Why bank shareholders should care about credit risk

Business News of Monday, 2 October 2017

Source: citibusinessnews.com

2017-10-02

For most banks, loans are the largest and most obvious source of credit risk

A number of things will happen in 2018: Russia will be hosting the football/soccer world cup. It will be a century since the end of World War I. IFRS 9, the new standard for financial instruments will be applied,and in Ghana; Banks will be required to meet the new minimum Capital requirement of GHS 400 million.

For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Most major banking problems have been either explicitly or indirectly caused by weaknesses in credit risk management.

Severe credit losses in a banking system usually reflect simultaneous problems in several areas, such as concentrations of credits to single borrowers or counterparties, a group of connected counterparties, and sectors or industries, such as commercial real estate, and oil and gas, failures of due diligence and inadequate monitoring.

Taking the Banking industry as a whole, at the end of June 2017, the non-performing loans (NPL) in the banking industry was GH¢7.96 billion. The potential losses of the NPL loans with its potential impact on depositors money is the reason why the Bank of Ghana requires the Banking industry as a whole to increase its capital by approximately GH¢ 8 billion. If the capital increase is to help current expected losses in the banking industry NPL, then how to minimize NPL growth and loss is the main issue to be addressed.

The question that this article seeks to address is: Why should Banks in Ghana care more about sound credit risk practices preached by Basel Committee on Banking Supervision (BCBS) in its Publication 75 issued in September 2000 called Principles for the Management of Credit Risk and the International Financial Reporting Standards (IFRS) 9: Financial Instrument (IFRS 9) impairment principles which is based on sound credit risk practices.

Myjoyonline website on September 25, 2015 stated that the governor of Bank of Ghana (BOG) Dr. Addison recommended that Banks that cannot meet minimum capital requirement of GHS 400 million can apply for a Savings and Loans license. This means missing the minimum capital requirement is not the end of the world for your Bank. But when it comes to IFRS 9/credit risk, your Bank may cease to exist even in the Savings and Loans world.

Your Bank’s failure will not be due to IFRS 9 but because of business reasons such as poor credit quality, deficient credit risk assessment and measurement practices. So should IFRS 9 be on your 2018 agenda?Some say it is an accounting standard and so let’s leave IFRS 9 to the accountants and instead we should think of raising capitaland grow our banking business. The absence of IFRS 9 onsome Banks’ 2018 agenda can be deduced from these actions of the Bank:

– Lack of comprehensive IFRS 9 credit risk practices, systems and data gap analysis.

– IFRS 9 impact assessment postponed until or till close to the deadline.

The above behaviours shown in not taking IFRS 9 seriously is reflected in the following situations:

i. The practice within banks that requires accountants to compute IAS 39 impairments. In the mind of those banks;with credit losses being reflected on the financial statements; and financial statements being governed by accounting standards so the task should be done by accountants with minimal or no involvement from other stakeholders such as credit risk department/staff.

ii. In Banks’ capacity building for IFRS 9 through training programs despite the point made time and time again that impairment or credit provision is not an accounting exercise, many IFRS 9 trainings are flooded with accountants witha small number of participants from credit risk departments.

The questions on some accountants’minds at IFRS 9 training is this, how do you ensure consistency among banks regarding IFRS 9? The responses of participants at such credit risk trainings from accountants is this: we don’t price all customers in the same way because all customers don’t have the same risk profile and in reflecting current customers risk through provision/impairment we cannot be consistent in how to measure the potential credit loss for each type of customer that may fail to meet its credit commitments.

What some accountants fail to note is that IFRS 9 impairment principles are based on the economics of lending; in which expected credit losses are implicit in the initial pricing of a loan and subsequent changes in expected credit losses are economic losses (or gains) of the entity in the period in which they occur.

Accountants also miss the architect of the IFRS 9 impairment model : after the 2009 impairment exposure draft was deemed not operable due to lack of integration between the banking system ( system that calculates interest) and credit risk system ( system that computes credit risk) , the accounting board assembled credit experts to recommend the way forward.

