Why Banks in Ghana and their shareholders should care more about credit risk and IFRS 9.

A number of things will happen in 2018: Russia will be hosting the football/soccer world cup. It will be a century since the end of World War I. IFRS 9, the new standard for financial instruments will be applied, and in Ghana; Banks will be required to meet the new minimum Capital requirement of GHS 400 million.

For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Most major banking problems have been either explicitly or indirectly caused by weaknesses in credit risk management. Severe credit losses in a banking system usually reflect simultaneous problems in several areas, such as  concentrations of credits to single borrowers or counterparties, a group of connected counterparties, and sectors or industries, such as commercial real estate, and oil and gas, failures of due diligence and inadequate monitoring.

Taking the Banking industry as a whole, at the end of June 2017, the non-performing loans (NPL) in the banking industry was GH￠7.96 billion. The potential losses of the NPL loans with its potential impact on depositors money is the reason why the Bank of Ghana requires the Banking industry as a whole to increase its capital by approximately GH￠ 8 billion. If the capital increase is to help current expected losses in the banking industry NPL, then how to minimize NPL growth and loss is the main issue to be addressed.

The question that this article seeks to address is: Why should Banks in Ghana care more about sound credit risk practices preached by Basel Committee on Banking Supervision (BCBS) in its Publication 75 issued in September 2000 called Principles for the Management of Credit Risk and the International Financial Reporting Standards (IFRS) 9: Financial Instrument (IFRS 9) impairment principles which is based on sound credit risk practices.

My joy FM website on September 25, 2015 stated that the governor of Bank of Ghana (BOG) Dr. Addison recommended that Banks that cannot meet minimum capital requirement of GHS 400 million can apply for a Savings and Loans license. This means missing the minimum capital requirement is not the end of the world for your Bank. But when it comes to IFRS 9/credit risk, your Bank may cease to exist even in the Savings and Loans world. Your Bank’s failure will not be due to IFRS 9 but because of business reasons such as poor credit quality, deficient credit risk assessment and measurement practices. So should IFRS 9 be on your 2018 agenda? Some say it is an accounting standard and so let’s leave IFRS 9 to the accountants and instead we should think of raising capital and grow our banking business. The absence of IFRS 9 on some Banks’ 2018 agenda can be deduced from these actions of the Bank:

-        Lack of comprehensive IFRS 9 credit risk practices, systems and data gap analysis

-        IFRS 9 impact assessment postponed until or till close to the deadline.

The above behaviours shown in not taking IFRS 9 seriously is reflected in the following situations:

-       The practice within banks that requires accountants to compute IAS 39 impairments. In the mind of those banks; with credit losses being reflected on the financial statements; and financial statements being governed by accounting standards so the task should be done by accountants with minimal or no involvement from other stakeholders such as credit risk department/staff.

-       In Banks’ capacity building for IFRS 9 through training programs despite the point made time and time again that impairment or credit provision is not an accounting exercise, many IFRS 9 trainings are flooded with accountants with a small number of participants from credit risk departments. The questions on some accountants’ minds at IFRS 9 training is this, how do you ensure consistency among banks regarding IFRS 9? The responses of participants at such credit risk trainings from accountants is this:  we don’t price all customers in the same way because all customers don’t have the same risk profile and in reflecting current customers risk through provision/impairment we cannot be consistent in how to measure the potential credit loss for each type of customer that may fail to meet its credit commitments. What some accountants fail to note is that IFRS 9 impairment principles are based on the economics of lending; in which expected credit losses are implicit in the initial pricing of a loan and subsequent changes in expected credit losses are economic losses (or gains) of the entity in the period in which they occur . Accountants also miss the architect of the IFRS 9 impairment model :  after the 2009 impairment exposure draft was deemed not operable due to lack of integration between the banking system ( system that calculates interest) and credit risk system ( system that computes credit risk) , the accounting board assembled credit experts to recommend the way forward. It was the recommendations of the Expert Advisory Panel (EAP) and the Basel committee that form the basis of the current IFRS 9 impairment model. The fact that an accounting standard requires credit provision does not make it an accounting exercise. IFRS 9 strongly impacts risk management and it is not an accounting exercise - it is about preparing your bank for future losses.

