Fair value of a loan commitment with below market interest rate

[hubertd]

Hi Everyone,

According to IFRS 9 loan commitments below market interest rates are within the scope of the standard and should initially be recognised at fair value. Does anybody know what the fair value of the loan commitment would be? Is it the present value of the commitments fees, similar to how fair value of the financial guarantee liability is calculated as present value of the fee premiums?

[Marek Muc]

You need to reflect the difference between committed and market rates, similarly to initial recognition accounting as illustrated here: https://ifrscommunity.com/knowledge-bas ... ate-loans/

[hubertd]

This illustration is for a loan below market interest rates not for loan commitment and I'm a lender not a borrower as it is the case in the illustration. Fair value of loan commitment is not equal to fair value of the loan to be provided (similarly to fair value of financial guarantee not being equal to fair value of the guaranteed debt).

[JakobLavrod]

So I guess the first question here is why the loan commitment is not at given at fair value? Secondly, what information is available. One could go all they way down to level 3, making some form of discounted cash flow analysis (also adjusting for the optionality in the agreement), but the simplest is if there are other market players giving similar instruments, and start from these.

[Marek Muc]

I didn't say the approach would be identical...

[hubertd]

It’s not only not identical but completely irrelevant to be honest and I was just looking for an informed answer.

[Marek Muc]

Why do you think it's irrelevant to determine the fair value of a below-market loan commitment based on the difference between the fair value of a loan issued at market rate and a loan at the committed below-market rate? What's the approach that you have in mind?

[hubertd]

Sorry for being a bit brash Marek. I think I’ve worked it out now. Not easy to find the right answer within ifrs I need to admit.. I’ll put it all here hopefully tomorrow. I’m a bit in a hurry right now.

[DJP]

How to fair value a loan commitment is not an accounting/IFRS question.

But in any case, Marek's point makes sense. If you can fair value a loan commitment at inception, you should be able to fair value the loan commitment at any point in time. Basically, at the reporting date, you will have to determine the commitment fee that you would charge if you were to provide a new commitment at that date. Most of the value should come from the expected credit loss and discounting effect.

[Marek Muc]

Thanks DJP for sharing your views! Can't wait to hear what hubertd comes up with

PS. I've edited the topic title to specify that it relates to fair value

[hubertd]

Some loans f.e infrastructure project loans have long drawdown profiles and commitment fees are payable as long as there's still some commitment not utilised. I have quite a lot of loan commitments for which commitment fees are payable on quarterly basis. Obviously most loan commitments are scoped out of IFRS 9 and we only recognise ECL for them. Loan commitments below market interest rates (or net cash settled) are however in scope of IFRS 9 and are to be initially recognised at fair value. Fair value of the loan commitment is the present value of the commitment fees receivable (similar to fair value of the financial guarantee which is present value of the guarantee fees).

IFRS9.BCZ2.8 clarifies for subsequent measurement that: "IFRS 9 requires that an issuer of a loan commitment to provide a loan at a below-market interest rate must measure it at the higher of (a) the amount of the loss allowance determined in accordance with Section 5.5 of that Standard and (b) the amount initially recognised less, when appropriate, the cumulative amount of income recognised in accordance with the principle of IFRS 15.

Once the loan commitment becomes a loan and ends up as an asset on the balance sheet then the fair value of the loan needs to be calculated as a difference between market and concessionary rate lending and loan recognised at fair value with difference between nominal and fair value handled in line with IFRS9.B5.1.2A or as explained in Marek's materials if it relates to related party loans.

[Marek Muc]

Fair value of the loan commitment is the present value of the commitment fees receivable.

Say a loan commitment is for $100 million over 5 years at an interest rate of 1%, compared to the typical market rate of 5%. The commitment fee is symbolically set at $1. Is the fair value of this commitment realistically $1(I'm ignoring discounting for simplicity)

[JakobLavrod]

So in this case of the 1 dollar fee, should one rather recognize the the amount of the loss allowance determined in accordance with Section 5.5 of that Standard?

