Gabriel Ryan, FRM on LinkedIn: Merton-Vasicek Model for IFRS 9. The Merton-Vasicek default probability… | 84 comments (2024)

The steps are accurate and clear.

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Very useful information here..

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IFRS 9 Impairment RequirementsIFRS 9 mandates the recognition of impairment losses on a forward-looking basis, thereby recognizing impairment loss prior to any credit event occurring. These losses are known as expected credit losses (ECL).The IFRS 9 impairment requirements apply to:Assets measured at amortized costAssets measured at FVOCI with recyclingLoan commitments (not at FVTPL)Financial guarantee contracts (not at FVTPL)Lease receivables (IFRS 16)Contract assets (IFRS 15)Approaches to Recognizing ImpairmentIFRS 9 sets out three distinctive approaches to recognizing impairment:General Approach:Follows a three-stage model, also known as the three-bucket model. In this approach, an entity recognizes either 12-month ECL or lifetime ECL, based on whether there has been a significant increase in credit risk.Simplified Approach: Applicable to certain trade receivables, contract assets and lease receivables. Entities aren’t required to monitor changes in the credit risk of financial assets. Instead, lifetime ECL are recorded from the date of initial recognition of a financial asset.Specific Approach: For purchased or originated credit-impaired financial assets (often abbreviated as ‘POCI’ assets). For such assets, an entity only recognizes the cumulative changes in lifetime ECL since the initial recognition of the asset.In summary, IFRS 9 provides guidelines for the calculation of impairment of financial instruments. It sets out three approaches for recognizing impairment: General approach, Simplified approach, and Specific approach. Each approach has its own set of rules and requirements for recognizing impairment losses. This ensures that financial instruments are accurately valued and that any potential losses are accounted for in a timely manner.#ifrs9 #impairment

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Demystifying Concept Of ‘Exposure At Default’ In Measurement Of Expected Credit Loss Under IFRS 9Exposure at Default (EAD) is an estimate of a bank’s exposure to its counterparty at the time of default. While the relevance of EAD in assessing ECL is obvious, estimating EAD is less so. In practice, the estimation of EAD relates to payment terms, tenure of exposure and the point of time at which default is expected, or actually occurs. For defaulted accounts, EAD is simply the amount outstanding at the point of default. However, for performing accounts, the following elements are needed for computation of EAD under IFRS 9 at the instrument/facility level:1️⃣ Time horizon over which EAD needs to be estimated2️⃣ Projected cash flows till the estimated default point3️⃣ Residual maturity4️⃣ Deterministic or non-deterministic nature of the payment terms5️⃣ Forward looking macroeconomic scenariosIFRS 9 guidelines suggest a need to incorporate forward-looking perspective for computation of ECL and EAD. The forward-looking factors prepayment, drawdown factor or credit conversion factor (CCF) - vary as per facility type, and depends upon the contract terms as well as business practices of the financial institution. The uncertainty associated with prepayment and CCF also adds a layer of complexity around maturity of the facility, as the prepayment reduces the effective maturity of the facility, and eventually the CCF impacts the payment term structures. This dependency can best be explained by considering examples of different facility types.🔷Loan Equivalent Exposure (LEQ) is defined as the change in the amount of drawn portion of exposure as a percentage of undrawn commitment. Thus, LEQ is a measure applied on entire off-balance sheet exposure. 🔷 CCF is defined as the exposure including undrawn portion at the time of default as a percentage of current drawn portion of total exposure. Thus, CCF is a measure applied on on-balance sheet exposure. The LEQ factor varies from 0% to 100%, whereas CCF is generally closer to 100%.EAD = Outstanding Exposure + LEQ x Undrawn Exposure .EAD = CCF x Outstanding Exposure Computation of EAD under revolving facilities like credit cards requires estimation of CCF on unutilised credit limit and definition of maturity of the facility. A contract’s exposure usually coincides with its outstanding balance, although this is not always the case. For example, for products with explicit limits, such as cards or credit lines, exposure should include the potential increase in the balance from a reference date to the time of default.The main difference between loss given default (LGD) and EAD is that LGD takes into consideration any recovery on the default. For this reason, EAD is the more conservative measurement as it is the higher figure.Thanks for reading…

