RiskTech Forum

Wolters Kluwer: The Year Ahead - Some Thoughts on IFRS and Other Regulatory Challenges

Posted: 24 January 2017  |  Author: Jeroen Van Doorsselaere  |  Source: Wolters Kluwer Financial Services

The pace of regulatory change shows no sign of abating in 2017.  And, as a result, it appears that regulatory technology, or RegTech, could well be a standout developmental theme for financial institutions in 2017. RegTech is devoted exclusively to compliance and related issues, such as risk analysis and management. One promising feature of the technology is that it should be able to work with existing systems since RegTech tends to be heavier on software than hardware. Such systems should keep institutions ahead of the game by allowing them to keep track of, and adjust to, new rules as soon as they are implemented.

But what are the regulatory changes that such firms need to be exploring and what will be the impact? Well, when it comes to CECL and IFRS 9 it’s fair to say the standards will impact P&L and capital requirements significantly, requiring financial institutions to combine credit risk modelling with a strengthened risk and finance process and the requirement to account for lifetime expected losses. Whilst IFRS 9 impacts Europe, South America, Canada and large parts of APAC, CECL is the guideline for expected loss in accounting within the US, Israel, Japan and other jurisdictions applying US GAAP. There is clearly a mismatch between the two standards, and this is the reason that the Basel committee is suggesting to defer the capital impact over several years. Although the shared objective of CECL and IFRS 9 is to offset the criticism of ‘too little too late’ (in reference to the fall-out from the financial crisis), the application is somehow different. This gives an additional challenge for institutions operating in different countries.

Closely related to this is the fact that the Basel committee, as well as the EBA, is looking to further revise the different credit risk frameworks. In 2016 the BCBS was relatively focussed on credit risk and credit risk forecasting, not only from an accounting perspective as within IFRS 9, but also for building a 2017 plan to make changes to the RWA calculations and credit risk standards.

For insurers, meanwhile, IFRS 17 is specifically designed to reshape insurance instruments by regulating the liability side, more closely aligning it with the asset side. It’s important firms also appreciate that there is a plenty of interaction with IFRS 9 which also hits the insurance sector. Both standards will have an impact on how the asset and liability side will be structured and measured and, for that matter, how this will take form in the more open disclosures of financial statements. This standard is, at least, set to be finalised by the IASB in the first half of this year.

Perhaps the biggest challenge, however, is not the regulation itself but the fact that financial institutions in general will need to deliver data in a more raw and detailed format and the fact they need to be sure that all their different regulatory obligations are delivered on time and in a consistent format. Take Anacredit for example. This regulation asks for detail line items of each contract for a set of transaction properties. Not only is that a challenge in itself, thanks to the sheer volume of work involved, it also exposes financial institutions’ raw data to the regulator.

Coping with increased regulatory demands

Financial institutions are now, of course, facing the mother of all questions. This is namely how to deal with reduced income from interest margins and fees, bad sentiment within the market and yet comply with mounting regulations. One thing for sure, not complying is not an option. Although almost everyone is talking about the cost of compliance, the cost of non-compliance seems to be forgotten.

In relation to IFRS 9 and CECL banks are particularly concerned about how to account for credit losses on their loan portfolios. With its emphasis on predicting credit losses, IFRS 9 is seen as an improvement on the traditional incurred-loss model, which only recognized losses after a default or other triggering event. CECL, meanwhile, is intended to make the same upgrade to the American method of accounting for credit risk, although it permits historical factors to retain a greater role in the process.

Preparing for and implementing IFRS 9, CECL and other procedures will compel firms to think about credit risk in new ways and to develop new models to account for it. As stated previously this will be particularly challenging for firms that operate across borders. Such a formidable undertaking will also require talking, not just thinking. Arguably, there is a strategic benefit for employing an integrated view of finance, risk and reporting to cope with the demands this new reality presents.

These new standards will, of course, affect banks’ regulatory capital ratios. And banks would be well advised to refocus their efforts to plan for the changes. Unfortunately, however, far too many banks are not yet prepared for implementation – and time is running out for them to start their projects (2018 for IFRS 9 and 2020 for CECL).

With IFRS 9, an increase in impairment depletes the capital adequacy of banks that use the Standardised approach to credit risk. This is because the 1:1 reduction in capital arising from increased impairments is not offset by reduced risk-weighted assets. However, the result is less obvious for those banks who use the internal ratings-based (IRB) approach. This reflects the more complicated interaction between impairment and the outcomes of the IRB capital formula.

Needless to say, impacts could be particularly notable in a stress, potentially necessitating additional capital to cover downturn impacts. To be blunt the only option is to prepare now.

Fundamentally, whether it’s with IFRS 9, CECL or regulations such as FRTB (The Fundamental Review of The Trading Book) or examining the impact of the IRRBB (Interest Rate Risk in the Banking Book), banks need to employ strategic planning across the enterprise, ideally taking into account an integrated view of their finance, risk and reporting obligations.  No matter what, it seems, 2017 will be a year of action….the cost of inaction is simply too great.