It’s no secret that modern economies depend on cross-border transactions and the free flow of capital between countries. Right now, over a third of all financial transactions occur across international borders, and that figure is only expected to grow in the coming years. Companies are becoming more and more globalized: many businesses conduct their operations through subsidiaries in multiple countries, and stakeholders are also constantly looking for opportunities to diversify and invest across the world.
Without certain standards in place, though, these international activities would be too complicated to undertake, if not downright impossible. Before them, different countries would maintain their own standards for accounting languages, practices, and statements. The lack of consistency with regard to these requirements created a costly and overly complex system that also exposed companies and individual investors to a significant amount of risk.
For this reason, an independent non-profit organization called the International Financial Reporting Standards Foundation (IFRS Foundation) developed the International Financial Reporting Standards (IFRS), a single set of accounting standards that aim to regulate the way a company’s financial performance and position is described so that its financial statements are understandable and comparable across international borders. Currently, the IFRS Standards are required in over 140 jurisdictions, including countries in the European Union, Asia, and South America.
IFRS 9 is one of the standards that has had a major impact on banks and other financial institutions since its implementation in January 2018. Find out how a robust regulatory reporting software solution can help your business keep up with the changes it’s brought:
The new IFRS 9 standard specifies how entities are expected to classify and measure several factors. These include financial assets, liabilities, and some contracts to purchase or sell non-financial items, to name a few. It makes use of a forward-looking expected credit loss (ECL) model to calculate provisions. This is to address the issue of pro-cyclicality when provisioning calculations in the traditional manner.
The introduction of the standard brings about changes in five key areas: financial instrument classification, stage identification, provision calculation, credit modeling, and reporting.
Financial Instrument Classification
According to IFRS 9 guidelines, banks must classify all instruments into one of the following categories:
The classification will be made based on the contractual cash flow characteristics of the instrument as well as the business model for managing the product, making it both a qualitative and quantitative classification.
In terms of credit provisioning, this is one aspect of IFRS 9 that is entirely new. Put simply, stage identification means that banks must assign a specific stage for every account that has been classified under FVOCI or amortized cost. The assignment of the stage is based on the following credit risk characteristics:
When it comes to the calculation of items, IFRS9 provides comprehensive guidelines to follow. They include effective interest rate (EIR), credit-adjusted effective interest rate, effective interest spread (EIS), and expected credit loss (ECL). All are based on forward-looking assessments.
Banks will have to utilize a forward-looking approach when estimating point-in-time probability default (PD) and loss-given default (LGD) for provision calculations. They will also have to build and calibrate point-in-time models.
Banks will also need to be able to report and analyze point-in-time data, as well as trends in provisions evolution, across all accounts once they’ve begun to make all these calculations on an account level granularity.
IFRS 9 will have a major impact on a bank’s current processes and procedures. A modern and robust software solution should be able to calculate provisions as well as provide accurate reporting. All these will ensure compliance with the revised standards.
A state-of-the-art software solution will be able to aid banks and financial institutions in computing cash flows at an instrument level, the data from which can be used for provision calculations. It should also greatly simplify stage assessment with prebuilt rules and workflows that account for common assessment criteria. These include rating migration, days-past-due migration, industry classification, and PD migration.
In conclusion, with such a solution in place, banks and financial institutions should be able to foresee credit losses that may occur under different scenarios using data collected from other systems and then compute for the required provisions. These preconfigured methods of estimating loan loss provisions can help to ensure compliance with the regulations put forth by IFRS 9.
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