[hubertd]

I have billions in loan commitments and we’re charging a market standard 35% of the applicable margin as a commitment fee. Why would anybody set a symbolic commitment fee? It’s a product that is priced appropriately in practice, not given away free of charge.

[Marek Muc]

@Jakob The initial recognition is at fair value. It's the *subsequent* measurement that is at the higher of ECL and the amount initially recognised.

[Marek Muc]

@ hubertd: So in the scenario that I outlined, what would be your commitment fee?

[hubertd]

Assuming 1% is a fixed rate I would need to split it into fixed benchmark and a margin. Let’s say it’s 50:50. In such a case we would charge 35% of 0.5% so 0.175% as commitment fee annualised on undrawn amounts.

[Marek Muc]

How do you factor in the fair value when the loan commitment is at a below-market interest rate? It looks like you're only considering the actual interest rate and not how it compares to the market rates.

[hubertd]

It doesn’t need to be factored in. The difference is between no requirement to recognise a loan commitment at market interest rate at all (out of scope of IFRS 9 apart from ECL) and recognising below market rate loan commitment as a liability at fair value. I only use market rates to discount commitment fees to present value.

[Marek Muc]

That's not a fair value of the loan commitment I'm afraid. See https://ifrscommunity.com/knowledge-bas ... framework/

[hubertd]

It exactly is the fair value of a loan commitment and we’re happy with our accounting now.

Taking your example of $100m loan commitment with a market interest rate of 5% and underlying loan rate of 1%, how in your view would a fair value of a loan commitment be calculated?

[JakobLavrod]

@Jakob The initial recognition is at fair value. It's the *subsequent* measurement that is at the higher of ECL and the amount initially recognised.

Good point Marek, I am aware the standard mentions this. My point is rather that in absence of other information, would not rather the ECL also be quite close to what we want to compute for fair value. Or another way, in the absence of any income to work with, one rather value the liability based on the future cash flows required (credit losses). Potentially, the EIR then become the leaver one uses to make it fair value.

or am I thinking about the problem the wrong way?

[Marek Muc]

Taking your example of $100m loan commitment with a market interest rate of 5% and underlying loan rate of 1%, how in your view would a fair value of a loan commitment be calculated?

I believe I explained it in my previous posts.

It exactly is the fair value of a loan commitment and we’re happy with our accounting now.

If you're okay with a fair value that doesn't take into account the main feature – the committed loan being at a below-market interest rate – then I've got nothing else to ask

[hubertd]

You explained how a loan below market interest rate is valued not a loan commitment. These are completely different products. You seem to be mixing these two separate instruments up. Fair value of the loan commitment is the consideration received which are commitment fees or their present value if received over time.

[Marek Muc]

Let's return to my scenario then: a parent commits to providing their subsidiary with a 5-year loan of $100 million. This loan has an interest rate of 1% per annum, compared to a market rate of 5% (taking credit profile etc into account). The commitment fee is symbolically set at $1. Are you saying that the fair value of this commitment is $1?

[hubertd]

We’re charging commercial rates as commitment fees not ‚symbolic’ amounts but can imagine this could happen between related parties. And yes this dollar is a fair value of the loan commitment as then a separate product to provide a loan, which a loan commitment is, is given away basically free of charge. The underlying loan valuation will be a separate calculation and recognition of course.

[Marek Muc]

So in my scenario, your opinion is that a third party would be willing to assume the obligation to provide this below market interest rate loan for just $1?

[hubertd]

If there’s no market as it’s between a parent and subsidiary 3rd party consideration is a mute point. If there is a market fair value of such a loan commitment would be present value of fees priced at market rates.

[Marek Muc]

In fact, the key to determining fair value is considering what a third party would pay or expect to be paid, even if there's no market for it: https://ifrscommunity.com/knowledge-bas ... framework/

[hubertd]

That’s been a long debate. Not the easiest one to come to the firm conclusions with. Thanks for the engagement, Marek.