An area that can help Banks take IFRS 9 seriously is the enforcement mechanism by the regulator as well as clear direction of the regulator’s expectation. On April 25, 2016, Bank of Ghana (BoG) wrote to all Banks requesting them to perform IFRS 9 impact assessment using their 2016 financial statement numbers and send the assessment to BoG by end of June 2017. The heading of the letter says “Adoption of IFRS on Impairment” but the body of the letter says IFRS 9 impact assessment. What I guess what is going to happen is most banks performing only impairment assessment and forgetting about classification and measurement and hedge account. Aside that, there was no requirement in the letter for in-between/project progress communication between Banks and BoG on the impact assessment and IFRS 9 preparedness for 2018. So imagine you go to school and you are told that at the end of the term/semester there will be exams but no home-work or quizzes expected to be completed. In this scenario when do you expect students to start studying for the exams? If you are a lucky headmaster, your students will start studying for the exams a week before the exam date. In most instances, most students will start studying the night before the exams and be awake till the next day. This is exactly what happened in the Banking industry in Ghana. In a letter dated May 30 2017, a month to the June 30 2017 deadline, the CFO network of the Ghana Association of Bankers wrote to BoG and said we are not ready with the IFRS impairment assessment (quietly they said we are thinking about capital)  so please give us an extension to the end of September 2017. Guess what happened? BoG provided the extension, again with no communications in-between. Guess what is going to happen at the end of today (September 29, 2017)? Some banks are going to ask for an extension or send some sub-standard product to BoG. This attitude of some banks can be prevented going forward through tough-love measures from the regulator.

Let me cut to the chase. IFRS 9 impairment provision is not an accounting issue, instead it is

-       The  detailed analysis of historical patterns and current trends to identify  the most relevant factors that affect the collectability of the loans (borrower-specific, facility specific, bank specific, macro-economic and environment factors collectively called credit risk drivers ).This analysis is based on the  linkage between credit risk and its drivers,

-       Using the identified credit risk factors above to segment the bank portfolio into portfolio of similar credit risk features

-       Using  credit risk assessment and management processes of the Bank to detect  well ahead of exposures becoming past due or delinquent and categorise segmented portfolio into performing , under-performing and defaulted loans based on current and  forward looking information that affect collectability of the loan portfolios  ;

-        Incorporate relevant past , current and  forward looking information that affect collectability of the loan portfolios to measure  appropriately the credit risk inherent in the bank’s current portfolio using and

-       Setting aside reserves to correspond to the credit risk inherent in current loan portfolio to cover any potential loss that may result from credit risk that exists in the portfolios.

IFRS 9 impairment requirements represent the biggest change to bank accounting ever. Don’t just think of IFRS 9 as an accounting change—but rather as a change to how all banks manage their business. IFRS 9 requires you to reserve a 12 month expected loss on day 1 when you first grant the credit/ loan. If the credit quality has worsened on day 2 relative to day 1, you will have to increase your reserves to a life-time expected loss. I like to think of IAS 39 as recording the credit losses in a Bank’s portfolio and IFRS 9 as recording the credit risk in a Bank’s portfolio.

 If you don't have the right credit risk systems and processes, you are likely not to underwrite certain loans such as long term loans/risky loans that you may think be profitable to your business. Your Bank’s refusal to underwrite such long term loans is because your Bank is scared that if on day 2 the credit quality of the facility has worsened relative to day 1, you will be forced to hold reserves for the full life of the credit which may be more than a year, further constraining your future ability to grant credit. When you have more information, you can better assess risk, allowing you to take on loans your competitors can’t accurately analyse. This will allow your Bank to grow.

