IFRS 9 ECL calculation after a contractual modification

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JakobLavrod
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IFRS 9 ECL calculation after a contractual modification

Post by JakobLavrod »

Hi!

I would be interested in hearing what you members in this Forum think about the interaction between the rules for contractual modification and ECL calculation in IFRS 9.

A specific example: A loan of 100 CU with eir = 10 % and payment at the end of each year, with a maturity of 15 years, is issued from bank A to customer C. At the end of year 2, customer C gets an offer from bank B of refinancing with eir = 5 %, and to avoid losing the customer, bank A decides to match the offer. Today, we do not view this as a substantial modification (as we have understood, the 10 % test of present value is meant to be used for liabilities and not assets).

The gross balance of the original loan is 90.5 CU at the end of year 2. If the new negotiated cash flows for the remainder of the loan are discounted using the initial interest rate, one gets 68.4 CU. Should the gross balance be adjusted, taking a loss of 22.1 CU in PnL?

If so, how should this change the ECL calculations? The standard method is to compute the ECL as PD x EAD x LGD. However, assume, for example, that the loan started going delinquent shortly after the modification. Legally, we can try to collect 90.5 CU rather than 68.4 CU. Since ECL should be the difference between the contractual cash flow and the cash flow expected to be collected, should one then adjust that the loss of 22.1 CU already taken serves as an extra "pillow" that will absorb losses?

Thanks in advance for the help in better understanding this matter. :D
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Marek Muc
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Re: IFRS 9 ECL calculation after a contractual modification

Post by Marek Muc »

Hi, yes, you need to recognise a one-off loss immediately in P/L:

https://ifrscommunity.com/knowledge-bas ... cash-flows

I don't think you can offset that loss with an impairment 'gain'. There are probably a few ways to arrive at this conclusion. I offer this one: ECL is the difference between contractual cash flows and cash flows expected to be received discounted using EIR. In your case, as I understand, this difference is negligible and thus so are ECL.
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Re: IFRS 9 ECL calculation after a contractual modification

Post by JakobLavrod »

Hi!

Thank you for the response Marek!
Using typical numbers, we would expect a PD12 of around 4 % and LGD = 50 %. If the instrument is assumed to be in stage 1, the 1 year PD would then just be (since the payments are yearly), 4 % x 90.5 x 50 % = 1.8 CU. While this number is small compared to the loss of 22.1, the sheer size of the portfolio means that the amount is material (in fact my job is working with how to calculate these numbers).

How would you then go about in a situation where the ECL cannot be neglected? Should one look at the recovery on the contractual amount to get something like (since the recovery indirectly determines what contractual cash-flows cannot be recovered): LGD_adjusted = 1 - (1 - LGD)*(contractual balance / gross balance) = 33.8 %, hence ECL = 4 % x 68.4 x 33.8 % = 0.9 CU
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Re: IFRS 9 ECL calculation after a contractual modification

Post by Marek Muc »

If I understand correctly, the expected cash shortfall, and hence the ECL, amounts to 1.8 CU
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Re: IFRS 9 ECL calculation after a contractual modification

Post by Marek Muc »

Ok but then you need to somehow take into account the fact that amortised cost is below the contactual cash flows. I don't have time to check your math, but it seems that 0.9 is too low compared to 1.8. What's your rationale?
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Re: IFRS 9 ECL calculation after a contractual modification

Post by JakobLavrod »

Thank you for the response!

The rationale for the 0.9 CU is as follows (please do not hesitate to point out if there are any flaws you see in the argument):

Right after the modification, the contractual balance is still 90.5, that is the amount we can go after the customer to try to collect (since the modification to the balance is due to the accounting treatment, not that we do not have any legal right to the balance in case of a default event). The ability to collect is 1 - LGD = 50 %. Hence within a year, if the customer default, we would be able to get back 90.5 CU x 50 % = 45.3 CU. If the customer default, the exposure at default will be 68.4 CU (the balance after the modification). Hence the shortfall will be 68.4 CU - 45.3 CU = 23.2 CU. The probability of default is 4 %, hence ECL = 4 % x 23.2 CU = 0.9 CU

The way I understand this is that the fact that we carry out the modification, but still can come after the original balance itself means that the loan becomes "collateralized" by its own modification which lowers the LGD from 50 % to 33.8 % (as can be seen in the calculations in my previous post). This effect will be reduced as time goes along due to the two amounts catching up to each other, however, so the effect is most clearly seen here.

Thanks in advance for the help!
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Re: IFRS 9 ECL calculation after a contractual modification

Post by Marek Muc »

Makes sense to me! :)
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Re: IFRS 9 ECL calculation after a contractual modification

Post by JakobLavrod »

Thanks a lot for the help in better understanding the matter! :D :D
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