At the beginning of this year, Kenyan banks joined their global peers in adopting the International Financial Reporting Standards 9 (IFRS 9), ushering in a significant shift in accounting for financial instruments.
As the financial institutions settle in under the new regime — which among other things requires that provisions are made on the basis of expected, rather than realised loan losses — focus is shifting to the impact this would have on the banking sector and the economy as a whole.
What is IFRS 9?
IFRS 9 is an International accounting standard that specifies how an entity should classify and measure financial assets and liabilities including impairment. It was launched in 2014, with a mandatory global compliance date of January 1, 2018.
IFRS 9 effectively replaces the old International Accounting Standard (IAS) 39 for organisations that deal with financial assets. Since the key purposes is to guide on accounting treatment of financial assets, this standard will impact lending institutions the most. It is, however, worth noting that the standard is applicable to non-financial institutions that carry financial assets in their balance sheet.
One of the fundamental changes that IFRS 9 introduces is the concept of provisioning for expected losses. This is a forward-looking impairment model, requiring banks to set aside funds, by way of provisioning, in anticipation of loan losses. This means that a loan does not necessarily have to slip into non-performing status for a provision to be taken — the provision can be due to a change in a risk factor such as forecasted drought for an agricultural sector customer or improved rail transport for a road transport service provider.
The basis of determining the expected losses is somewhat complex but is guided by the standard in building the appropriate impairment models. Under IAS 39, provisions were made only after default had occurred and the loan classified as non-performing. Consequently, recognition of value reduction was not possible until the loss trigger events had occurred. Principally, this has changed the way banks book provisions on financial assets such as loans and other debt instruments.
Impact on financial institutions
The shift to expected losses provisioning will require financial institutions to re-look at their business models with changes in internal procedures and controls to cater for risk growth areas. To survive in this new environment, banks will have to evolve and employ innovative risk management tools that are able to robustly estimate credit risk losses and establish when significant changes in risk occur.
The standard requires banks to make more provisions for sectors or areas that are deemed to be high risk. As a result, banks will need to reassess their product offering and risk management, which is likely to lead to tightening of credit scoring and appraisal processes.
The impact of adopting IFRS 9 will vary from bank to bank and will cast a sharper spotlight on capital allocation. To mitigate expected high impact on capital especially in the first year of implementation, the Central Bank of Kenya has given banks that might dip below Capital Adequacy Requirements (CAR) a 5-year window to recapitalise.
This should, however, not be misconstrued as “postponing” implementation of IFRS 9 but rather a soft landing recovery phase to mitigate capital requirements. Use of the window is optional. It takes 18-24 months to plan, test and implement IFRS 9, the process is onerous and resource intensive.
What is in it for customers?
As a result of the stringent risk assessment and credit scoring, the vast majority of borrowers categorised as risky will find it challenging to access credit. The law capping interest rates further exacerbates the situation due to the fact that it incapacitates the lenders' ability to price for risk.
IFRS 9 is the reset button for 2018, defining the new normal for the financial sector globally.
—The writer is KCB Group Chief Finance Officer
