International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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risk of a default occurring depends on:
• the original credit risk at initial recognition: the same absolute change in PD for a
financial instrument with a lower initial credit risk will be more significant than
those with a higher initial credit risk (see 6.1 and Example 47.14 below); [IFRS 9.B5.5.9]
and
• the expected life or term structure: the risk of a default occurring for financial
instruments with similar credit risk increases the longer the expected life of the
financial instruments. Due to the relationship between the expected life and the
risk of a default occurring, an entity cannot simply compare the absolute risk of a
default occurring over time. For example, if the risk of a default occurring for a
financial instrument with an expected life of 10 years at initial recognition is the
same after five years, then this indicates that the credit risk has increased. The
standard also states that, for financial instruments that have significant payment
obligations close to the maturity of the financial instrument (e.g. those where the
principal is only repaid at maturity), the risk of a default occurring may not
necessarily decrease as time passes. In such cases, an entity needs to consider other
qualitative factors. We note, however, that while the risk of default may decrease
less quickly for an instrument with payment obligations throughout its contractual
life, normally, the risk of default will still decrease as maturity approaches.
[IFRS 9.B5.5.10, B5.5.11].
Some of these challenges are illustrated by examining the historical levels of default
associated with the credit ratings of agencies, such as Standard & Poor’s.
• It is apparent that the PDs increase at a geometrical, rather than an arithmetic, rate
as the credit ratings decline. Hence, the absolute increase in the PD between two
relatively low risk credit ratings is considerably less than between two relatively
higher risk ratings.
• The relative increase in PD between each of these ratings might be considered
significant, since most involve a doubling or trebling of the PD. In contrast, because
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credit rating is an art rather than a science, the smaller changes in credit risk
associated with the plus or minus notches in the grading system are less likely to
be viewed as significant.
• In addition, as the time horizon increases, the PDs also increase across all credit
ratings (i.e. the PD increases with a longer maturity).
The majority of credit exposures that are assessed for significant credit deterioration
will not have been rated by a credit rating agency. However, the same logic will apply
when entities have developed their own PD models and are able to classify their
exposure by PD levels.
The determination of what is significant will, for the larger banks, be influenced by the
guidance issued by banking regulators (see 7.1 below).
Given the exponential shape of the PD curve relative to ratings, some banks are
considering that a bigger downgrade, as measured by the number of grades, would be
significant for a higher quality loan than for one with a lower quality. The extent to
which this is appropriate will depend on how the different grades map to PDs. Also, the
calibration of a significant deterioration has to take into account the fact that PD
multiples for very good ratings only represent very small movements in absolute risk,
whereas the same multiple applied to bad ratings can represent a significant change in
the absolute amount of PD.
Banks have varying views on how much of an increase in PD is significant. Also, while they
may view a quantitative threshold, such as a doubling of PD, to be significant, many also
require a minimum absolute PD increase, such as 50 basis points so as to avoid very high
quality assets moving to stage 2 as a result of a very small change and to filter out ‘noise’.
Banks have also introduced various metrics to assess the effect of different approaches
to assess significant increase in credit risk and for management information. Examples
include the volume of stage 2 assets compared to the total portfolio and compared to
12-months of lifetime expected losses, the volume of movement (back and forth)
between stages 1 and 2, the amount of assets that jump directly from stage 1 to stage 3,
the proportion of assets in stage 3 which went via stage 2, and how long assets were in
stage 2 before moving to stage 3.
6.4 Operational
simplifications
When assessing significant increases in credit risk, there are a number of operational
simplifications available. These are discussed below.
6.4.1
Low credit risk operational simplification
The standard contains an important simplification that, if a financial instrument has a
low credit risk, then an entity is allowed to assume at the reporting date that no
significant increases in credit risk have occurred. The low credit risk concept was
intended, by the IASB, to provide relief for entities from tracking changes in the credit
risk of high quality financial instruments. This simplification is only optional and the low
credit risk simplification can be elected on an instrument-by-instrument basis.
[IFRS 9.BC5.184].
Financial instruments: Impairment 3799
This is a change from the 2013 Exposure Draft, in which a low risk exposure was
deemed not to have suffered significant deterioration in credit risk.
