IFRS9 implementation approach and

challenges for Banks in the Middle East

By Pranav Satheesan
pranav.satheesan@gmail.com / pranav.satheesan@alumni.ie.edu

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source .

IFRS9 implementation approach and challenges for Banks in the Middle East

Contents
1.

Preface ............................................................................................................................................ 2

2.

IFRS 9............................................................................................................................................... 2

3.

Classification and Measurement ...................................................................................................... 2

4.

5.

I.

The business model test- ............................................................................................................. 3

II.

The cash flow characteristic test- ................................................................................................. 3

Impairment...................................................................................................................................... 4

III.

Staging-.................................................................................................................................... 4

IV.

ECL Computation...................................................................................................................... 5

Hedge Accounting- .......................................................................................................................... 7

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

No problem can be solved unless it is reduced to some simple form

-

From the Internet

1. Preface
This work paper illustrates the challenges faced by banks in the middle east region in incorporating IFRS 9 into the
current accounting / reporting environment in the region. The work paper aims to highlight some of the technical /
practical difficulties that exist in implementing the updated regulation and how financial institutions (FIs) in the region
are approaching (or in certain cases not approaching) them.
I implicitly assume that the reader of this paper has a basic accounting background (with respect to terminology /
definitions) and also has taken a first (and hopefully a second) review of the IFRS 9 standards issued by IASB . I
further state that the views represented in this paper are purely my own based on my personal experience and does
not represent the viewpoints of any official organization to which I may or may not be affiliated to.

2. IFRS 9
IFRS 9 replaces the IAS39 standard of IASB. The motivation of the IFRS 9 project is to resolve some of the
cumbersome standards currently in place for reporting financial instruments and incorporate forward looking credit
loss models in to the reporting framework. The IASB in its traditional way has taken a principal based approach to
IFRS 9 rather than a rule based one. The IFRS 9 standards in general provide much more latitude to institutions in
classifying their financial instruments and focuses more on the economic sense of an instrument rather than its
legal underpinnings.
IFRS 9 has three major areas of coverage as listed below

Classification and measurement of financial instruments.

Impairment / provisioning
Hedge accounting

IFRS 9 also incorporates standards for classifying and measuring financial liabilities. This topic will be excluded in this
paper as the FIs in the middle east are in general not currently implementing frameworks for the same (therefore I
will not be spending my valuable time writing on the same).
Each of the three above listed areas of coverage will be discussed in the following sections. The sections will also
detail as to how FIs in the middle east are approaching the standards and general implications of implementing them.
The work paper will also cover the common approaches adopted by banks in the region in implementing the
standards. Please note that implementation approaches elaborated in this work paper is indicative of how a bank
might go about adopting the standards. None of these methods should be adopted without performing end to end
quantitative impact assessments (QIAs). Ultimately what differentiates one bank from the other is the balance sheet
and the underlying asset / liabilities which drive the numbers. Based on the nature of your balance sheet, some
implementation methods may be inappropriate or require modifications.

3. Classification and Measurement

IFRS 9 replaces the existing financial instrument classification as per IAS39 - Held for Trading (HFT), Available for
Sale (AFS) and Held to Maturity (HTM) - with three new classification definitions which are Fair Value through Profit
and Loss (FVTPL), Fair Value through Other Comprehensive Income (FVOCI), and Amortized Cost (AC). IFRS 9
stipulates guideline principles based on which the three new classifications can be assigned to a financial instrument.

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

A common practice of the Banks in the middle east region has been to map instruments earlier classified as
HTM, AFS and HFT to AC, FVOCI and FVTPL without conducting any detailed analysis if the instrument
actually meets the required classification mandates. Although this approach is highly preferred for its
simplicity, there exists the risk that a classification might be in violation of the standard. A common scenario
where this simple approach creates distortion is in the classification of variable interest rate instruments. For
e.g banks might be tempted to classify all their loans disbursed as amortized cost, but if you have a variable
interest rate loan with say interest reset every six months and the interest rate used is the 5 year LIBOR, the
instrument may not meet the standards of the AC classification unless the 5 year LIBOR rate does not
deviate significantly from the 6 month LIBOR.
The classification designation of IFRS 9 is based on the below two tests

The entitys business model for managing financial assets.

The contractual cash flow characteristics of the financial asset.

