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IFRS 9: Impact on Sri Lankan Banks

IFRS 9: Impact on Sri Lankan Banks. August 2014. Sujeewa Mudalige Managing Partner - PwC. Agenda. IFRS 9 overview Expected credit losses Challenging times ahead. IFRS 9 Overview. 1. Timeline of IFRS 9. Nov 2009

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IFRS 9: Impact on Sri Lankan Banks

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  1. IFRS 9: Impact on Sri Lankan Banks August 2014 Sujeewa Mudalige Managing Partner - PwC

  2. Agenda • IFRS 9 overview • Expected credit losses • Challenging times ahead

  3. IFRS 9 Overview • 1 IFRS 9: Financial Instruments

  4. Timeline of IFRS 9 • Nov 2009 • IASB issues IFRS 9 (2009) – classification and measurement of financial assets • Oct 2010 • IASB issues IFRS 9 (2010) – financial liabilities and derecognition • Nov 2013 • General Hedging amendments to IFRS9 • July 2014 • Final Standard • Nov 2009 • IASB issues ED on impairment • Jan 2011 • FASB and IASB issue supplementary document on impairment • March 2013 • IASB re-exposes impairment and issues limited amendments to IFRS 9 (2010) • 2018 • Effective date IFRS 9: Financial Instruments

  5. Key Highlights of IFRS 9 IFRS 9: Financial Instruments

  6. Audit Committees need to be active now IFRS 9: Financial Instruments

  7. Key Highlights of IFRS 9 IFRS 9: Financial Instruments

  8. IFRS 9 – Key changes • It will replace the existing standard IAS 39 in 2018 and will introduce important changes to accounting rules for financial instruments in three main areas: • Classification; • and • Measurement • Impairment • Hedge • Accounting • The largest impact is likely to be due to the new approach in measuring impairment IFRS 9: Financial Instruments

  9. Key Highlights of IFRS 9 Background • It will change the way banks book provisions on financial assets like loans and bonds. Key considerations • IFRS 9 requires banks to make appropriate provisions in anticipation of future potential losses, rather than the current practice of providing only when losses are incurred. • This means that banks will have to recognise provisions from the day they extend any loan, including undrawn commitments. IFRS 9: Financial Instruments

  10. SL Banks may have higher provisions It will lead to banks, in some cases, having to make substantially higher provisioning, which could hurt earnings and weigh on their capital. It could also potentially affect dividend payouts. The day 1 impact of IFRS 9 adoption, provisioning could potentially jump by more than 50% for some of the banks!!

  11. SL Banks may have many challenges

  12. Impact on SL Banks

  13. Expected credit losses • 2 IFRS 9: Financial Instruments

  14. IAS 39 vs IFRS 39

  15. From incurred loss to expected loss model Incurred Loss Expected Loss • • Used by IAS 39 • • An entity is not permitted to consider the effects of future expected losses • Credit losses recognised when an event has occurred that has a negative effect on • future cash flows & the • effect can be reliably • estimated • Used by IFRS 9 • Requires earlier • recognition of credit • losses in many cases • Requires an entity to • make an ongoing • assessment of expected • credit losses

  16. Financial Assets - A principles based approach IAS 39 Classification IFRS 9 Classification • Rules based • Complex and difficult to apply • Multiple impairment models • Complicated re-classification rules • Principles based • Classification based on business model and the nature of the contractual cash flows • One impairment model • Business model driven classification IFRS 9: Financial Instruments

  17. Expected credit lossesGeneral model Change in credit quality since initial recognition Recognition of expected credit losses Lifetime expected credit losses Lifetime expectedcredit losses 12 month expected credit losses Interest revenue Effective interest on gross carrying amount Effective interest on gross carrying amount Effective interest on amortised cost carrying amount Stage 1 Stage 2 Stage 3 Performing (Initial recognition*) Underperforming (Assets with significant increase in credit risk since initial recognition*) Non-performing (Credit impaired assets) *Except for purchased or originated credit impaired assets

  18. Lending landscape may change IFRS 9: Financial Instruments

  19. Expected credit lossesGeneral model • Information to take into account for assessment of increased credit risk Changes in external market indicators Changes in business Other qualitative inputs Changes in internal price indicators Changes in operating results Changes in credit ratings 30 days past due rebuttable presumption • However….

  20. Lending landscape may change • To deal with the potentially higher provisioning, banks may reprice or restructure the loans, making it more expensive for borrowers with riskier credit profiles. Additional quantitative disclosures are required on transition • Banks will likely be revising their business strategy. For example, they might think twice about extending certain types of loan facilities if they are deemed too risky or no longer profitable. These could include reducing the limit of undrawn facilities such as overdrafts. IFRS 9: Financial Instruments

  21. Expected credit losses (ECL)General model • Overview – Stage 1 • For accounts that fall under Stage 1, the bank has to provide 12-month forward-looking expected credit losses. • 12-month ECL are the expected credit losses that result from default events that are possible within 12 months after the reporting date. • Borrowers with good credit risk profile will likely fall under Stage 1. IFRS 9: Financial Instruments

  22. Expected credit losses (ECL)General model • Overview – Stage 2 • When accounts fall under or get into Stage 2 that it gets more problematic for banks, as this is where the provisioning gets heavier. (could be 4 to 5 times more than that for Stage 1 depending on the product). For Stage 2 accounts, banks have to provide lifetime ECL. • Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the loan. If a mortgage loan has an expected maturity of 20 years and it has gone into Stage 2, you have to provide (over) 20 years ECL, instead of 12 months.