 Before IFRS 9, accounting rules forced banks to “wait” for a loss event before recording a loss against a loan asset. This was the case even when banks expected that a percentage of their loans would not be paid back in full. When the downturn came they had to catch up by recording significantly larger losses all at once. The result was the heavy criticism of banks during the financial crisis for providing “too little too late”. 

IFRS 9, expected credit loss (ECL) model, is the standard setter’s response to the financial crisis. Banks’ lending too much money to people who could not repay was one of the factors that fuelled the global financial crisis. Accounting, in particular the incurred loss model, was criticized for contributing to the crisis. Incurred loss means you don’t book the loss until it happens. Expected credit loss means that that when each loan is made, the possibility that the loan will default in future economic conditions is given effect. ECL accelerates the recognition of bad loan losses.

Capital is designed as a buffer to protect depositors (and the tax payer) in a financial crisis. Capital measures might help an investor predict how the bank would fare in a crisis, but are not primarily designed for investors. Here are some of the reasons why Bankers in Ghana and their shareholders should care about IFRS 9/credit risk.

1.    It provides useful information

IFRS 9 is designed to give useful information for investment decisions. It provides granular information relevant to assessing credit risk and forecasting profitability. An example is information about changes in credit risk over time; highly relevant to assessing the profitability of a loan. A bank expects some borrowers to default so it will include a credit spread in the interest rate charged. In a perfect world, the credit spread would cover the risk of default. The ‘excess’ interest paid by borrowers who don’t default, in theory, would cover the losses from those who do for a portfolio of loans. A significant increase in a loan’s credit risk increases the risk that the expected losses on that loan are not covered by the borrower’s interest rate. IFRS 9 reflects this by increasing the credit loss (from a 12 month expected loss to a lifetime loss) and requiring more disclosures. Appropriate application of IFRS 9 will enable your Bank answer these credit risk performance questions on a day to day basis:

-       What are the delinquency levels in the portfolio?

-       Which products are performing well, and which are performing poorly?

-       Which location/ geographies are performing well, and which are performing poorly?

-       Which business units are performing well, and which are performing poorly?

-       Which vintages are performing well, and which are performing poorly?

-       How much of the portfolio is rolling from one delinquency bucket to the next?

-       What are credit scores throughout the portfolio?

-       Which starting credit rating are rolling into default and at what point do they roll into default?

-       How many new loans are being originated, and with what characteristics?

-       Are write-offs rising or falling, and is one product type or geography experiencing more write-offs than another?

-       Are receivables, delinquencies and write -offs in-line with forecasts for these metrics?

-       How is the portfolio performing on such metrics as probability of default, loss given default and exposure at default?

2.    It encourages good banking behaviour

The impact of IFRS 9 goes beyond accounting. A bank that does a thorough implementation of IFRS 9 will need to generate new data and new models for measuring credit risk. And the old adage ‘what gets measured gets managed’ kicks in. This new information, if used to manage credit risk, is likely to influence how a bank behaves. The bank may take credit risk management actions earlier or may adjust the pricing or other terms of some loans or may even cease to sell some products.

 IFRS 9 was introduced to help investors understand the risks a bank faces. It’s high time for investors and Bank management to pay attention to IFRS 9 implementation and its impact on the business model and how to effectively manage capital. While it is equally important to give attention to raising capital to meet the new minimum regulatory requirement, analysts and shareholders reviewing the performance of banks should give consideration to other factors beyond the fact that a bank has met the new capital requirement. These factors and the analysis that is important are explained in the paragraphs that follow.

3.   Customer relations

Today we look at delinquent customers and ask, which ones do I want to keep? That question is going to change in two major ways under IFRS 9.

First, if a customer is in Status 2 or 3, curing them doesn’t change their status. They still represent a higher risk, and you’re still going to be paying lifetime impairments on them. So you have to ask, what is the cost of keeping them on the books? Unless you can make a case for why their actual risk status has changed (rebuttable), they’re still going to be expensive.

