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Credit Risk According to IFRS 9: Significant Increase in Credit Risk and

Implications for Financial Institutions

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DOI: 10.2139/ssrn.2654120

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Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions Page - 1 -

Credit Risk according to IFRS 9: Significant increase in

Credit Risk and implications for Financial Institutions
Dr. Dirk Beerbaum, Sammar Ahmad*
University of Surrey, Guildford, Surrey Business School; University of Cologne

Abstract
This study explores the literature about definitions and concepts when a significant increase in credit risk is achieved. In
response to the financial crisis the IASB has introduced a new standard (IFRS 9) on impairment, which requires a three-
step approach, which in general replaces the current incurred impairment model with a new expected loss model. This
research paper summarizes alternative impairment models and partucuarly focus on the significant detreortaion criteria,
which is a cornerstoneof the new IFRS 9 impairment model. The expected loss model is not completely new within the
accounting literature. The study provides early insights into implemenation of IFRS 9 on impairment, as IFRS 9 will
become applicable 2018. It is also relevant for regulators, as it becomes obvious due to the nonexistance of a dominant
approach, the question arises if the regulator should provide more guidance to avoid that all companies pursue complete-
ly different models resulting in decreasing comparabity for investors.

Keywords: IFRS 9, impairment, credit risk, financial institutions, accounting literature.

The new model requires three stages of
1 Introduction impairment considering changes in credit
The aims of accounting standards are quality since initial recognition.
substantially different to those of bank regula-
tion. Financial reporting follows a general
purpose to provide information to those out- Figure 1.1 Thee-Stage Model of IFRS 9
side the firm to support decision usefulness. In Impairment
contrast to this prudential bank regulation
seeks to decrease the frequency and cost of
bank failures and to protect the financial sys-
tem as a whole by limiting the frequency and
cost of systemic crises [1].

These differing objectives are at the

center of a standing debate over loan loss ac-
counting as reflected in recent high profile
proposals: Impairment of Financial Assets -
The Expected Loss Model (EFRAG), Basel
Committee on Banking Supervision, and
Guidance on accounting for expected credit
losses. In response to the financial crisis and
these proposals the IASB has introduced a new
(Source: PwC, 2014 and adapted by author [4]
standard IFRS 9 on impairment [2], which
requires a three-step approach, which in gen-
eral replaces the current incurred impairment In the first stage financial assets are
model with a new expected loss model. The included, which are exposed to a low credit
new model is very much influenced by prudent risk. A significant increase in credit risk could
bank regulation and the aim to reduce income not be measured since the initial recognition.
smoothing [3]. Even if no impairment was incurred, for these

