IFRS9: the impact on collections and recoveries for businesses
May 2016 | SPOTLIGHT | ACCOUNTING & FINANCE
Financier Worldwide Magazine
At this stage, most organisations are well on their way to coming up with a compliant solution for the new accounting standard IFRS9, which becomes mandatory on 1 January 2018. Management teams are also starting to understand the direct impact of IFRS9 to their profit and loss (P&L) and as a result, thought naturally leans toward the secondary impacts of the implementation of this regulation.
There are, of course, many secondary impacts to consider, both operational and financial, such as the opportunities for improved pricing or collections strategies and the use of forbearance, the implications of debt sales, the requirements for monitoring and validation of more sophisticated models and the impact on capital.
One of the most difficult impacts for a business to predict is the impact on collections strategy and performance and the knock-on effect that this could have on debt sales across the industry.
In terms of why IFRS9 make a difference, there are two main areas we should be thinking about: the relationship between collections activity and impairment and the value of existing portfolios when measured at Lifetime Expected Loss (LEL).
Relationship between collections and impairment
Traditionally, the relationship between collections and impairment is one way under IAS39. Collections activity can influence the severity of the loss and, in the best case, can return accounts to order. This impacts the impairment line in two ways: the amount recovered and the direct cost of collecting it.
The reason for this very one directional relationship is the way in which impairment is calculated currently under IAS39. It is estimated based on incurred loss, so a binary trigger event has to occur before a loss is recognised in the P&L. These binary events typically occur as a result of financial difficulty and manifest themselves as missed payments (delinquency) or help with payment schedules. Often, once these states are no longer applicable and the customer is back to paying their regular schedule, and are up to date, these assets are treated as performing and only a small amount of provision is held. This has no ongoing impact on the provision of that asset.
Under IFRS9, these binary measures are only used as back stops, either for entry to Stage 2 or entry to Stage 3 but critically a ‘cure’ period is expected, similar to that used in Internal Ratings Based (IRB) approach to indicate when an asset has not only got back up to date but is also not likely to re-default in the near future. How this is assessed is still up for debate but it does extend the period for being treated as Stage 3, even if the account is up to date; for example, if interest has been reduced or frozen on a credit card.
In addition to this, IFRS9 is an Expected Loss (EL) approach and places emphasis on monitoring the change in risk of default over the lifetime of the asset. If the change in risk of default is ‘significant’ you are required to move an account to Stage 2 and recognise lifetime losses, which can have a significant impact on your P&L. Most organisations are using their underlying scorecards as a base to this assessment, and most scorecards will factor previous defaults in the overall risk of default, so by applying forbearance, you not only commit to recognising assets in Stage 3 for longer but also increase the likelihood of remaining in Stage 2 for a period long after they have cured, recognising lifetime losses all through that period.
This raises the question: “Will this change the way an organisation treats early and pre-arrears customers?” It might if they believe that the majority of customers will cure without intervention and by applying early forbearance they disadvantage themselves by recognising lifetime losses unnecessarily early. This may have implications for customers that do rely on the help and support lenders provide, even if they do so reluctantly, which is unlikely to have been the intent of the standard and may not be viewed favourably by other regulators.
Debt sale and valuation
Another interesting consideration is the effect on valuation and pricing. Under IAS39 you only consider lifetime losses when the impairment event has already happened, so you only hold a small amount of provision for your entire up to date book. When you have to hold lifetime losses for a significant portion of this up to date book under IFRS9, organisations may find that some of these portfolios are no longer profitable, despite being regular payers. This situation is also exacerbated by the interplay between capital and impairment. Without going into too much detail, as a general rule, more capital resources will be required under IFRS9, which could lead to an increase in the cost of capital overall and certainly per pound lent.
This could lead to organisations wanting to push more performing debt out to the market. If this happens there will likely be lower returns for organisations, despite the debt purchasers buying better quality debt. There is a significant competitive advantage to being first to market with this and it will be interesting to see how organisations approach this.
How will this play out?
Whilst none of this is certain, it is definitely food for thought and IFRS9 won’t be the only consideration for lenders. Customer impact will definitely play a part and it is more than likely that the Financial Conduct Authority will be interested in the results.
Damien Burke is the head of regulatory practice at 4most Europe. He can be contacted on +44 (0)207 623 9337.
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