post ifrs 9 - lending and pricing strategy · nature of credit provision under ifrs 9 means that...

Post IFRS 9 - Lending and Pricing Strategy June 2018

© 2018 Deloitte Romania 2

January 1st 2018 was just the beginning

IFRS 9 had a direct, quantifiable direct impact on provisions feeding into the P&L but it also has an indirect material impact on a wide range of factors contributing to shareholder value.

IFRS 9 Business-wide

impact

While banks have focused their efforts on the high complexity of IFRS 9 implementation…

…less time has been allocated on the assessment of impact on business strategy implications, and of consequences on profitability

The lack of focus on business and strategic impact was exacerbated by the fact that most banks ran their IFRS 9 implementation programs from their risk and finance departments, without the active involvement of commercial business leaders.


Who to lend to? What? How to price?

Is the bank transforming to achieve risk-based profitability?

Portfolio Strategy

Loan Approval & Origination

Pricing Credit Risk

Management Product

Development

Staff Performance

and Remuneration


Portfolio Strategy (1/2)

Banks will change their lending mix as a consequence of IFRS 9 adoption

Balance

Increase

Find a better balance between business segments and profitability: • industries with higher volatility of

impairments / high business cycle dependence (e.g. investment, specialized lending)

and • business segments with lower

volatility / less business cycle dependence (retail, SME, sovereigns, etc.).

• Increase the understanding of the economic cycle phase, explore the sectors that are more resilient through the economic cycle. Those are more resilient to the stage 1 exposures migrating to stage 2 and thereby less P&L volatility.

Reduce

Limit

• reductions in appetite for affected asset classes: volatile sectors, higher risk assets and long maturity exposures

• A more prudent approach to products most likely to be vulnerable to stage 2 migration, such as longer-duration retail mortgages and longer-term uncollateralized facilities, including project-finance deals.

As a result of increases in provisioning levels,

the banks find themselves in a position to revise their credit

portfolio allocation by evolving and changing

their lending mix


Portfolio Strategy (2/2)

Banks will need to review their portfolio strategy at a much more granular level

IFRS 9 will make some products and business lines less profitable:

Industry Maturity Collateral Counterparty Ratings

The forward-looking nature of credit provision under IFRS 9 means that banks will need to reconsider their allocation of lending to economic sectors with greater sensitivity to the economic cycle, also to evaluate whet is phase of the cycle.

The longer the time frame, the higher the probability of default. Under IFRS 9, stage 2 impairments are based on lifetime ECL and will therefore require higher loan-loss provisions.

Guarantees help mitigate the increase in provisions for loss given default under IFRS 9, particularly for exposures migrating to stage 2. Therefore, unsecured exposures registered the biggest hit under the new standard

IFRS 9 imposes heavier provisions on exposure to higher-risk clients, so counterparty ratings will have a direct impact on profitability, specially for those with increased risk since origination.


Loan Approval & Origination

Banks introduce measures to manage the origination of products most likely to be vulnerable to stage 2 migration

• Shall the size of impairment have an influence on the

loan approval process and replace the probability of 12-month default criteria?

• Should the first-year expected loss or life expected loss be

taken into consideration for the approval process? • PIT or TTC calibration should be used?

• What are the clients to be assessed with greater care?

Revise lending policies and update procedures with new

loan approval guidelines, in order to:

• introduce new credit limits for the clients, sectors, or products most affected by IFRS 9

• Explore the IFRS 9 relevant client/product/channel/risk segmentation • change the origination by improving the link between the risk-appetite framework

and underwriters • encourage origination of products with characteristics designed to reduce the

impact of IFRS 9 on profitability, by adjusting: - maturity, - repayment schedule, - pre-amortization period, - loan-to-value, and


Pricing (1/4)

Banks should balance pricing to sustain profitability and competitive position

Price

Net Interest Income

Interest Income

Operating Expenses

Prepayments Funding

cost

Cost of capital

Cost of provisions

Cash flows

Liquidity expenses

Introduction of macro component

A forward-looking macroeconomic component

has to be included in models. Introduces

uncertainty.

Possible need of provision volatility buffer.

Introduction of stage 2

Rapid surge in provisions for deteriorating (but

not defaulted) exposures

Transition from LIP to 12M horizon

Under IAS 39 banks calculated expected losses

in time horizon usually shorter than 1 year.

Under IFRS 9 the time horizon is set to 12

months for fully performing loans.

Im

pact o

f IFR

S 9

Capital Buffers

Impairment volatility may drive up capital buffers

Profitability & Benchmarking

• Price high enough to ensure profitability

• Price competitive to similar market players


Pricing (2/4)

Can pricing contribute to limit stage 2 loss?

• Can banks predict that a certain portfolio enters stage 2 in the future?

• Can banks assess such customers adequately at the moment of application? How is this recorded/historized in lifetime PD at origination?

