected from the repayment of a financial instrument (however it may be recovered). The ECL reflects:
The workout LGD models out the cash flows received on a defaulted loan to generate a rate to apply to loans that have a similar risk.
The following is a worked example given for guidance purposes:
In December 2009, Bobs Credit Union originated a mortgage on a commercial property in Port of Spain to Mr. Regit under the following terms and conditions.
Amount of mortgage: $20,000,000
Interest rate: 5% (Fixed)
Term: 5 years
Internal risk rating: 5 out of 10
The following is a summary of the credit experience on the mortgage.
In addition to the above the following costs were incurred during the administration process.
The first step is to define default. As stated before, there is no definition of default in IFRS 9 and so Bobs Credit Union must use its own definition of default. Bobs Credit Union considers any loan with a risk rating of 8 or above to be in default and so the relevant default date is December 2012 when the mortgage was downgraded to 8.
Having identified our point of default, the next logical step is to calculate the present value of the cash flows and the costs of recovery using the initial date of default as time zero in the discounting calculation. Since the original mortgage was at a fixed rate the appropriate discount rate to use for this calculation is also 5%.
Calculating the present value of the net recovery on the facility is a case of finding the present value of the net recoveries on the mortgage since the initial date of default (December 2012). This is summarised in the table below.
Having calculated the present value of the net recovery Bobs Credit Union would now have to calculate the Exposure at Default (EAD).
The EAD is the balance of the loan at the date of default (not the date the loan is written-off) and includes the amount of principal and any accrued interest that has not been paid.
In the case of the above facility the date of the default was December 2012 when the amount of principal and accrued interest outstanding stood at $18,659,474.
Having reached this point we are able to calculate the Loss Given Default (LGD) as a rate which can be used as a benchmark moving forward for a portfolio of assets that share similar risks.
The LGD formula is = 1 – Present Value [Net Recovery] / EAD.
LGD = 1 – (12,047,183)/(18,659,474)
LGD = 1 – 64.56%
LGD = 35.44%
Having worked out the LGD we could now adjust that rate for any applicable forward-looking factors that may improve or devalue that %.