*Corresponding authors: Dr Dirk Beerbaum, University of Surrey, Guildford, Surrey Business School, MBA, CEFA;
E-mail: beerbaumdirk@gmail.com; Sammar Ahmad, MBA, CEMS MIM, University of Cologne, Copenhagen Business School, CEMS; Citation:
Beerbaum D., Ahmad, S. (2015) Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions.
Copyright: © 2015 Beerbaum D., Ahmad, S. Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial
Institutions`; Working Paper
Electronic copy available at: http://ssrn.com/abstract=2654120
Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions Page - 2
-
assets the 12-month Expcted Credit Loss
(ECL) is calculated. Interest revenue is
calculated based on the gross carrying amount
[3].
12-month ECL are caused by default events
that are possible within 12 months after the
reporting date [2]. It is often misunderstood, as
it is not the expected cash shortfalls over the
12-month period but the entire loss on an asset
weighted by the probability that the loss will
occur in the next 12 months. This stage is
summarized as the under-performing state.
In the second stage financial
instruments are included which were exposed
to a significant increase in credit risk since
initial recognition and no objective evidence of
impairment is provided. For these assets,
lifetime ECL are recognized, but interest
revenue is still calculated on the gross carrying
amount of the asset. Lifetime ECL are the
expected credit losses that result from all
possible default events over the expected life
of the financial instrument. Expected credit
losses are the weighted average credit losses
with the probability of default (‘PD’) as the
weight [1].
The third stage includes financial assets
for which objective evidence of impairment at
the reporting date has taken place. For these
assets, lifetime ECL are recognized and
interest revenue is calculated on the net
carrying amount (net of credit allowance) [2].
In this three-stage approach the IASB
has implemented a general change from the
incurred to expected loss model. According to
the EFRAG (European Financial Reporting
Advisory Group) and FEE (Federation of Eu-
ropean Accountants), the issue with the in-
curred loss model is that impairment losses
(and resulting write-downs in the reported val-
ue of financial assets) can only be recognized
when there is evidence that they have been
incurred. It is not permitted to reporting enti-
ties to subjectively consider expected losses.
The assumption is that prudent recognition of
loan losses could have potentially decreased
the cyclical moves in the recent financial crisis
[5].
Electronic copy available at: http://ssrn.com/abstract=2654120
However according to Bushman and Lands-
man [5] it is not only a model change, but it
also shows that regulation of financial report-
ing in light of the recent financial crisis needs
to develop towards the prudent regulatory
model. The reality is that the regulation of
corporate reporting is just one piece of a larger
regulatory configuration and that forces are at
play that would “subjugate accounting stand-
ard-setting to broader regulatory demands” (p.
260). IFRS 9 illustrate this point.
2 Literature Review
This literature review starts to provide an
overview of the different impairment models
existing: Incurred Loss Model, Expected Loss
Model, Fair-Value based Model and Dynamic
Provisioning. The selection of the methods is
based on an analysis of the EFRAG and the
FEE, who provided a summary of the domi-
nant models. This is followed by a detailed
literature review on the increase of credit risk.
Incurred Loss Model
Under the incurred loss model, investments are
regarded as impaired if there is no longer rea-
sonable assurance that the future cash flows
related to them will be either collected in their
entirety or when due. Entities search for evi-
dence of situations that would indicate im-
pairment, such triggering events are seen when
the entity:
• Is experiencing notable financial dis-
tress,
• Has defaulted on or is past due on mak-
ing interest or principal payments,
• Is likely to undergo a major financial
reorganization or enter bankruptcy, or
• Is in a market that is experiencing sig-
nificant negative economic change.
According to Leventis et al.[6] many re-
searchers have concluded that loan loss provi-
sioning is used as a tool for earnings manage-
ment. However according to an empirical
study about commercial banks they can draw
an opposite conclusion that the introduction of
Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions Page - 3
-
IAS 39 in the past has mitigated earnings man-
agement behavior.
Expected Loss Model
Under an expected loss impairment model,
estimates of future cash flows used to deter-
mine the present value of the investment are
made on a continuous basis and do not rely on
a triggering event to occur. Even though there
may be no objective evidence that an impair-
ment loss has been incurred, revised cash flow
projections may indicate changes in credit risk.
Under the expected loss model, these revised
expected cash flows are discounted at the same
effective interest rate used when the instru-
ment was first acquired, therefore retaining a
cost-based measurement. Calculating the Im-
pairment cost is the same as the Incurred Loss
Model
Fair-Value based Model
In a fair value based impairment approach, an
entity would book impairment losses on a fi-
nancial asset held at amortized cost to the ex-
tent that the fair value of that asset is less than
its carrying amount. Fair value would include
credit and noncredit related changes in fair
value i.e. using market based values and dis-
count rates. It is envisaged that a fair value-
based impairment approach would incorporate
a ―trigger of some sort, since automatic ad-
justments in fair value movements would seem
contrary to carrying a financial asset at amor-
tized costs. This model would imply to be very
volatile and clearly pro-cyclical, although not
as much as a full fair value model.
Dynamic Provisioning
The dynamic provisioning model contrary to
the incurred loss model follows the main ob-
jective to improve the financial soundness of
banks. Dynamic provisioning applies an anti-
cyclical approach, .i.e. in “good times” a loan
reserve is set-up so it will not face insolvency
due to charge-offs and provisions in “bad
times” [8].
3 Discussion of Models
3.1 Expected loss-Model versus
Incurred loss-Model
One of the main difference between the ex-
pected loss and the incurred loss model is that
it is more subjective in nature, as it is based
significantly on the estimate of cash flow ex-
pectations prepared by the reporting entity.
This process of analyzing future cash flow
streams is inherently subjective and represents
potential to become susceptible for earnings
management [4]. “Too little to late” was the
summary often mentioned as part of the expo-
sure draft discussion of IFRS 9.
Critics of the accounting standard argue that
the recognition after identification of evidence,
such as a counterparty failing to meet its con-
tractual obligations, is much too late because
the expenses in the income statement for im-
pairments then accumulate in economic down-
turns when losses materialize. This provision-
ing regime therefore increases pro-cyclicality.
In good times, when lending is already at a
high level, banks are not required to set aside
buffers for expected losses, and thus overstate
the economic value of the loan portfolio and
understate losses in the income statement. As a
result, lending can be expanded beyond the
amount that would be possible under a differ-
ent accounting regime. In economic downturns
high credit losses occur, but the lack of availa-
ble provisions increases the losses reported in
banks’ income statements, which reduces capi-
tal and may force banks to recapitalize or re-
duce lending and sell assets. Hence, provisions
set aside in good times could serve as a buffer
against risk; one that alleviates the impact of
these effects and reduces the likelihood of
banks becoming insolvent.
Therefore some safeguards need to be built
into the process such as disclosures of methods
applied and periodical back testing and imme-
diate reflection of the results of the back test-
ing in the models applied for the future.
Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions Page - 4
-
3.2 Expected Loss Model
3.2.1 Significant deterioration
A main new trigger within IFRS 9 to fall into
stage 2 is a significant increase in credit risk.
As expected, IFRS 9 does not provide detailed
guidance what should be criteria’s, as this rep-
resents typical principal-based accounting in-
crement.
What is required for financial institutions is to
define a comprehensive methodology, which
considers the large universe of possible criteria
and circumstances which may lead to a signif-
icant deterioration. As financial institutions
need to comply besides accounting require-
ments with regulatory requirements, this arti-
cle will also focus on regulatory definition of
deterioration, which is forbearance. The EBA
has introduced an umbrella approach for the
definition of forbearance [9]: “Forborne expo-
sures can be identified both in the performing
and in the non-performing portfolios”, (p.6).
By this concept EBA intends to define credit
deterioration broader when necessary for su-
pervisory purposes.
Before providing further analysis on this
methodology the IFRS 9 presented indicators
are illustrated. According to IFRS 9 indicators
are provided according to those financial insti-
tutions can conclude that a 12 month ECL is
only required:
• Low credit risk
• Borrower is financial sound to meet is
obligations
• Adverse macroeconomic changes will
not have an impact on the borrower’s
capacity to fulfill its obligations
However the Basel SCRAVL (Sound credit
risk assessment and valuation for loans) doc-
ument limits this so called low credit expedi-
ent. [10]“The Committee expects that the low
credit ingredient would be used by banks only
in rare and appropriate circumstances, since
the Committee views lending activities as the
core of the bank’s business” (p.33).
According to IFRS 9 the assessment of signifi-
cant credit risk deterioration should include a
multifactor and holistic approach. Whether one
factor needs to be weighted more than another
one needs judgement. To simplify this judge-
ment, IFRS 9 provides a list of non-exhaustive
factors, which are summarized as followed:
• Significant change in internal price
• Other changes in the rates of terms of
an existing financial instrument
• Significant changes in external market
indicators IFRS 9 B5.5.17]
o Credit spread
o Credit default swap price
o Duration that the fair value is
less then the amortized cost
o Other market information relat-
ed to the borrower
• Significant change in the credit rating
• Internal credit rating downgrade
• Significant change in the value of the
collateral
The assessment of whether there has been a
significant increase in credit risk is based on
an increase in the probability of a default oc-
curring since initial recognition. Under the
standard, an entity may use various approaches
to assess whether credit risk has increased sig-
nificantly, however it needs to be ensured that
the approach is applied consistently.
The literature discusses different accounting
regulations and regulatory requirements for
significant deterioration, which are summa-
rized in the Table 1.1, which is principal-based
within IFRS in cluding a list of indicators, a
codified approach according to US GAAP and
the most prescriptive according to the Europan
Banking Authority guidelines. US GAAP
makes obvious that deterioration needs to have
taken place in effect. Companies should con-
Credit Risk according to IFRS 9: Significant increase in Credit Risk and implications for Financial Institutions Page - 5
-