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IFRS 9 : Identification Of “Significant Increase In Credit Risk” In Proposed Expected Credit Loss Model In The BanksThe expected credit loss approach in IFRS 9 introduces a dual credit loss measurement approach : whereby the loss allowance is measured:i) at an amount equal to the 12 month expected credit losses for those financial assets where there is no significant increase in credit risk since initial recognition. [ stage 1 : Performing]. For such assets, the interest income is calculated on the gross carrying amount of the financial asset. ii) at an amount equal to the lifetime expected credit losses for those assets where a “significant increase in credit risk” has been noticed. [ Stage 2 : Under-performing]. For such assets , the interest income is calculated on the gross carrying amount of the financial asset. iii) at an amount equal to the lifetime expected credit losses for those financial assets which have become impaired. [ Stage 3 : Impaired/Non-performing]. For such assets, the interest income, however, is recognised on the net carrying amount of the financial asset.◼️ Meaning Of 12 Month ECL12 month ECL is the portion of lifetime ECLs associated with the possibility of a loan defaulting in the next 12 months. It is not the expected cash shortfalls over the next 12 months but the effect of the entire credit loss on a loan over its lifetime, weighted by the probability that this loss will occur in the next 12 months.◼️ Meaning Of Lifetime ECLLifetime ECLs are an expected present value measure of losses that arise if a borrower defaults on its obligation throughout the life of the loan. They are the weighted average credit losses with the probability of default as the weight. 🟦 Definition Of Significant Increase In Credit Risk (SICR)SICR is a significant change in the estimated default risk over the remaining expected life of the financial instrument at each reporting date.🟦 Identification Of SICR In ECL ModelIn determining whether there is a significant increase in credit risk or not, following details to be analysed relating to the asset/receivable account which is under consideration for ECL:1️⃣ Any fluctuations with respect to external market indicators such as cost of debt or equity2️⃣ Existence of any adverse changes in operational/economic situations3️⃣ Any fluctuations with respect to internal value indicators including negative changes in credit rating4️⃣ Fluctuations in the market value of the collateral held or changes in the repayment pattern5️⃣ Defaults in payments6️⃣ Financial assets with a low credit risk would not meet the lifetime ECL criterion. An entity shall not recognise lifetime ECL for financial assets that are equivalent to 'investment grade', viz the asset has a low risk of default.7️⃣There is a rebuttable presumption that credit risk has increased significantly when contractual payments are more than 30 days past due. (Lifetime ECL criteria)Thanks for reading…

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IFRS 9 : Expected Credit Loss Model : A Best Model For Provisioning For Impaired Assets In The Banks In contrast to recognition of credit losses based on actual deterioration of financial assets under the extant “Incurred Loss Model”, IFRS 9 requires that credit losses on financial assets are measured and recognised using the 'expected credit loss (ECL) approach. ECLs are classified into (i) 12-month ECL and (ii) lifetime ECLs. 12 month ECLs are those that result from default events that are possible within 12 months after the reporting date. Lifetime ECLs are those that result from all possible default events over the expected life of a financial instrument.Under the IFRS 9, it is no longer necessary for a loss event to have occurred but instead an entity is required to account for ECLs on initial recognition of the financial asset & then separately account for changes in the ECL at each reporting date. Therefore, the impairment of financial assets is recognised in stages:Stage 1️⃣ [Performing]As soon as a financial instrument is originated or purchased, a 12-month ECL is recognised in profit or loss and a loss allowance is established (may be nil). For financial assets, interest revenue is calculated on the gross carrying amount (ie without deduction for ECLs).Stage 2️⃣ [ Under Performing ]At each reporting date, the ECL is remeasured:➡️ If the credit risk has not increased significantly, continue to recognise a 12 month ECL. The calculation of interest revenue is the same as for Stage 1.➡️ If the credit risk increases significantly and is not considered low, full lifetime ECLs are recognised in profit or loss. The calculation of interest revenue is the same as for Stage 1.Stage 3️⃣ [Non-Performing]If the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated based on the amortised cost. Financial assets in this stage will generally be assessed individually. Lifetime ECLs are recognised on these financial assets.🟦 Assessment Of Significant Increase In Credit RiskThe assessment of significant increases in credit risk can be performed on a collective basis, rather than on an individual basis, if the financial instruments share the same risk characteristics. However if any assets are deemed credit impaired they will generally be assessed on an individual basis. Financial assets with a low credit risk would not meet the lifetime ECL criterion. An entity does not recognise lifetime ECL for financial assets that are equivalent to 'investment grade', which means that the asset has a low risk of default.There is a rebuttable presumption that lifetime expected losses should be provided for if contractual cash flows are more than 30 days overdue. If the credit quality subsequently improves and the lifetime ECL criterion is no longer met, the credit loss reverts back to a 12-month ECL basis. Thanks for reading….

