With only months to go to the live date of March 2018, IFRS 9 raises many issues. Banks are at various levels of preparation and face different challenges according to their size and experience. And the new regulation has significant knock-on effects beyond compliance.
Typically, banks will start with tactical measures to meet the deadline (Day 1), moving on to automation and embedding of processes (Day 2), with an end goal of capital optimization (Day 3). This will require a realignment of functions across the organization, including finance, risk and lines of business, and will bring greater awareness of credit risk into decision making.
Many smaller banks have left preparation late, even for the impairment rules. They often underestimated how many tentacles IFRS 9 has and how far they reach
The three-phased approach
The response to IFRS 9 will typically follow three phases. Day 1 is compliance – simply meeting the requirements by the deadline. Few banks will have comprehensive, fully developed systems in place by March 2018, so methods will be at least partly spreadsheet- and manual-based.
Day 2 is the automation of processes, replacing shortcuts and workarounds and embedding IFRS 9 in business-as-usual. This includes automating workflow around the classification of new deals, the response to credit events, and the staging of impairment. (Automation will be essential if the eventual goal of pre-deal estimation of risk and return and impact on capital is to be achieved.)
Day 3 – because of the impact of expected losses on capital requirements under the new regime, banks will be looking to optimize capital, which will require realignment and greater cooperation across the enterprise, including finance, risk and lines of business.
Preparation for compliance
The larger Tier 1 and 2 banks are generally better prepared for Day 1, especially in terms of the new rules on how impairment is handled. An issue that remains outstanding for some is embedding the required stress testing in credit risk modelling in a way that satisfies governance requirements.
Tier 1 and 2 banks have an advantage in that they mostly opted for the internal ratings-based (IRB) approach under Basel II and so are experienced in credit modelling.
They have had to reformulate their models from Basel II's through-the-cycle measurement of probability of default (PD), exposure at default (EAD) and loss-given-default (LGD) to point-in-time projections under IFRS 9. But this is easier than having to start credit modelling from scratch as banks taking the standardized approach under Basel II are have to do.
Many smaller banks have left preparation late, even for the impairment rules. They often underestimated how many tentacles IFRS 9 has and how far they reach. They now face significant Day 1 challenges in terms of managing data, putting processes and controls in place and creating the infrastructure to support compliance.
They will need to take a tactical approach initially, using spreadsheets and manual methods to meet the deadline, and then working towards more strategic solutions. On the plus side, because of their size, smaller banks can often get all the relevant people together in one room to address the issues.
Given the challenges, preparation timetables have slipped in many cases. With the focus on the hard elements such as data and calculations, many of the softer issues have not received full attention, such as systems of governance, the management information that the committees and meetings might need, and how to work with the business on new products and pricing.
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