Since the financial turmoil of 2007/08, regulators and standard setters have become increasingly aware of credit risk and credit risk valuation and never tire of publishing new standards and regulations. Over the next few years, several new requirements will become effective. To this end, I will be looking at these credit risk standards and how they affect financial institutions in a series of blogs. Implementation of some new requirements has already started. For efficiency reasons, it would be desirable to ensure consistency in implementation across all standards, if at all possible. An early start on analysing the new requirements and impacts is recommended because the devil is in the details.
It is all about credit risk
Financial institutions have started with (pre-)implementation work for the new IFRS 9 Financial Instruments standard, which replaces IAS 39 and which will become effective as of 1 January 2018. The standard consists of three parts, namely, a model for the classification and measurement of financial instruments, a forward-looking expected credit loss impairment model and a reformed approach for hedge accounting.
In association with this new standard, in February 2015 the Basel Committee published the consultation paper for the Guidance on accounting for expected credit losses. Comprising 11 principles, the guidance sets out the supervisory requirements on sound credit risk practices associated with the implementation and ongoing application of accounting standards that involve expected credit risk losses.
The Revisions to the standardised approach for credit risk were published for consultation in December 2014. The main objective is to reduce reliance on external credit ratings and to replace such with a number of risk drivers. The revisions should achieve more granularity in various risk profiles and thus reduce variability in risk-weighted assets.
The standard on Capital requirements for bank exposures to central counterparties was published in April 2014 and will apply as of 1 January 2017. In the meantime, the interim capital requirements will remain effective. Compared to the interim requirements, a new approach for determining the capital requirements for bank exposures to qualify central counterparties is now included. An explicit cap on the capital charges will apply for bank exposures to qualified central counterparties and the treatment for multi-level client structures is also specified.
Related to this standard is The standardised approach for measuring counterparty credit risk exposures, published in March 2014 and also effective as of 1 January 2017. The standard comprises a non-modelled standardised approach for the measurement of counterparty credit risk associated with OTC derivatives, exchange-traded derivatives and long settlement transactions. The new standard replaces all previous methods.
And finally, in July 2015 the Basel Committee published for consultation the Review of the credit valuation adjustment (CVA) risk framework. The objective is to include all risk factors relevant to CVA, not only the credit spread risk and associated CVA hedges. Additionally, convergences to the valuation practice under the accounting standards are targeted as is consistency with the Fundamental review of the trading book, the revision of the market risk framework. Consequently, instead of having a stand-alone CVA approach, the goal is to have an integrated view including the market risk framework.
What are the main changes?
Throughout this series of credit risk blogs, I will go more deeply into the details of the new requirements and changes. So, for the time being, I will only give a brief summary of the most important changes.
What all the new requirements have in common is that they aim for greater integration and a holistic view of the risks. The intention is that such risks will not be considered from a stand-alone perspective any longer. The new requirements will integrate more forward-looking elements and market risk drivers. In parallel, they seek more comparability by introducing standardised single calculation approaches.
Starting with IFRS 9 Impairment, the biggest change is to move to an expected credit loss model relying on the relative change in credit risk. If the credit risk increases, the expected credit loss over the whole lifetime has to be recognised.
Revisions to the standardised approach for credit risk aim at reducing the reliance on external credit ratings as used in the current standardised approach. These are replaced with a limited number of risk drivers. The goal is also to achieve better comparability to the internal rating-based approach with respect to definitions and treatment of similar exposures.
In the Capital requirements for bank exposures to central counterparties and The standardised approach for measuring counterparty credit risk exposures, single and standardised approaches are introduced replacing the various current methods.
Regarding CVA, the goal is to align the models and calculations with accounting practice and to integrate them into the new market risk framework in order to achieve a holistic view of CVA.
Who is affected?
Whereas IFRS 9 affects all companies that hold financial instruments, especially banks and insurance companies, the Basel Committee regulations only affect banks. While banks are looking for basic consistency in implementation of the IFRS 9 Impairment standard with the Basel Committee regulations, and wish to leverage as much as possible from there, the insurance companies are seeking consistency and leverage with the Solvency II framework. Nonetheless, the insurers are also looking at the Basel Committee regulations as they feel there is some implicit pressure on them to achieve more consistency where possible with the Basel Committee’s recommendations.
What actions are required?
Of course, becoming familiar with all the published and proposed standards and regulations as early as possible will be advantageous, however, performing a thorough analysis of differences and similarities of all the guidance, on the one hand, and a gap analysis on what already exists in your financial institution, on the other, is the obvious next step. My experience shows that the main challenge is to integrate the different perspectives and needs from risk, accounting, data and most crucially, IT systems, and to allocate sufficient time and staff to do that.
If you have any questions, please do not hesitate to contact me.