It was the recommendations of the Expert Advisory Panel (EAP) and the Basel committee that form the basis of the current IFRS 9 impairment model. The fact that an accounting standard requires credit provision does not make it an accounting exercise. IFRS 9 strongly impactsrisk management and it is not an accounting exercise – it is about preparing your bank for future losses.

An area that can help Banks take IFRS 9 seriously is the enforcement mechanism by the regulator as well as clear direction of the regulator’s expectation. On April 25, 2016, Bank of Ghana (BoG) wrote to all Banks requesting them to perform IFRS 9 impact assessment using their 2016 financial statement numbers and send the assessment to BoG by end of June 2017.

The heading of the letter says “Adoption of IFRS on Impairment” but the body of the letter says IFRS 9 impact assessment. What I guess what is going to happen is most banks performing only impairment assessment and forgetting about classification and measurement and hedge account. Aside that, there was no requirement in the letterfor in-between/project progress communication between Banks and BoG on the impact assessment and IFRS 9 preparedness for 2018.

So imagine you go to school and you are told that at the end of the term/semester there will beexams but no home-work or quizzes expected to be completed.

In this scenario when do you expect students to start studying for the exams? If you are a lucky headmaster, your students will start studying for the exams a week before the exam date. In most instances, most students will start studying the night before the exams and be awake till the next day.

This is exactly what happened in the Banking industry in Ghana. In a letter dated May 30 2017, a month to the June 30 2017 deadline, the CFO network of the Ghana Association of Bankers wrote to BoG and said we are not ready with the IFRS impairment assessment (quietly they said we are thinking about capital) so please give us an extension to the end of September 2017. Guess what happened? BoG provided the extension, again with no communications in-between.

Guess what is going to happen at the end of today (September 29, 2017)? Some banks are going to ask for an extension or send some sub-standard product to BoG. This attitude of some banks can be prevented going forward through tough-love measures from the regulator.

Let me cut to the chase. IFRS 9 impairment provision is not an accounting issue, instead it is

– The detailed analysis of historical patterns and current trends toidentify the most relevant factors that affect the collectability of the loans(borrower-specific, facility specific, bank specific, macro-economic and environment factors collectively called credit risk drivers ).This analysis isbased on the linkage between credit risk and its drivers,

– Using the identified credit risk factors above to segment the bank portfolio into portfolio of similar credit risk features

– Using credit risk assessment and management processes of the Bankto detect well ahead of exposures becoming past due or delinquent and categorise segmented portfolio into performing , under-performing and defaulted loans based on current and forward looking information that affect collectability of the loan portfolios ;

– Incorporate relevant past , current and forward looking information that affect collectability of the loan portfolios to measure appropriately the credit risk inherent in the bank’s current portfolio using and

– Setting aside reservesto correspond to the credit risk inherent in current loan portfolio to cover any potential loss that may result from credit risk that exists in the portfolios.

IFRS 9 impairment requirements represent the biggest change to bank accounting ever. Don’t just think of IFRS 9 as an accounting change—but rather as a change to how all banks manage their business. IFRS 9 requires you to reserve a 12 month expected loss on day 1 when you first grant the credit/ loan.

If the credit quality has worsened on day 2 relative to day 1, you will have to increase your reserves to a life-time expected loss. I like to think of IAS 39 as recording the credit losses in a Bank’s portfolio and IFRS 9 as recording the credit risk in a Bank’s portfolio.

If you don’t have the right credit risk systems and processes, you are likely not to underwrite certain loans such as long term loans/risky loans that you may think be profitable to your business.

Your Bank’s refusal to underwrite such long term loans is because your Bank is scared that if on day 2 the credit quality of the facility has worsened relative to day 1, you will be forced to hold reserves for the full life of the credit which may be more than a year, further constraining your future ability to grant credit. When you have more information, you can better assess risk, allowing you to take on loans your competitors can’t accurately analyse. This will allow your Bank to grow.

Before IFRS 9, accounting rules forced banks to “wait” for a loss event before recording a loss against a loan asset. This was the case even when banks expected that a percentage of their loans would not be paid back in full.

When the downturn came they had to catch up by recording significantly larger losses all at once. The result was the heavy criticism of banks during the financial crisis for providing “too little too late”.