Let us look at these two tests in detail below and see how banks in the region have been using them -

I.

The business model test-

The business model test requires banks to determine if their own business or the business model of the entity
managing the particular asset of the bank is to collect either contractual cash flows or not. If the business model of
the entity is to collect contractual cash flows which are purely principal and interest, then the instruments managed by
the entity can be classified as Amortized Cost. Even if the entity does sell and buy certain instruments to earn a short
term profit, the Amortized Cost classification will stand, provided the entity can prove that the overall objective is to
collect contractual cash flows consisting only of principal and interest. If the entity aims to collect contractual cash
flows and also profit by selling and buying of financial instruments, then the classification is FVOCI. If the entity does
not fall under both the above classifications, then the FVTPL classification is used.
IFRS 9 recommends multiple granular level tests for business model, which involves verifying if how the managers of
the entity are compensated (e.g.is it based on exceptional business performance or by receipt of contractual cash
flows), the cash flow characteristic of the entity and other tests including the nature of the majority of instruments held
by the entity.
The challenge for banks- Business model test is done at an entity level. For most banks, a range of financial
instruments are held in the books and no entity is assigned or created to manage them. How do we go about
using the business model test for classification? The solution for this problem lies in the principle based
approach of the IASB. IFRS 9 does not provide as to what exactly constitutes an entity. For e.g as per the
IFRS 9 interpretation a portfolio of assets can be grouped together as an entity as long as the purpose of the
portfolio is well understood (as in to collect contractual cash flows or not).
To make things more technically clear, let me elaborate by answering a popular question asked by banks in
the region- Can a general ledger (GL) code and all instruments in that GL code be classified based on the
business model test?. The answer is Yes provided it can be reliably proved that the entries parked in the
GL code are for instruments which have the same overall objective (with respect to collecting contractual
cash flows or not). Banks further have the option to consider the GL code and all instruments parked under it
as a portfolio. Therefore the business model test in this case can be applied to the GL code.

II.

The cash flow characteristic test-

The cash flow characteristic test is the second principal based approach to determining the classification of Financial
Instruments in IFRS9. The premise of this test is simple, if the cash flows from a financial instrument can be reliably
proved to consist only of contractual cash flows consisting of principal and interest, then the instrument can be
categorized as Amortized Cost. If the cash flow test for contractual cash flows fails, then the appropriate treatment
should be applied as per FVOCI or FVTPL.

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

This test on paper looks cumbersome for banks to implement as all financial instruments will have to be individually
tested for appropriate classification. In reality a modified form of the cash flow test is the most popular one used by
banks in the middle east.
How are major Banks in the middle east approaching asset classification as per IFRS 9 ?
For answering this question, let us breakdown the asset side of the balance sheet of banks into two major
components product portfolio and investment portfolio.
Product portfolio consists entirely of the various products issued by banks like term loans, wholesale
financing etc. For most (or rather all) banks in the middle east , the product portfolio represents the vast
majority component of the balance sheet assets. The product portfolio represents the biggest risk from an
IFRS9 perspective for banks as the second part of the IFRS9 standards which relate to impairment /
provisioning directly hit this segment and thereby flows in to the profit /loss statement impacting the return
on equity. For the product portfolio, most banks in the middle east have taken the cash flow characteristic
test approach. Meaning middle eastern banks are applying IFRS9 classification at a product code level i.e
all products of the same type are automatically assigned the same classification. Banks individually assess
the cash flow for each product that they offer, say a term loan for a retail customer and apply the same
classification for all asset items issued against that product code. By this e.g all term loans of the same
type (same product code) will be automatically classified as say Amortized Cost by the IFRS9 engine which
will either be a core banking system or an additional platform like say SAS (Statistical Analysis System) or
any other banking platform deployed for the purpose.
For the Investment portfolio assets, banks in the middle east are using a hybrid of the business model and
cash flow test (in reality it is more of business model and less of cash flow) to determine the appropriate
classification. The most common approach has been to identify assets which will be classified as HTM as per
IAS39 and park them under the same GL code. This in turn allows the banks to classify the newly regrouped
assets as Amortized Cost from a business model standpoint. The fact that IFRS9 allows some assets in a
portfolio to be sold or traded in the short term without changing the overall objective of the portfolio and
thereby the classification treatment for the portfolio is used by the banks in the region to their advantage.
The other assets are similarly parked in appropriate codes and marked as either FVOCI or FVTPL.

