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.
© 2018 Deloitte Romania 3
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
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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
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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.
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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
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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
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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.
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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
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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?
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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
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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
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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)
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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:
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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.
© 2018 Deloitte Romania 16
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