OREANDA-NEWS. September 14, 2015. The introduction of International Financial Reporting Standard (IFRS) 9 will mark a considerable change in the way banks account for credit losses. It will likely dent bank capital significantly and probably add volatility to earnings and regulatory capital ratios, says Fitch Ratings. However, it is too early to estimate the full impact that IFRS 9 introduction will have on individual banks or for the industry as a whole.

IFRS 9 requires banks to switch to recognising and providing for expected credit losses (ECL) on loans, rather than the current practice under IAS 39 of providing only when losses are incurred. It comes into effect in January 2018 and, as well as introducing ECL provisions, will change the way banks account for a wide range of financial assets.

Disclosure about the process and assumptions made for ECL calculations will be paramount for investors' understanding of a bank's financial position. A loan's ECL will be calculated differently depending on a bank's risk assessment of the loan during its life and will vary among banks. Preparation for applying the standard requires the development of complex models and data collection so that the final loan numbers reported on banks' balance sheets under IFRS 9 will be subjective. Reporting of loans across banks will be more inconsistent than is currently the case.

There is a three-stage approach to ECL calculations under IFRS 9. The least predictable is the second stage and we think this could result in substantial additional impairment charges and high volatility at some banks. The second stage will apply to loans that experience a 'significant increase' in credit risk and ECL is then calculated on a lifetime rather than a 12-month basis. Banks are working through numerous scenarios to establish a framework for identifying when a 'significant increase' (as they define it) has occurred. They then need to derive lifetime losses prior to impairment, including assumptions for example on revolving loans or those with no fixed maturity, such as overdrafts and credit cards.

Banks are required to determine whether there has been a 'significant increase' in credit risk on any loan that is not considered low risk when collateral is excluded. This could result in a surge in impairment charges on long-term secured lending, such as retail mortgage books because historic data provided to Fitch by many of the banks we rate shows that most mid- to long-term loans that experience repayment problems do not default in Year 1. Volatility in transferring between 12-month and lifetime losses will work both ways because a loan can also transfer back into stage one, which would trigger a provision reversal.

Loans in stage one (when a loan is first made or acquired, remains low risk or has not seen a significant increase in credit risk) will trigger a capital hit when IFRS 9 is first applied because the standard requires 12-month ECL to be deducted for all loans. The third stage captures loans considered to be credit-impaired, which banks are already reserving so we would not expect any notable impact from the transition to IFRS 9 from these loans. On an ongoing basis, loan loss provisions are likely to be higher than in the past because ECL provisions will be a function of loan growth rather than incurred impairment; this will be especially true for banks experiencing rapid loan growth.

It is unclear whether regulatory capital calculations or ratio expectations will be adjusted to allow for the more conservative loan reporting under IFRS 9. The 12-month ECL concept is a familiar one for banks applying internal risk-based models to calculate risk-weighted assets for regulatory reporting. However, there are important differences, for example for regulatory 12-month ECL, the 12-month PD is multiplied by 12-month LGD but IFRS 9 requires lifetime LGD.