4. Impairment
The impairment section of IFRS9 represents the most material part of the new standard for Banks. The
implementation of the impairment standards of banks will have direct consequence on the Profit / Loss statement
along with the return on equity. Naturally, banks in the region have adopted a cautious approach to implementing the
impairment standards with multiple Quantitative Impact Assessments (QIAs) being conducted to arrive at the right
model for impairment.
The impairment standards of IFRS9 can be broken apart to two areas Staging and Expected Credit Loss (ECL)
measurement. Both of these topics are discussed in detail in the following sections.

III.

Staging-

IFRS9 requires banks to identify credit deterioration in financial assets since initial recognition. Based on the
transition of credit worthiness banks have to appropriately calculate expected credit losses (ECLs) and park the
assets into different stages of credit worthiness (e.g stage1, stage 2 etc). As per IFRS9, banks have to calculate 12
month expected credit loss (ECL) for all credit risky assets issued by them or bought by them. If a significant
deterioration in credit quality occurs (IFRS9 provides various generic examples of credit deterioration in the
standards), then banks have to measure the lifetime expected credit loss for those assets. Impairment is the section
in the IFRS9 standards where banks will have to implement a new quantitative engine. The calculation of 12 month
expected credit loss or lifetime ECLs require banks to model the 12 month probability of default (PD) or the lifetime
PD along with associated loss given defaults (LGDs) , (To put in more simple terms, if you are a bank this is the

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

section where the most money will be spend on consultants to come and model the PDs and ECLs for you). Some
draft approaches to obtaining the PDs and ECLs by banks in the middle east will be discussed later in this paper.
Quick Question- IFRS9 requires banks to measure the transition of credit worthiness from date of initial
recognition. What exactly is initial recognition?. The correct answer to this question will be the date on
which the asset was originated from the bank or to be more specific the date on which the bank was exposed
to credit risk due to the asset in question.
Does the above definition for initial recognition stand valid for banks in the middle east?. Probably not for
the simple reason being some of the most sophisticated banks in the middle east have only data history of 7
years or in the best cases 10 years. So a product or facility originated say 20 years back, banks will not have
sufficient credit history available in the database to identify date of initial recognition.
Now that we know that we cannot reliably estimate date of initial recognition, what can we do?. Take the
earliest available date in the system and consider it as initial recognition, is the only plausible answer. If the
information is not there, then it is not there. We have to move forward with the information at hand.

How are banks in the middle east implementing staging of their credit risky assets?
IFRS9 provides a list of examples in the standards which can indicate deterioration of credit worthiness.
Some of the examples provided by the standards include loss of revenue for wholesale customers, increase
in bond yields, increasing spread on credit default swaps and other metrics which is time / cost consuming
to keep track of. As with everything, most banks in the middle east region have found easy workarounds on
this seemingly challenging problem.
The simple approach which banks in the region have implemented is in the form of transition matrices (or
some form of transition matrices even if the banks do not call it so) which provides the transition of the
internal credit score across time. For clients for whom internal score cards are not available, the external
rating issued by a rating agency is used as an input into the simple transition matrices. There will still exist
some clients who may not have either internal or external rating. The bank in this case assign an appropriate
rating and plug them into the transition matrices. Once the matrices are ready, rules are then defined (e.g a
drop in rating by two notches in one year is significant credit deterioration) and both the rules and the
transition matrices are fed into the quantitative engine which performs the staging and ECL calculation.
Now that we are done with staging, the most complicated part of IFRS9 still remains and that is the modeling of the
PDs / LGDs to obtain the 12 month and lifetime ECLs.

IV.

