Methodological thoughts on expected loss estimates for IFRS 9 impairment: hidden reserves, cyclical loss predictions and LGD backtesting

After the release of the final accounting standards for impairment in July 2014 by the IASB, banks will face the next significant methodological challenge after Basel 2. The presented work shares some first methodological thoughts and proposes ways how to approach underlying questions. It starts with a detailed discussion of the structural conservatism in the final standard. The exposure value as outlined in the IFRS 9 exposure draft (ED 2009) will be interpreted as an economically justified value under amortized cost accounting and provides the main methodological benchmark. Consequently, the ED 2009 can be used to quantify conservatism (ie hidden reserves) in the actual implementation of the final standard and to separate operational side-effects caused by the local implementation from actual credit risk impacts. The second part continues with a quantification of expected credit losses based on Impact of Risk instead of traditional cost of risk measures. An objective framework is suggested which allows for improved testing of forward looking credit risk estimates during credit cycles. This framework will prove useful to mitigate overly pro-cyclical provisioning and to reduce earnings volatility. Finally, an LGD monitoring and backtesting approach, applicable under regulatory requirements and accounting standards as well, is proposed. On basis of the NPL Backtest, part of the Impact of Risk framework, specific key risk indicators are introduced that allow for a detailed assessment of collections performance versus LGD in in NPL portfolio (bucket 3).