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IFRS9 Expected Credit Loss (ECL) Models For Retail Lending

It is expected that IFRS9 adoption should lead to an increase in provisions (initially a balance sheet / retained earnings adjustment only with commentary on retrospective impacts). Typically, the increase is mostly a result of loss provisions for all accounts (regardless of a loss event) and the extension of the loss period from a typical 12 months to lifetime (e.g. for structured loans the remaining term of the loan plus time to default/write-off plus the recoveries window).

The below schematic provides an overview of the probable movements in provisions moving from IAS39 standard practices to an IFRS9 compliant solution:

We’ve written extensively on IFRS 9, and in this blog, we’ll cover our IFRS 9 solution and process in depth.

Principa’s IFRS 9 Solution Project Phases

Principa follows four key project phases in providing an IFRS9 solution, as can be seen in the schematic overview of the process below.

Phase 1: Business Overview: A review of the current environment

During phase 1 we conclude an initial review of the business in the context of provisioning. This includes getting an overview of the company, all business units and each lending product option. We’d also explore the data environment, check data availability and accessibility. The review would further extend to the business processes, credit risk management policies and practices, the current risk assessment toolkit (for both new and existing customers), the current IAS39 solution, -provision methodology and supporting principle and models, as well as the current provision coverage and any upfront IFRS 9 expectations and known compliance requirements or principle.

This phase would also include a review of any existing auditor observations, an offsite documentation review and an onsite workshop.

Phase 2:  IFRS9 Framework Design – IFRS9 gap analysis and roadmap to compliance

During phase 2, we’d aim to work with the client and their auditors to determine what the compliance principles are and what the final solution will look like. This phase ensures a smooth phase 3 and 4, and a clean audit after implementation.

This phase includes an IFRS9 requirements workshop to facilitate discussion around requirements principles and methodology; data extracts; defining, documenting and facilitating a management agreement of the IFRS9 compliance principles and methodology and the related roadmap; and defining the delivery approach, resourcing and timing and all project dependencies such as data requirements.

This would include the analytics required to provide supporting evidence to conclude the compliance principles, for example:

  • Determination of a significant finance component
  • Proposed IFRS9 approach: Simplified vs Generalised
  • Defining appropriate segmentation for the loans book
  • Defining the stage definitions
  • Confirming default / write-off / final loss definitions
  • Defining the lifetime period
  • Defining the recoveries performance window
  • Confirming the appropriate effective interest definitions and rates
  • Confirming discount rates
  • Unused exposure / commitment
  • Stage 3 Effective Interest recognition approach
  • Confirming most appropriated loss provisioning modelling methodologies (e.g. vintage based, portfolio run-off triangle, Markov, account level scoring)
  • Forward-looking approach

Phase 3:  ECL Model Development – Development and delivery of the IFRS9 compliant provisions solution

In phase 3, we move on to align data, definitions and assign stages and IFRS9 approach (simplified/general). As far as feasible, Principa will look to utilise the off-the-shelf Principa IFRS9 product solutions, for both the ease and speed to deployment, which can include:

  • Markov Loss Forecasting: A Markov based solution used to model expected future cash flows, per risk state, over the product’s credit life cycle.
    • This can be used to determine expected gross provisions.
    • Includes embedded revenue recognition outputs.
  • Recoveries Modelling: Run-off triangle solutions to determine expected recoveries over time
  • Forward-looking economic indicators modelling and scoring tool
  • Report and Disclosures reporting templates: Automated reporting relating to IFRS9 credit loss movements over time.
  • Standardised IFRS9 policy, model and user guide documentation templates.

Our bespoke solutions are tailored to meet our clients’ needs, and where a client’s environment does not enable the use of these off-the-shelf solutions, alternatives will be proposed during Phase 2.

The Markov ProVision Solution

We develop a portfolio level propensity to default balance model to output default balances by month and specifically for at 12 months and lifetime.  Our Markov ProVision solution determines the cash flow movements between a range of risk states (defined analytically). This solution allows the user to determine expected future cash flows, per risk state, which is useful for budget setting, credit risk monitoring and management. Below is an illustration of the underlying logic of a Markov Chain Solution.

Recoveries modelling

We develop a portfolio level run-off triangle loss given default model (modelling expected post-default recoveries), which includes:

  • LGD1 for the loss given default at the time of default
  • LGD2 for the loss given default of the default portfolio of accounts

The following illustration shows how the data input for the run-off triangle solution is structured. The blue shaded areas indicate the recoveries relating to October 2017. Historical performance is used to determine an expectation of future recoveries, with the use of development factors (e.g. the relationship between the cash flows in area B are compared to those in area A to determine the likely cash flows to expect from month 4 to 5). The solution includes backtesting and could be used to monitor collections performance over time.

Forward-looking economic indicators modelling scoring tool

Principa creates the capability to output a forward-looking scenario weighted final provisions.

The forward-looking approach looks at modelling the relationship between macroeconomics and expected losses, both expected defaults and recoveries. This is done by using linear regressions to predict the 12-month error rates historically produced by the gross expected credit loss recoveries models. The underlying assumption is that these models (along with known business strategy change overrides) are not entirely accurate due to external factors that change the portfolio’s performance. As such, by resolving these errors with economic variables, we should be able to produce more accurate future provisioning results. This approach also ensures that there is no double counting of economic effects in the early performance of a portfolio already embedded in the forecast. Although the life of an account might be longer, the first 12 months typically represent a majority of expected credit losses. The underlying assumption is that the error rate of the model of the initial majority short-term losses represents the longer term error position.

Read more on the Key Considerations when Managing Your IFRS 9 Forward-Looking Overrides.

Report and Disclosures reporting templates

We define final provisions and overall provisions structure and conclude in the IFRS9 reporting suite.  The reporting coverage is:

  • Provisions Disclosure Summary Report:
  • Provisions Disclosure by Credit Risk
  • Provisions and Expected Credit Loss Key Metrics Over Time

The below image shows a summarised view of the IFRS9 Provision solution. Additional insights, in the broader reporting pack, allow you to assess why your provisions have increased/decreased over a specified period.

Standardised IFRS9 policy, model and user guide documentation templates

We provide the following documents and supporting material coverage of the IFRS9 solution:

  • IFRS9 Policy Framework Document – describing the policies and principles within which the provision model would function.
  • The IFRS9 Model Documentation – describing the development data, modelling approach and conclusions, including the validation results.
  • The IFRS9 Model User Guide – describing the monthly run procedure.

For further detail on the supporting documents and information we provide, read our blog Auditing Provisions: The Auditing Journey Over Time.

Phase 4: Deployment – Handover and Implementation support

After implementation, we provide backtesting to evidence model accuracy, deliver and handover the run procedures that includes a data solution (SAS / SQL) and excel total provisions calculation procedure and set in place detailed model write-ups covering both modelling methodology and run procedures. We also develop provision disclosure reporting, complete impact assessments, provide advice on provision governance structure and guidance to the impairment committee / executive committee through the sign-off for the adoption of the new provisioning procedures (IFRS9 compliance policies and procedure) and through the technical requirements for implementation into software for automation.

Our projects are delivered with a high level of collaboration between clients and Principa to ensure a business focussed solution that will pass audit standards. It is also recommended to have key milestone checkpoints with the auditors such as to agree on the development principles.

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