Introduction of stage 2 forces banks to maintain higher provisions generating

opportunity costs.

The impact is different, depending on products.

Impact on provisions

Unsecured loans Secured loans Corporate loans

Short maturities have less impact even

if a loan enters stage 2.

A significant part of credit portfolio

may enter stage 2 (due to lifetime PD

comparison if the assumption is that

the remaining lifetime is in recession,

while at origination boom prediction

was considered).

Long maturities generate very high

lifetime ECL when assigned to stage 2.

Projection of real estate market decline

increases ECL estimation.

Due to lifetime comparison potentially

smaller part of portfolio should enter

Stage 2 (as recession is only a small

part of product’s lifetime and at

origination recession is already

considered).

Danger of unbalanced portfolio:

• Sensitive to new technologies

• Hotels

• Construction

There is a risk that whole business

sectors may enter stage 2 at once.


Pricing (3/4)

Integrate impairment model within risk based pricing calculation and further use the results for products, segments and channels optimization

• Does the bank use lifetime parameters in pricing?

• Are lifetime parameters consistent with parameters used in other processes?

• Are operating costs (data gathering, models maintenance, IT structures) significantly higher after IFRS 9 introduction? How to counterbalance IFRS 9 costs?

Banks developed or enhanced models for lifetime PD estimation.

1 Risk-based pricing calculation should be updated to new impairment

2

Profit projections depends on model accuracy and discrimi- nation

3


Pricing (4/4)

Banks could adopt pricing schemes that distribute part of the cost to customers

Banks could raise prices at origination and later provide discounts based on good payment behavior

Raise prices for longer-term and less collateralized products and for higher-risk clients

If flexible pricing is not possible, the expected additional cost of a stage 2 migration should be accounted for up front in pricing

What is the cost of: - maturity in a certain product/sector? - none or low quality collateral? - higher-risk clients?


Product Development (1/2)

Banks could develop “IFRS 9 friendly” products especially for high risk clients

The Business model test is the

first of the two tests that

determine the classification of a

financial asset. Two business

models are positively defined:

• a ‘hold to collect’ business model • a ‘hold to collect and sell’ business model

Contractual cash flows characteristics test labelled the ‘solely payments of principal and interest’ (SPPI) test is the second of the two tests that determine the classification of a financial asset. For the test to be met, the contractual terms of the financial asset must give rise on specified dates to cash flows that are solely payments of principal and interest.

SPPI test Business model test

Banks are developing new procedures and controls to streamline the process of product development, incorporating the tests for

asset classification at the development phase

Avoid the burden of managing non-standard deals measured at fair value and causing P&L volatilities


Product Development (2/2)

Models can add value to the business, beyond compliance

Maximum usage of IFRS 9 models Capital

Allocation

Product

Optimization

New Product

Pricing

Profit

Management

IFRS 9 Model estimations and findings should be

further used for:

- new product design

- balance sheet optimization

- optimum capital allocation


Credit Risk Management (1/2)

IFRS 9 triggered the necessity to review credit risk management processes

The banks need to be more proactive and forward-looking in managing credit risk, by preventing credit deterioration; reducing stage 2 inflows; enhancing performance monitoring and increasing the scope of their credit risk management.

Introduce new restructuring and debt sale tools

Increase collateral data monitoring

Enhance early-warning mechanisms

We anticipate changes in the early warning systems by establishing new capabilities (e.g. introduction of forward-looking risk indicators, enhancing watch list) Also, banks will want to flag warning signs to relationship managers to trigger remedial actions.

Redesign early collection

Early collection should be redesigned to predict the probability of significant increase in credit risk (stage 2 criteria)


Credit Risk Management (2/2)

IFRS 9 will change not only the appetite for credit risk, but their overall risk appetite framework (RAF)

A bank should have a sound credit risk assessment and measurement process that provides it with a strong basis for common systems, tools and data to assess and price credit risk and account for expected credit losses. Basel Committee on Banking Supervision: Guidance on accounting for expected credit losses

Banks’ credit risk appetite will change as a result of IFRS 9

Review credit strategy to limit origination in this area

Adjust the limits in their RAF

Limit new business development in such deals.

For example, if banks consider a certain area to be subject to volatile behavior, they should:


Performance Evaluation & Remuneration of Staff

How can banks increase staff involvement in this transformation?

The business may take new

responsibilities and play an active role in

increasing portfolio quality

Banks can change the performance and compensation metrics to reflect IFRS 9

adjusted profitability

• Relationship managers can be assigned to new responsibilities such as monitoring clients’ risk of deterioration and proposing mitigation actions to prevent stage 2 migration.

• The Relationship managers can be evaluated and compensated on an appropriate risk-adjusted profitability metric

• Banks can review the incentive schemes to ensure that Relationship managers are held accountable for client performance deteriorations in their portfolio, with clear accountability for how well stage 2 costs are managed.


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