sider downgradesin credit rating and the
change in watchlist.
• Portfolio-based relative approach
• Non-portfolio based absolute approach
Portfolio-based approach define conditions for
significant credit risk decrease depending upon
the quality and the characteristics of the port-
folio. A low risk portfolio might be more sen-
sitive in relation to absolute rating migrations.
A low change in the credit risk might imply a
significant deterioration, although in absolute
terms the delta is minimal. Considering typical
asset classes this encounters that small rating
changes for Sovereigns would lead to relative
significant deterioration, however for corpo-
rates the same absolute change would not lead
to the same implications.
In a non-portfolio based approach, regardless
of the inherent characteristics of the portfolio a
fixe criteria would be applied to trigger signif-
icant deterioration. What is often mentioned is
a downgrade indicator for instance measured
in notches, while it could be two or three,
which is in general an ongoing debate between
IASB, regulators and audit firms.
an incurred to an expected loss model. This
research paper summarizes alternative im-
pairment models and particularly focus on the
significant deterioration criteria, which is a
cornerstone of the new IFRS 9 impairment
model. The expected loss model is not com-
pletely new within the accounting literature.
The study provides early insights into imple-
mentation of IFRS 9 on impairment, as the
standard will become applicable from 2018.
The new model will have a material impact on
the financial institutions especially bank sys-
tems and processes. Moreover, it will also
have a tightening effect on earnings manage-
ment [9]
Based on the findings, the question arises if
standard setters and regulators should provide
more guidance to avoid that a heterogene set
of methodologies are implemented resulting in
a decreasing comparability especially for in-
vestors.