[IFRS 9.BC5.181, BC5.182, BC5.183]. The amendment to make the simplification optional was
made in response to requests from constituents, including regulators. The Basel
Committee guidance (see 7.1 below) considers the use of the low credit risk
simplification a low-quality implementation of the ECL model and that the use of this
exemption should be limited, except for holdings in securities.
For low risk instruments for which the simplification is used, the entity would recognise
an allowance based on 12-month ECLs. [IFRS 9.5.5.10]. However, if a financial instrument
is not, or no longer, considered to have low credit risk at the reporting date, it does not
follow that the entity is required to recognise lifetime ECLs. In such instances, the entity
has to assess whether there has been a significant increase in credit risk since initial
recognition which requires the recognition of lifetime ECLs. [IFRS 9.B5.5.24].
The standard states that a financial instrument is considered to have low credit risk if:
[IFRS 9.B5.5.22]
• the financial instrument has a low risk of default;
• the borrower has a strong capacity to meet its contractual cash flow obligations in
the near term; and
• adverse changes in economic and business conditions in the longer term may, but
will not necessarily, reduce the ability of the borrower to fulfil its contractual cash
flow obligations.
A financial instrument is not considered to have low credit risk simply because it has a
low risk of loss (e.g. for a collateralised loan, if the value of the collateral is more than
the amount lent (see 5.8.1 above)) or it has lower risk of default compared to the entity’s
other financial instruments or relative to the credit risk of the jurisdiction within which
<
br /> the entity operates. [IFRS 9.B5.5.22].
The description of low credit risk is equivalent to investment grade quality assets,
equivalent to a Standard and Poor’s rating of BBB– or better, Moody’s rating of Baa3 or
better and Fitch’s rating of BBB– or better. When applying the low credit risk
simplification, financial instruments are not required to be externally rated. However,
the IASB’s intention was to use a globally comparable notion of low credit risk instead
of a level of risk determined, for example, by an entity or jurisdiction’s view of risk based
on entity-specific or jurisdictional factors. [IFRS 9.BC5.188]. Therefore, an entity may use
its internal credit ratings to assess what is low credit risk as long as this is consistent with
the globally understood definition of low credit risk (i.e. investment grade) or the
market’s expectations of what is deemed to be low credit risk, taking into consideration
the terms and conditions of the financial instruments being assessed. [IFRS 9.B5.5.23].
The Basel Committee guidance (see 7.1 below) states that the investment grade category
used by ratings agencies is not considered homogeneous enough to be automatically
considered low credit risk, and internationally active and sophisticated banks are
expected to rely primarily on their own credit assessments.
In practice, entities with internal credit ratings will attempt to map their internal rating
to the external credit ratings and definitions, such as Standard & Poor’s, Moody’s
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and Fitch. The description of the credit quality ratings by these major rating agencies
are illustrated below.19
Figure 47.5 External credit ratings and definitions from the 3 major rating agencies
Standard & Poor’s
Moody’s
Fitch
Investment grade would usually Investment grade would usually Investment grade would usually
refer to categories AAA to BBB refer to categories Aaa to Baa (with
refer to categories AAA to BBB
(with BBB– being lowest investment
Baa3 being lowest investment grade
(with BBB– being lowest investment
grade considered by market considered by market participants).
grade considered by market
participants).
participants).
BBB
Baa
BBB: Good credit quality
Adequate capacity to meet financial
Obligations rated Baa are judged to
Indicates that expectations of default
commitments, but more subject to be medium-grade and subject to risk are currently low. The capacity
adverse economic conditions.
moderate credit risk and as such may
for payment of financial
possess certain speculative
commitments is considered adequate
characteristics.
but adverse business or economic
conditions are more likely to impair
this capacity.
The dividing line between investment grade and speculative grade
BB
Ba
BB: Speculative
Less vulnerable in the near-term but
Obligations rated Ba are judged to be
Indicates an elevated vulnerability to
faces major on-going uncertainties to
speculative and are subject to default risk, particularly in the event
adverse business, financial and substantial credit risk.
of adverse changes in business or
economic conditions.
economic conditions over time;
however, business or financial
flexibility exists which supports the
servicing of financial commitments.
Examining the historical levels of default associated with the credit ratings of agencies
such as Standard & Poor’s, the PD of a BBB-rated loan is approximately treble that of
one that is rated A. Hence, many entities would consider the increase in credit risk to
be significant, if the low risk simplification is not used.