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Thanks for sharing and it’s worth reading on IFRS9 approach

IFRS 9 : Expected Credit Loss Approach For Impaired Assets In The BanksIn contrast to recognition of credit losses based on actual deterioration of financial assets under the extant “Incurred Loss Model”, IFRS 9 requires that credit losses on financial assets are measured and recognised using the 'expected credit loss (ECL) approach. Credit losses are the difference between the present value (PV) of all contractual cashflows and the PV of expected future cash flows.It is often referred to as the ‘cash shortfall’. The present values are discounted at the original effective interest rate. ECLs are, then calculated using the weighted average of credit losses with the respective risks of a default occurring as the weights. The ECL approach also impacts on the calculation of interest revenue recognised from the financial asset.ECLs are further classified into (i) 12-month ECL & (ii) lifetime ECLs. The former are those that result from default events that are possible within 12 months after the reporting date. The latter are those that result from all possible default events over the expected life of a financial instrument.Under the approach required by IFRS 9, it is no longer necessary for a loss event to have occurred but instead an entity is required to account the impairment of financial assets in stages:🟦 Stage 1️⃣ As soon as a financial instrument is originated or purchased, a 12-month ECL is recognised in profit or loss and a loss allowance is established (may be nil). For financial assets, interest revenue is calculated on the gross carrying amount (ie without deduction for ECLs).🟦 Stage 2️⃣ At each reporting date, the ECL is remeasured:➡️ If the credit risk has not increased significantly, continue to recognise a 12 month ECL. The calculation of interest revenue is the same as for Stage 1.➡️ If the credit risk increases significantly and is not considered low, full lifetime ECLs are recognised in profit or loss. The calculation of interest revenue is the same as for Stage 1.🟦 Stage 3️⃣ If the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated based on the amortised cost. Financial assets in this stage will generally be assessed individually. Lifetime ECLs are recognised on these financial assets.🟧 Assessment Of Significant Increase In Credit Risk (SICR)The assessment of SICR can be performed on a collective basis, rather than on an individual basis, if the financial instruments share the same risk characteristics.Financial assets with a low credit risk would not meet the lifetime ECL criterion. An entity does not recognise lifetime ECL for financial assets that are equivalent to 'investment grade', which means that the asset has a low risk of default.There is a rebuttable presumption that lifetime expected losses should be provided for if contractual cash flows are more than 30 days overdue (‘backstop indicator’). Thanks for reading….