3.2.2 Implications for Financial In-

stitutions
According to Basel Draft Guidance banks are
requested to develop system and processes to
generate all available and sound information to
attain a high quality, robust and consistent
implementation of the IFRS 9 expected credit
loss model. Financial institutions as Basel rec-
ommends to plan high upfront investments, as
quality would far outweigh associated costs
from a long-term perspective [11]

4 Conclusion
This article explores the definitions and con-
cepts of a significant increase in credit risk is
achieved. With IFRS 9 prudent accounting has
been a strong influencer for the change from
 Page 6

Tabele 1.1: Summary of Significant deterioration requirements-IFRS vs. US-

GAAP vs. EBA

IFRS US GAAP EBA

IFRS 9.5.5.9: SFAS 115: Sale or Financial difficulty: Forbearance measures

At each reporting date, transfer of held-to- consist of concessions towards a debtor facing
an entity shall assess maturities security if or about to face difficulties in meeting its
whether the credit risk evidence of a financial commitments (“financial
on a financial instrument significant difficulties”).
has increased deterioration in
significantly the issuer’s (a) a modification of the previous
creditworthiness terms and conditions of a contract
the debtor is considered unable to
Summary

comply with due to its financial

Principal-based, • Actual
however indicators:
• Significant change
in internal price • Not await an actual
• Other changes in
the rates of terms
of an existing
financial instrument
• Significant changes
in external market
indicators IFRS 9
B5.5.17]
• Credit spread
• Credit default swap
price
• Duration that the
Indicators
difficulties (“troubled debt”) to
allow for sufficient debt service
ability, that would not have been
granted had the debtor not been in
financial difficulties;
(b) total or partial refinancing of a
troubled debt contract, that would
not have been granted had the
debtor not been in financial
difficulties
Performing: Loans and debt securities that are
deterioration needs not past-due and without risk of non-
to take place repayment and performing off-balance
sheet items
downgrading in the Non-Performing:
issuer's published Past due more than 90 days and / or unlikely
credit rating or to pay.
inclusion on a The non-performing exposures include the
"credit watch" list defaulted and impaired exposures
Exposures with “incurred but not reported
losses” shall not be considered as non-
performing exposures unless they meet the
criteria to be considered as non-performing
exposures.

fair value is less Exposures may be considered to have ceased

then the amortized being non-performing when all of the
cost following conditions are met:
• Other market
information relat- • the exposure meets the exit criteria
ed to the borrower applied by the reporting institution
• Significant change for the
in the credit rating • discontinuation of the impairment
• Internal credit and default classification;
rating downgrade • the situation of the debtor has
• Significant change improved to the extent that full
in the value of the repayment, according to the
collateral original or when applicable the
modified conditions, is likely to be
made;
• the debtor does not have any
amount past-due by more than 90
days.
 Page 7

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