Banks are going to need to get forensic with treatment analytics and decisions. Who you keep and why is now far more complicated.

That brings me to the second big change here: You may find yourself in the position of saying goodbye to customers you just cured. That makes it tricky for collectors – what can you tell customers about their near-term relationship with the Bank once they cure? It will be a communications headache for customer relations. At some point, regulators will probably have something to say about this too.

And then, if you are going to be exiting “good” customers, who will you sell them to? When? And at what cost? Will debt purchasers understand how to price these accounts? Will your current debt collection agencies have the capacity to handle more accounts from you? Will they want to work the low-performing debt or performing debt?

4.   Pricing decisions

In a Deloitte survey, most price makers expect that moving to an IFRS 9 expected credit loss (ECL) model will have an impact on product pricing, while most price takers still think that this is unlikely to have credit pricing decision on a risk adjusted price. If all Banks  start factoring the expected losses likely to be maintained on account of on boarding a particular account in the pricing of the products, pricing is expected to increase manifold (at least for the moderate and high-risk customers). This kind of scenario may not prove economical for these customers to go for a banking facility. Customers are about to come across lot of surprises in terms of pricing. As a cyclical effect, higher levels of pricing may lead to more defaults.

Also, there might be a need for institutions to revise the pricing for the existing portfolio of funding. It may happen that customers who have opted for adjustable rates on loans are quite likely to feel the pinch.

5.   Collection and recovery practice

Until now, it’s been OK for a certain amount of accounts to roll from current (stage 1) to special mention (Stage 2). This kept Banks within their cost to collect, Banks met their regulatory requirements, Banks only have so much capacity to work accounts, and Banks know that some accounts will self-cure in special mention.

That’s not going to be the case under IFRS 9. Your CFO is going to come down to collection & recovery department and say, “I can’t afford for this number of accounts to get to Stage 2, because I can’t afford to take this much provision back onto the good book. How do we stop this from happening?”

Why is the CFO going to be looking for you? Simply because just about every authority on IFRS 9 is saying impairments will rise by not less than 30%. Some are saying 50%. That is going to have a significant impact on profitability at the account, segment and portfolio levels. It’s going to make your CFO take a keen interest in how collections can impact the volume of accounts rolling to Stage 2.

Banks will carry a heavy cost of letting those accounts that cure after 31 days past due get that far. So you will have to do more in the first 30 days than ever before. At the same time you will have to watch the cost to collect, Net Promoter Score (NPS) and regulatory compliance.

As noted earlier delinquency shouldn’t be your primary trigger for escalating impairments if you want to meet the spirit of the standard. If by any measure your Bank can tell that a customer’s creditworthiness has eroded, you will probably need to escalate that customer to Stage 2.

6.   Watch-list process

If a Bank is planning to use its existing watch-list process to capture and monitor the qualitative factors that influence significant increase in credit risk, the key step that the Bank needs to perform is to perform a gap analysis  i.e. compare the existing watch list systems and process that it has versus what IFRS 9 requires.  For example are all of the 16 qualitative factors or the relevant ones already captured in the watch-list process and if they are, what is the governance around that to ensure that they are being interpreted consistently to judge whether individually or in aggregate those qualitative factors indicate significant increase in credit. Also, the watch list process has to be linked with ratings, relative measure, and processes as well as ensuring that it is symmetrical.

