IFRS 9 Lifetime ECL

All topics related to IFRS Standards.
Post Reply
Arthur Dania
Posts: 2
Joined: 31 Jan 2023, 23:22

IFRS 9 Lifetime ECL

Post by Arthur Dania »

All,

I'm having a dispute with an external auditor and bank on a IFRS 9 implementation project. It regards the definition of the Lifetime ECL.

My Approach
Lifetime ECL is calculated based on the gross carrying (outstanding balance including accrued interest) till the contract maturity date. I basically want to use the contractual cash shortfalls to maturity, discounted by the EIR as the EAD. The EAD is subsequently multiplied by the PD and the LGD to get the ECL.

Auditor/ Bank Approach
Lifetime ECL is calculated based on the outstanding exposure amount including accrued interest at reporting date. In other words, the auditor and the bank indicates that they cannot loose more than what is currently outstanding in their books. Subsequently they also multiply the PD with the LGD and EAD to get the Lifetime ECL.

The differences between the two approaches are obviously huge and as the one takes into account cash short fall and the other doesn't.

What are your thoughts on the above? and what is correct?
DJP
Trusted Expert
Posts: 345
Joined: 26 Jun 2020, 15:57

Re: IFRS 9 Lifetime ECL

Post by DJP »

Hi,

The auditor/bank approach is correct.

The EAD should be based on contractual cash flows. For simple instruments, this is basically the contractual cash flows discounted back to the reporting date. (EAD is a bit more tricky to determine if we are talking about unutilised committed credit facilities).

The PD is an estimate of the likelihood (%) of the counterparty going into default.

The LGD is an esimate of how much you will lose (%) should your counterparty go into default (here you will take into considerations guarantees that you may have).

ECL = PD x LGD x EAD

In your approach, you are considering cash shortfalls to determine your EAD. If you do so, you are basically estimating your future cash flows. If you then compare those cash flows to your contractual casflows and discount everything back to the reporting date, you should get your impairment loss (and this methodology is also correct and should provide a very similar result to the auditor/bank's approach). However, it doesn't make sense to multiply your estimated future cash flows (considering cash shortfalls) by a PD and LGD, because in that case you will be double counting expected losses.

Hope this helps.
Arthur Dania
Posts: 2
Joined: 31 Jan 2023, 23:22

Re: IFRS 9 Lifetime ECL

Post by Arthur Dania »

Hi DJ,

Thanks for your swift reply, I truly appreciate your feedback.

I do have a follow-up questions when it regards simple loans in stage 3. Should the EAD amount include the accrued interest for the remainder of the contract discounted back to reporting date?
DJP
Trusted Expert
Posts: 345
Joined: 26 Jun 2020, 15:57

Re: IFRS 9 Lifetime ECL

Post by DJP »

Yes, it should. Because what you are comparing is what you should get back with what you expect to get back.

Note however that in level 3 it doesn't make much sense to talk about "exposure at default". In level 3 you are already in default, and what you do is apply the good old "incurred loss model" where you compare your outstanding balance with the future expected cash flows discounted at the original EIR.
User avatar
JakobLavrod
Trusted Expert
Posts: 190
Joined: 15 Apr 2022, 17:11
Location: Stockholm
Contact:

Re: IFRS 9 Lifetime ECL

Post by JakobLavrod »

Hi!

I struggle a little to follow, but if we take the example of a loan, I hope that how I view the matter is easier to explain.

Assume you have given out a loan of 100 000 with monthly payments, APR = 12 % and 10 years duration. The customer will then pay 1435 per month. In order to compute the lifetime ECL, I would first make a forecast of the probability to go to default for each month, p1, p2, p3,...,p120 (since we have 120 month of tenure). PD_lifetime = p1 + p2 + p3... + p120. EAD is given by first computing the default balance at each of the future month. To do this, assume that the account pays as contractual until 3m before the default (since default is 90 days) and then assumes no payment and the loan just accures interest for the 3m of delinquency (this is a bit of simplification as customers can go in and out of delinquency but often works quite nice). This calculations gives you the EAD for the different month: EAD1, EAD2, ..., EAD120. To get the EAD parameter, compute a weighted and discounted average: EAD = EAD1*p1/(1 + EIR)^(1/12) + EAD2*p2/(1 + EIR)^(2/12) + EAD3*p3/(1 + EIR)^(3/12) + ...

Hence notice for this calculation that EAD can be considerably smaller then outstanding amount most of the risk is far into the future. Caping EAD at current balance can therefore could lead to overestimating the EAD.

Hope that makes it more clear :D

Also, for stage 3, your only accure interest on the gross balance - ECL
IFRS 9 Impairment Specialist
Risk Control at Svenska Handelsbanken
Post Reply