Coping With IFRS 9, Like It Or Not
Focus On Economic Signals, Not Accounting Noise, As Loss Accounting Changes
Back when we were very young analysts with a strong aversion to vegetables, we often
heard ‘how do you know you don’t like it until you try it?’. We very rarely did like it
(and would never give our parents the satisfaction of admitting it when we did). We
have not yet tried IFRS 9, but we already know we don’t like it.
That said, like those greens, there is no choice here. New loan loss accounting is
coming in F2018 for the Big Six banks (F2019 for CWB and LB). We are not going to
guess at the transition impact because it should not change the economic value of
these firms. In this note, we instead spend time looking at some ideas to help us look
through the volatility that will come with the new accounting.
IFRS 9 is about three main topics: measurement of financial instruments, impairment
of financial assets, and hedge accounting. We are primarily concerned with the second
and the implications for loan loss accounting. Little has been disclosed so far, but we
do know that earnings volatility is set to rise as we move to a more forward-looking
approach to provisioning. The recent oil price collapse is an example of an event to
which the new standard would have over-reacted, much to investors’ detriment.
So, what to do? Our approach will evolve, but we do expect to give more prominence
to some secondary metrics. First, pre-tax pre-provision trends will insulate us from
over-reacting to a large change in the provision line. Second, we will be looking more
closely at net write-offs. The write-off occurs not when the stress arrives but once the
stress is worked out, and so is not ideal. Except for timing, there ought to be little
difference between the provision and the charge-off. In practice, though, we now
expect to see bigger provisions and reversals, so we will need the charge-off to gauge
actual underwriting prowess. We show both in this note.
Finally, we also add a supplementary balance sheet measure to account for the fact
that earlier loan losses will build a reserve with funds that otherwise would have gone
into retained earnings (and therefore CET1). We combine reserves and CET1 to get a
better sense of absolute and relative balance sheet positioning.