Conclusion

Meeting a capital requirement is critical, but looking at a Bank holistically by its   fundamentals is also key: does the Bank have strong fundamentals in place?; i.e. clear business strategy, strong corporate governance, size and dynamics of its customer base as well as satisfaction and retention levels, strengths of its brand, balance strength combined with strong risk management and operating efficiency and a satisfied workforce. In analysing its financial performance it is important to note the quality of its current earnings as well its future earning capacity. Some of the major categories for analysing a bank’s performance are: earnings, efficiency, risk-taking and leverage. While it is clear that a bank must be able to generate “earnings”, it is also important to take into account, the composition and volatility of those earnings.   “Efficiency” refers to the bank’s ability to generate revenue from a given amount of assets and to make profit from a given source of income. “Risk-taking” is reflected in the necessary adjustments to earnings for the undertaken risks to generate them (e.g. credit-risk cost over the cycle). Initiatives to improve risk management must be identified and implemented with rigour. “Leverage” might improve results in the upswing – in the way it functions as a multiplier – but, conversely, it can also make it more likely for a bank to fail, due to rare, unexpected losses.

Regarding efficiency indicators, give more emphasis to risk-adjusted metrics, such as the return-on-risk-weighted assets and strategic cost management and reduction programs. Ultimately bank management must aim to achieve ROEs in excess of the cost of equity. To assess the sustainability of bank revenues, you have to identify either the share of core banking income (i.e. net interest, as well as fee and commission income) or the share of non-recurring revenue (e.g. income from fees, excluding fees related to loans, trading income and other one-off gains). This analysis should be supplemented by considering the volatility of revenues e.g. trading revenue and the breakdown of key income drivers.

 The earnings analysis is linked to the asset quality analysis and is an issue which has drawn a good deal of attention since the crisis began. Persistently high levels of profitability should trigger alarming signals. Very high profitability can imply excessive risk-taking and a build-up of vulnerabilities, which would eventually jeopardize sustainable profitability. The focus should be on predictability and low volatility of earnings in order to enable performance sustainability. The diversification and specialization of banks’ activities is a relevant issue in this respect. There is much literature on this topic, but the empirical evidence is mixed. In theory, diversification (including product diversification) should lead to reduced volatility of earnings. However, earnings arising from non-interest activities of banks are much more volatile than net interest income – a large part of these gains is considered non-recurring (trading income, non-retail fee income). It is unclear as to whether the over-the-cycle profits of these non-recurring activities are sufficient to make up for increased volatility. Nevertheless, in times of financial stress, the recurring components of revenues are carefully valued by analysts. Market participants appear to carefully observe the structure of banks’ revenues and capital by business line and try to assess the sustainability of their business models. Metrics adjusted to the features of individual business lines are required to accomplish this goal.

 On other areas of assessing the quality of bank earnings/liquidity we have to consider strong non-interest bearing deposits to total deposits ratio, continuing growth in current account balances, low cost of funds, profitability ratios such as fair balance or strong percentage of noninterest revenue to total bank revenue, good net interest margins combined low NPLs/low credit losses. Also, improvement in products per customer, increase in new client acquisitions, improvement in trends in client retention ratios, good Net Promoter Score (NPS ) , increase in market shares of various products and services, diversified client base; may take together give an indication of quality of earnings.

 Regarding credit risk, pay attention to key Loan reserve ratios such as Impairment charges as a percentage of total loans, Loan Loss Reserve / Loan Ratio , NPL ratio and Loan Loss Reserve / Non-Performing Loans Ratio ( coverage ratio).. A declining Loan Loss Reserve / Loan Ratio suggests that the bank’s loan loss Provision is either not keeping up with loan growth or that current period loan charge-offs are more than the loan loss provision. Future income could be affected as provisions are recorded to increase the loan loss reserve / loan ratio.

An increasing level of nonperforming assets suggests that credit risk in the portfolio may be increasing, while a lower ratio of reserves to non-performing loans may indicate that future increases in loan loss reserves (and provision) could occur. One should remember that some of these ratios are connected with past decisions. Banks need to consider future implications through stress testing, capital planning and application of IFRS 9 impairment requirements. To be proactive, banks must strengthen credit origination standards, ongoing credit monitoring including early warning systems and strengthen recovery efforts for impaired loans.