IFRS 9: Impact on Sri Lankan Banks - PowerPoint Presentation

1. IFRS 9: Impact on Sri Lankan BanksAugust 2014Sujeewa MudaligeManaging Partner - PwC

2. AgendaSlide 2IFRS 9 overviewExpected credit lossesChallenging times ahead

3. IFRS 9 Overview1IFRS 9: Financial InstrumentsSlide 3August

4. Timeline of IFRS 9Slide 4July 2014Final StandardNov 2009IASB issues IFRS 9 (2009) – classification and measurement of financial assetsOct 2010IASB issues IFRS 9 (2010) – financial liabilities and derecognitionNov 2013General Hedging amendments to IFRS92018Effective dateNov 2009IASB issues ED on impairmentJan 2011FASB and IASB issue supplementary document on impairmentMarch 2013IASB re-exposes impairment and issues limited amendments to IFRS 9 (2010)AugustIFRS 9: Financial Instruments

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

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

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

8. Slide 8It 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 MeasurementImpairmentHedge AccountingIFRS 9 – Key changesAugustIFRS 9: Financial InstrumentsThe largest impact is likely to be due to the new approach in measuring impairment

9. Key Highlights of IFRS 9Slide 9BackgroundIt will change the way banks book provisions on financial assets like loans and bonds. Key considerationsIFRS 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 provisionsIt 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!! Slide 10

11. SL Banks may have many challengesSlide 11

12. Impact on SL BanksSlide 12

13. Expected credit losses2IFRS 9: Financial InstrumentsSlide 13August

14. Slide 14IAS 39 vs IFRS 39

15. From incurred loss to expected loss modelSlide 15Incurred Loss• Used by IAS 39• An entity is not permitted to consider the effects of future expected lossesCredit losses recognised when an event has occurred that has a negative effect onfuture cash flows & theeffect can be reliablyestimatedExpected LossUsed by IFRS 9Requires earlierrecognition of creditlosses in many casesRequires an entity tomake an ongoingassessment of expectedcredit losses

16. Financial Assets - A principles based approachAugustIFRS 9: Financial InstrumentsSlide 16IAS 39 ClassificationRules basedComplex and difficult to applyMultiple impairment modelsComplicated re-classification rulesIFRS 9 ClassificationPrinciples basedClassification based on business model and the nature of the contractual cash flowsOne impairment modelBusiness model driven classification

17. Expected credit lossesGeneral modelSlide 17Effective interest on gross carrying amount12 month expected credit lossesRecognition of expected credit lossesInterest revenueChange in credit quality since initial recognitionStage 1Stage 2Stage 3Performing(Initial recognition*)Underperforming(Assets with significant increase in credit risk since initial recognition*)Non-performing(Credit impaired assets)Effective interest on gross carrying amountLifetime expected credit lossesEffective interest on amortised cost carrying amount Lifetime expected credit losses*Except for purchased or originated credit impaired assets

18. Lending landscape may changeAugustIFRS 9: Financial InstrumentsSlide 18

19. Changes in operating resultsExpected credit lossesGeneral modelSlide 19Changes in external market indicatorsChanges in credit ratingsChanges in internal price indicatorsChanges in businessOther qualitative inputs30 days past due rebuttable presumptionHowever….Information to take into account for assessment of increased credit risk

20. Lending landscape may changeTo 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 transitionBanks 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.AugustIFRS 9: Financial InstrumentsSlide 20

21. Expected credit losses (ECL)General modelOverview – Stage 1For 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.Slide 21AugustIFRS 9: Financial Instruments

22. Expected credit losses (ECL)General modelOverview – Stage 2When 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.Slide 22

23. Expected credit losses (ECL)General modelOverview – Stage 2Accounts 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.Slide 23

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.Slide 24

25. Expected credit losses (ECL)General modelOverview – Stage 2In 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.Slide 25

26. Expected credit losses (ECL)General modelOverview – Stage 2If 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. Slide 26

27. Expected credit losses (ECL)General modelOverviewBanks 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. Slide 27

28. IFRS 9 – Implementation projectsScope 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•Slide 28

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

30. Expected credit lossesDisclosuresAugustIFRS 9: Financial InstrumentsSlide 30QuantitativeQualitativeReconciliation of opening to closing amounts of loss allowance showing key drivers of changeWrite off, recovers and modificationsReconciliation of opening to closing amounts of gross carrying amounts showing key drivers of changeGross carrying amounts per credit risk gradeInputs, assumptions and estimation techniques for estimating ECLWrite off policies, modification policies and collateralInputs, assumptions and estimation techniques to determine significant increases in credit risk and defaultInputs, assumptions and techniques to determine credit impaired

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

32. IFRS 9 – Data requirementsSlide 32

33. Challenging times ahead3Slide 33

34. A silent revolution in banks’ business modelsWhat should banks do to get ahead??Adjusting portfolio strategy to prevent an increase in P&L volatilityRevising commercial policies as product economics and profitability changeReforming credit-management practices to prevent exposures from deterioratingRethinking deal origination to reflect changes in risk appetiteProviding new training and incentives to personnel to strengthen the commercial networkSlide 34(source:McKinsey)

35. Challenging times for SL Banks2018-2020Slide 35Factors to be considered?Basel IIINew Taxes ?S LBanksIFRS 9Debt RepaymentLevyNew IRA

36. Capital requirementsThe 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.Slide 36

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.Slide 37

38. Government providing USD24 billion. The banks are expected to raise the rest through, fresh equity issuance, Indian Government willing to accept a dilution of its ownership to 52%What is the Indian Government doing?USD 32 billion capital infusionIndianState Banks123Slide 38

39. Government willing to broad base ownership of BoC and PBSome licensed commercial banks have raised capital through rights issues in 2017Most banks would require to raise capital on an annual basis for the next 3-4 years.What are the SL banks doing?SL Banks123Slide 39Developments:

40. How much is enough?Slide 40BankEquity (Rs Mn)Debt (Rs Mn)RaisedProposedRaisedProposedHNB14,545    Com Bank10,143   Sampath7,602  *6,000 Seylan   **10,000 NTB 3,208     3,500* 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.