The low credit risk simplification will not be relevant if an entity originates or purchases
a financial instrument with a credit risk which is already non-investment grade.
Similarly, this simplification will also have limited use when the financial instrument is
originated or purchased with a credit quality that is marginally better than a non-
investment grade (i.e. at the bottom of the investment grade rating), because any credit
deterioration into the non-investment grade rating would require the entity to assess
whether the increase in credit risk has been significant.
Partly because of the Basel Committee guidance, most sophisticated banks intend to apply
the low risk simplification only to securities. It is yet to be seen whether less sophisticated
banks will use this operational simplification widely for their loan portfolios. Investors
that hold externally rated debt instruments are more likely to rely on external rating
agencies data and use the low credit risk simplification. However, some sophisticated
Financial instruments: Impairment 3801
banks are intending not to use it at all, preferring to use the same criteria as for other
exposures (e.g. changes in the lifetime risk of default as the primary indicator followed by
other risk metrics such as credit scores and ratings). It is also important to emphasise that
although ratings are forward-looking, it is sometimes suggested that changes in credit
ratings may not be reflected in a timely matter. Therefore, entities may have to take
account of expected change in ratings in assessing whether exposures are low risk.
The following example from the standard illustrates the application of the low credit
risk simplification. [IFRS 9 IG Example 4 IE24-IE28].
Example 47.11: Public investment-grade bond
Company A is a large listed national logistics company. The only debt in the capital structure is a five-year
public bond with a restriction on further borrowing as the only bond covenant. Company A reports quarterly
to its shareholders. Entity B is one of many investors in the bond. Entity B considers the bond to have low
credit risk at initial recognition in accordance with paragraph 5.5.10 of IFRS 9. This is because the bond has
a low risk of default and Company A is considered to have a strong capacity to meet its obligations in the
near term. Entity B’s expectations for the longer term are that adverse changes in economic and business
conditions may, but will not necessarily, reduce Company A’s ability to fulfil its obligations on the bond. In
addition, at initial recognition the bond had an internal credit rating that is correlated to a global external
credit rating of investment grade.
At the reporting date, Entity B’s main credit risk concern is the continuing pressure on the total volume of
sales that has caused Company A’s operating cash flows to decrease.
Because Entity B relies only on quarterly public information and does not have access to private credit risk
information (because it is a bond investor), its assessment of changes in credit risk is tied to public
announcements and information, including updates on credit perspectives in press releases from rating agencies.
Entity B applies the low credit risk simplification in paragraph 5.5.10 of IFRS 9. Accordingly, at the reporting
date, Entity B evaluates whether the bond
is considered to have low credit risk using all reasonable and
supportable information that is available without undue cost or effort. In making that evaluation, Entity B
reassesses the internal credit rating of the bond and concludes that the bond is no longer equivalent to an
investment grade rating because:
(a) The latest quarterly report of Company A revealed a quarter-on-quarter decline in revenues of 20 per
cent and in operating profit by 12 per cent.
(b) Rating agencies have reacted negatively to a profit warning by Company A and put the credit rating
under review for possible downgrade from investment grade to non-investment grade. However, at the
reporting date the external credit risk rating was unchanged.
(c) The bond price has also declined significantly, which has resulted in a higher yield to maturity. Entity B
assesses that the bond prices have been declining as a result of increases in Company A’s credit risk.
This is because the market environment has not changed (for example, benchmark interest rates,
liquidity, etc. are unchanged) and comparison with the bond prices of peers shows that the reductions
are probably company specific (instead of being, for example, changes in benchmark interest rates that
are not indicative of company-specific credit risk).
While Company A currently has the capacity to meet its commitments, the large uncertainties arising from
its exposure to adverse business and economic conditions have increased the risk of a default occurring on
the bond. As a result of the factors described above, Entity B determines that the bond does not have low
credit risk at the reporting date. As a result, Entity B needs to determine whether the increase in credit risk
since initial recognition has been significant. On the basis of its assessment, Company B determines that the
credit risk has increased significantly since initial recognition and that a loss allowance at an amount equal to
lifetime ECLs should be recognised in accordance with paragraph 5.5.3 of IFRS 9.
Some of the challenges in assessing whether there has been a significant increase in credit
risk (including the use of the low credit risk simplification) and estimating the ECLs, are
illustrated in the following example. It illustrates different ways of identifying a significant
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