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‘Exposure At Default’ In Measurement Of Expected Credit Loss Under IFRS 9Exposure at Default (EAD) is an estimate of a bank’s exposure to its counterparty at the time of default. While the relevance of EAD in assessing ECL is obvious, estimating EAD is less so. In practice, the estimation of EAD relates to payment terms, tenure of exposure and the point of time at which default is expected, or actually occurs. For defaulted accounts, EAD is simply the amount outstanding at the point of default. However, for performing accounts, the following elements are needed for computation of EAD under IFRS 9 at the instrument/facility level:1️⃣ Time horizon over which EAD needs to be estimated2️⃣ Projected cash flows till the estimated default point3️⃣ Residual maturity4️⃣ Deterministic or non-deterministic nature of the payment terms5️⃣ Forward looking macroeconomic scenariosUnder IFRS 9, the computation of EAD requires consideration of residual maturity, cash flow uncertainty, default prediction- all simultaneously. The projection of cash flow for such facilities is subjected to uncertainty associated with prepayment, or possibility of a drawdown from undrawn portion under forward looking macroeconomic scenarios or idiosyncratic scenarios.IFRS 9 guidelines suggest a need to incorporate forward-looking perspective for computation of ECL and EAD. The forward-looking factors prepayment, drawdown factor or credit conversion factor (CCF) - vary as per facility type, and depends upon the contract terms as well as business practices of the financial institution. This dependency can best be explained by considering examples of different facility types.🔷Loan Equivalent Exposure (LEQ) is defined as the change in the amount of drawn portion of exposure as a percentage of undrawn commitment. Thus, LEQ is a measure applied on entire off-balance sheet exposure. 🔷 CCF is defined as the exposure including undrawn portion at the time of default as a percentage of current drawn portion of total exposure. Thus, CCF is a measure applied on on-balance sheet exposure. The LEQ factor varies from 0% to 100%, whereas CCF is generally closer to 100%.EAD = Outstanding Exposure + LEQ x Undrawn Exposure .EAD = CCF x Outstanding Exposure Computation of EAD under revolving facilities like credit cards requires estimation of CCF on unutilised credit limit and definition of maturity of the facility. A contract’s exposure usually coincides with its outstanding balance, although this is not always the case. For example, for products with explicit limits, such as cards or credit lines, exposure should include the potential increase in the balance from a reference date to the time of default.The main difference between loss given default (LGD) and EAD is that LGD takes into consideration any recovery on the default. For this reason, EAD is the more conservative measurement as it is the higher figure.Thanks for reading…

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IFRS9 Series :7/nSPPI and the Business Model Test, in the context of financial assets classification under IFRS 9.SPPI (Solely Payments of Principal and Interest):SPPI is a critical criterion used to classify financial assets as measured at amortized cost or at fair value through other comprehensive income (FVOCI) under IFRS 9. To be eligible for classification under either of these categories, a financial asset must meet the SPPI condition. It means that the asset's contractual cash flows must represent solely payments of principal and interest on the principal amount outstanding.Example of SPPI:Let's consider a straightforward example of a fixed-rate corporate bond. The bondholder lends money to a company in exchange for periodic interest payments and the repayment of the principal amount at maturity. As long as the bond contract specifies that the company will make these fixed payments on time and in full, the cash flows meet the SPPI criterion. Thus, the bond can be classified as measured at amortized cost or at FVOCI if certain conditions are met.Business Model Test:The Business Model Test is another important step in the classification process of financial assets under IFRS 9. It helps determine whether the financial asset is held within a business model whose objective is to hold assets to collect contractual cash flows, or whether it is held for other purposes, such as trading for short-term profits.Example of the Business Model Test:Let's consider a financial institution, ABC Bank, which has two types of financial assets in its portfolio: loans to retail customers and a trading portfolio of securities.a. Loans to Retail Customers: These loans are part of ABC Bank's core business model, which is to hold assets and collect contractual cash flows from customers. The bank intends to hold these loans until they mature or are repaid. As a result, these loans pass the Business Model Test and can be eligible for classification at amortized cost or FVOCI, depending on the SPPI condition.b. Trading Portfolio of Securities: ABC Bank also maintains a separate portfolio of financial instruments, such as stocks and bonds, that are actively traded to generate short-term profits. The objective of this portfolio is not to collect contractual cash flows but to profit from price fluctuations. As a result, these securities fail the Business Model Test and should be classified at fair value through profit or loss (FVTPL).In conclusion, both the SPPI condition and the Business Model Test are essential considerations when classifying financial assets under IFRS 9. Meeting the SPPI criterion is crucial for determining whether assets can be measured at amortized cost or FVOCI, while the Business Model Test helps assess the objective of the business model for holding the financial assets#ifrs #ifrs9 #finance #accounting #indas #riskmanagment

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