IFRS 9, expected credit loss (ECL) model, is the standard setter’s response to the financial crisis. Banks’ lending too much money to people who could not repay was one of the factors that fuelled the global financial crisis. Accounting, in particular the incurred loss model, was criticized for contributing to the crisis.

Incurred loss means you don’t book the loss until it happens. Expected credit loss means that that when each loan is made, the possibility that the loan will default in future economic conditions is given effect. ECL accelerates the recognition of bad loan losses.

Capital is designed as a buffer to protect depositors (and the tax payer) in a financial crisis. Capital measures might help an investor predict how the bank would fare in a crisis, but are not primarily designed for investors. Here are some of the reasons why Bankers in Ghana and their shareholders should care about IFRS 9/credit risk.

1. It provides useful information

IFRS 9 is designed to give useful information for investment decisions. It provides granular information relevant to assessing credit risk and forecasting profitability. An example is information about changes in credit risk over time; highly relevant to assessing the profitability of a loan. A bank expects some borrowers to default so it will include a credit spread in the interest rate charged. In a perfect world, the credit spread would cover the risk of default. The ‘excess’ interest paid by borrowers who don’t default, in theory, would cover the losses from those who do for a portfolio of loans.

A significant increase in a loan’s credit risk increases the risk that the expected losses on that loan are not covered by the borrower’s interest rate. IFRS 9 reflects this by increasing the credit loss (from a 12 month expected loss to a lifetime loss) and requiring more disclosures. Appropriate application of IFRS 9 will enable your Bank answer these credit risk performance questions on a day to day basis:

– What are the delinquency levels in the portfolio?

– Which products are performing well, and which are performing poorly?

– Which location/ geographies are performing well, and which are performing poorly?

– Which business units are performing well, and which are performing poorly?

– Which vintages are performing well, and which are performing poorly?

– How much of the portfolio is rolling from one delinquency bucket to the next?

– What are credit scores throughout the portfolio?

– Which starting credit rating are rolling into default and at what point do they roll into default?

How many new loans are being originated, and with what characteristics?

– Are write-offs rising or falling, and is one product type or geography experiencing more write-offs than another?

– Are receivables, delinquencies and write -offs in-line with forecasts for these metrics?

– How is the portfolio performing on such metrics as probability of default, loss given default and exposure at default?

2. It encourages good banking behaviour

The impact of IFRS 9 goes beyond accounting. A bank that does a thorough implementation of IFRS 9 will need to generate new data and new models for measuring credit risk. And the old adage ‘what gets measured gets managed’ kicks in. This new information, if used to manage credit risk, is likely to influence how a bank behaves.

The bank may take credit risk management actions earlier or may adjust the pricing or other terms of some loans or may even cease to sell some products.

IFRS 9 was introduced to help investors understand the risks a bank faces. It’s high time for investors and Bank management to pay attention to IFRS 9 implementation and its impact on the business model and how to effectively manage capital.

While it is equally important to give attention to raising capital to meet the new minimum regulatory requirement, analysts and shareholders reviewing the performance of banks should give consideration to other factors beyond the fact that a bank has met the new capital requirement. These factors and the analysis that is important are explained in the paragraphs that follow.

Customer relations

Today we look at delinquent customers and ask, which ones do I want to keep? That question is going to change in two major ways under IFRS 9.

First, if a customer is in Status 2 or 3, curing them doesn’t change their status. They still represent a higher risk, and you’re still going to be paying lifetime impairments on them. So you have to ask, what is the cost of keeping them on the books? Unless you can make a case for why their actual risk status has changed (rebuttable), they’re still going to be expensive. Banks are going to need to get forensic with treatment analytics and decisions. Who you keep and why is now far more complicated.

That brings me to the second big change here: You may find yourself in the position of saying goodbye to customers you just cured. That makes it tricky for collectors – what can you tell customers about their near-term relationship with the Bank once they cure? It will be a communications headache for customer relations. At some point, regulators will probably have something to say about this too.

And then, if you are going to be exiting “good” customers, who will you sell them to? When? And at what cost? Will debt purchasers understand how to price these accounts? Will your current debt collection agencies have the capacity to handle more accounts from you? Will they want to work the low-performing debt or performing debt?

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