ECL Computation

ECL computation in IFRS9 is a forward looking model which will compute either the 12 month or lifetime ECL based
on staging. There various quantitative ways of approaching ECL modeling. Some draft methods will be listed in the
work paper (but I will not go into the quantitative details, Modeling the futuristic PDs is a work paper in itself).
Irrespective of which methodology is used for computing expected ECLs, all banks have to start at the same initial
point and that is the pooling of their credit risky assets into various buckets. PDs will generally be computed at a pool
of instruments level rather than at a granular facility or instrument level for the simple reason being banks cannot
keep track of and recalibrate millions of PD curves every year for all the credit risk assets that they have.
How are banks in the region actually performing pooling of their assets?
There is no one approach to pool the credit risky assets. Different banks have different balance sheets and
the nature of their clientele combined with services provided will drive the pooling. Pooling can be done at a
portfolio level (say retail and corporate which will be too high level of a pooling) or say at a product level
(which is what many banks actually do) or say based on similar risk characteristics (if you are a

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

sophisticated bank) or any other level depending on the nature of your balance sheet. What we do know
for sure is that pooling of assets has to be done.
Once the assets are pooled based on their characteristics into separate buckets, the actual quantitative work begins
on modeling the PDs. The PDs (or the PD curves) are modeled separately for each pool of assets. The modeling
technique for PDs vary wildly between banks with some following simplistic approach to others performing
complicated regression analysis.
How are banks in the region in general modeling the PDs?
I shall list three common approaches used by banks in the region starting with the most simple one.
The simplest of approaches is to use the PD based on historical data. For e.g obtain the average of PDs for
different pools across various 12 month periods prior to the current date and use it as the forward looking 12
month PD. A similar historic data approach can be used for lifetime PDs as well. The use of this method is
acceptable provided it can be reliably proved that the PDs estimated are in line with actuals occurring in the
future.
The next approach is more quantitative and involves modeling the PDs for various pools by performing a
regression. This will generally involve the PD as the dependent variable along with numerous independent
variables ranging from say oil price or interest rate movements etc. The complexity of this approach is that
we have to end up generating PD equations with high adjusted R square (nerd language which basically
means the model has good predictive power) . In addition the issues associated with multiple regression
like autocorrelation, multicollinearity, heteroskedacity, significance of coefficients and other issues which
are too big to pronounce have to be resolved (the granular details of regression model tests is outside the
scope of this paper). In addition the PD models built may need to be recalibrated in the future so as to keep
intact their predictive power.
Lastly advanced quantitative models can be applied like the Vasicek single factor model or the Merton
models (with some modifications of course). I will not be detailing these models in this work paper.
Now that we are done with modeling the PD curves we have to now obtain the LGD and EAD. The EAD is directly
obtained at an instrument or facility level and can be in most cases reliably estimated. For LGD, we can take either of
two approaches- The LGD can be blanket set as a static number for each pool based on say historic data (for e.g
LGD for retail salaried portfolio is 20%) or quantitative modeling similar to PD can be done. It should be noted that the
first approach where a blanket LGD is applied is a popular one and generally used for ECL computation.
With all three factors, PD, LGD and EAD available, we can now directly compute the ECL easily.
A common question by banks in the region Is there a simple approach to ECL computation? My bank
does not want to perform all these heavy quantitative modeling?
IFRS9 also provides a simplistic approach to ECL computation which does not involve any of the heavy
quantitative modeling. This method is to create a simple provision matrix in which provisions are fixed based
on historic data for each pool. For e.g say for my pool of term loans maturing in three years I shall fix a
provision of 3% for 12 month and say 9 % for lifetime. This provision number is then directly rolled into the
P/L and balance sheet.
If such a simple option is available, then why should I use heavy quantitative techniques to model the ECL?
The above technique will work only in a simple bank with a small balance sheet. In most medium to large
sized banks, this approach will not yield provision results which will be in line with actual expected credit
losses. No regulator worth their salt will accept such simple reporting of provisions for their medium and
large sized banks.

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.

IFRS9 implementation approach and challenges for Banks in the Middle East

5. Hedge AccountingImplementing hedge accounting as per IFRS9 is the most simple part of the new standard. (Therefore I will not
provide end to end details in this section). I shall now provide a one stop solution to implement hedge accounting as
per IFRS9- i.e simply elect to continue performing the hedge accounting as per IAS39 and add a note in the financial
statements stating so.
IFRS9 allows banks to continue using the IAS39 requirements for hedge accounting. Banks do have an option to use
new standard requirements of IFRS9 also, in which case all hedge instruments have to adhere to IFRS9 reporting
frameworks for accounting.
What are banks in the middle east doing to implement hedge accounting as per IFRS9?
Well, they are doing nothing actually. Most banks (and I believe all) have continued with the IAS39
accounting framework for hedge accounting and state so in the financial statements.

Copyright 2016 Pranav Satheesan. Please do not use any part of this paper without citation of source.