Charta is on Google Play: practise on the go. Get the app
Charta

Account for what IFRS 9 requires when expected loss is estimated.

FRM® Part II · Credit Risk Measurement and Management · Credit Risk Management · FRM2.CR.3.g

The idea

IFRS 9 replaced the incurred-loss model with an expected credit loss model, so losses are recognised before a default occurs. Stage 1 assets, with no significant increase in credit risk since initial recognition, carry an allowance equal to 12-month expected credit losses. Stage 2 assets, where credit risk has increased significantly (with a rebuttable presumption at 30 days past due), carry lifetime losses. Stage 3 assets are credit-impaired, carry lifetime losses and earn interest on the net carrying amount. 90 days past due is a rebuttable presumption of default. The estimate must be unbiased and probability weighted. It must reflect time value by discounting at the effective interest rate, and use reasonable and supportable information including forecasts. The stage test is relative to origination, not an absolute PD level.

Formulas

Expected credit loss under IFRS 9

ECL = Σ(pᵢ × Lᵢ) ÷ (1 + EIR)ᵗ

pᵢ
the probability of scenario i
Lᵢ
the loss in scenario i
EIR
the effective interest rate
t
years until the loss occurs

Probability weighted and discounted at the effective interest rate. Stage 1 uses 12-month default risk; Stages 2 and 3 use lifetime.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which feature distinguishes a Stage 3 asset under IFRS 9 from a Stage 2 asset?

  1. Stage 3 uses 12-month ECL while Stage 2 uses lifetime ECL, so Stage 3 provisions are smaller.Why not: Reverses the stages: both Stage 2 and 3 use lifetime ECL.
  2. Stage 3 assets are removed from the balance sheet.Why not: Credit-impaired assets stay on the balance sheet until derecognised or written off.
  3. Stage 3 estimates are not probability weighted.Why not: All stages use an unbiased, probability-weighted estimate.
  4. Stage 3 assets are credit-impaired, with interest recognised on the net carrying amount. - correct

Both stages use lifetime ECL; the difference is credit impairment and the basis for interest revenue. Stage 1 and 2 assets earn interest on the gross carrying amount.

A harder one

A loan of USD 100 million has a 12-month PD of 2 percent, a lifetime PD of 9 percent and an LGD of 45 percent. It moves from Stage 1 to Stage 2. Ignoring discounting, the additional allowance to be recognised is:

  1. USD 4.05 millionWhy not: Gives the full Stage 2 allowance and forgets the 0.90 already held.
  2. USD 0.90 millionWhy not: Recomputes the 12-month ECL, which is the Stage 1 level.
  3. USD 3.15 million - correct
  4. USD 7.00 millionWhy not: Uses the PD difference (7 percent) on the exposure and omits LGD.

Stage 1: 2% x 45% x 100 = 0.90. Stage 2 uses lifetime ECL: 9% x 45% x 100 = 4.05. The increase is 4.05 - 0.90 = 3.15 million.

The hardest tier

A Stage 2 loan could produce a loss at the end of year 2 in one of three scenarios: no loss (probability 55 percent), a loss of USD 5 million (30 percent) or a loss of USD 14 million (15 percent). The effective interest rate is 8 percent. The lifetime expected credit loss is closest to:

  1. USD 3.60 millionWhy not: Probability weights the loss but does not discount it.
  2. USD 3.09 million - correct
  3. USD 5.43 millionWhy not: Gives equal weight to the three scenarios instead of their probabilities.
  4. USD 3.33 millionWhy not: Discounts for one year instead of the two years until the loss.

Probability-weighted loss = 0.30 x 5 + 0.15 x 14 = 3.60. Discounted two years at 8%: 3.60 / 1.08² = 3.09.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Credit Risk Management