  23. Expected credit losses (ECL)General model • Overview – Stage 2 • Accounts generally fall under Stage 2 when there is “significant increase in credit risk” since the loan was extended. • The standard has 16 criteria, including if the borrower is 30 days past due, so if you miss your one-month payment, you come to Stage 2. • But banks can rebut this, with a 30-day rebuttable presumption, if they feel it doesn’t warrant going to Stage 2. Banks have to build a model to argue that even though the borrower is one-month past due, a downgrade is not required.

  24. Expected credit losses (ECL) • A 10-year loan versus a 5-year loan will carry different provisioning. With the longer tenure, provisioning will be higher. • In the past, where banks would give a loan and would like to stretch it because it gives them recurring income, now they will have to think it through for borrowers with not a very good rating. • An SME customer, for example, to get a longer tenure loan can be more expensive, going forward. • Banks may have to re-look at the basis on which loans are re-scheduled at present.

  25. Expected credit losses (ECL)General model • Overview – Stage 2 • In general, banks are likely to rebut retail loans rather than corporate loans. • If corporates miss a payment, it’s usually not a good sign and an indication that they are underperforming. It would be difficult to rebut corporate and SME accounts. • To avoid having assets fall to Stage 2 because of a missed payment, the banks’ collection department is going to play an increasingly important role, going forward. Early payment alert will become a key strategy for banks.

  26. Expected credit losses (ECL)General model • Overview – Stage 2 • If you’ve gone to Stage 2, banks may seek legal advice on whether, based on the existing contract with the borrower, they can ask for additional interest or additional collateral. • Banks should explore what else they can do when accounts go to Stage 2. • It is important to ensure that customers don’t go from Stage 1 to Stage 2.

  27. Expected credit losses (ECL)General model • Overview • Banks now have to make a provision for un-utilised credit lines. • Overdraft limit and bank guarantees — which are all off the balance sheet — will need to be provided for. • Your credit card limit will now carry a provision. This means banks are going to be very careful about credit card customers and some may consider reducing the limit. • Interestingly, apart from loans, banks will now also have to make provisions for bonds that they invest in. Bonds also have to be put in Stage 1, 2 or 3. That means that the treasury department also gets affected.

  28. IFRS 9 – Implementation projects • Scope • Development of ECL Model for the Loans & Advances Portfolio • 12months Expected Credit Loss (ECL) • Lifetime Expected Credit Loss (ECL) • Multiple economic scenarios • Exposure at Default • LGD Computation • Disclosure requirements • Establish the financial asset classification for financial instruments Training of Staff members : • Financial Asset Classification • Expected Credit loss modelling • •

  29. IFRS 9 – Rankthe following in order of difficulty (encountered or expected) when designing and implementing your IFRS 9 provision and impairment solution.

  30. Expected credit lossesDisclosures Quantitative Qualitative • Write off, recovers and modifications • Write off policies, modification policies and collateral • Reconciliation of opening to closing amounts of loss allowance showing key drivers of change • Inputs, assumptions and estimation techniques for estimating ECL • Reconciliation of opening to closing amounts of gross carrying amounts showing key drivers of change • Inputs, assumptions and estimation techniques to determine significant increases in credit risk and default • Gross carrying amounts per credit risk grade • Inputs, assumptions and techniques to determine credit impaired IFRS 9: Financial Instruments

  31. IFRS 9 – Rankthe following in order of difficulty (encountered or expected) when designing and implementing your IFRS 9 provision and impairment solution.

  32. IFRS 9 – Data requirements

  33. Challenging times ahead • 3

  34. A silent revolution in banks’ business modelsWhat should banks do to get ahead?? • Adjusting portfolio strategy to prevent an increase in P&L volatility • Revising commercial policies as product economics and profitability change • Reforming credit-management practices to prevent exposures from deteriorating • Rethinking deal origination to reflect changes in risk appetite • Providing new training and incentives to personnel to strengthen the commercial network (source:McKinsey)

  35. Challenging times for SL Banks2018-2020 Factors to be considered? • Basel III • IFRS 9 • New • Taxes ? • S L • Banks • New • IRA • Debt • Repayment • Levy

  36. Capital requirements • The banks are expected to disclose the full effects of IFRS 9 on provisions, profitability and capital in their 2017 annual reports • In SL, the change in accounting standards is happening at a time when some banks are struggling to meet progressive increases in minimum capital requirements as Basel III is phased in.

  37. What are the challenges for SL banks? • Sri Lanka does not have enough instruments that qualify for Additional Tier I capital (AT 1) apart from Common Equity Tier 1 (CET 1) capital. • This means that banks will depend heavily on the capital market to raise additional capital and this can pose some challenges. • This can be aggravated where existence of common shareholders prevail in a shallow capital market.

  38. What is the Indian Government doing? • USD 32 billion capital infusion Indian State Banks 1 Government providing USD24 billion. 2 The banks are expected to raise the rest through, fresh equity issuance, 3 Indian Government willing to accept a dilution of its ownership to 52%

  39. What are the SL banks doing? • Developments: SL Banks 1 Government willing to broad base ownership of BoC and PB 2 Some licensed commercial banks have raised capital through rights issues in 2017 3 Most banks would require to raise capital on an annual basis for the next 3-4 years.

  40. How much is enough? * Rs 4 Bn in sub convertible debentures with an option to issue a further Rs 2 Bn ** Rs 6 Bn in subordinated debentures with an option to issue a further Rs 4 Bn

  41. This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. • All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.

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