How have PH banks fared on PFRS 9?

In 2014, the International Accounting Standards Board (IASB) issued the completed version of the financial instruments standard, otherwise known as International Financial Reporting Standard (IFRS) 9, Financial Instruments, which was locally adopted as Philippine Financial Reporting Standard (PFRS) 9.

It was a result of five years of work in response to criticisms that the incurred loss provisioning model recognized impairment “too little, too late” during the global financial crisis in 2008, and that the previous accounting standard (International Accounting Standards (IAS) 39, Financial Instruments: Recognition and Measurement) is “a very rule-based standard which is complex and difficult to understand and apply”.

Fast forward to 2018, PFRS 9 is now in full swing across different companies and industries – particularly for banks, to which this change has the greatest impact. Let’s look at how PFRS 9 implementation affected the 11 listed commercial banks in the Philippines and see whether the goal of the new standard has been met and how the banking industry has responded.

Changes in classification and measurement

The covered banks retained most of the previous classification categories of their financial instruments, with only an average of 31 percent of the total outstanding balance of investments being reclassified to another category. While the affected securities may not be extensive, the reclassification has caused significant remeasurement of outstanding balances, mainly on account of debt investments being reclassified from ‘available-for-sale securities’ to ‘investments at amortized cost’.

The increase in value of the investments is due to the reversal of the accumulated market losses on fixed-income securities having lower market values. For loans and advances, most of the banks have retained the amortized cost measurement, with only two banks having to reclassify some loans outside of the amortized cost category.

New credit loss models – as expected?

Comparing the requirements of the new standard with IAS 39, it was anticipated that loan loss provision would increase with the introduction of the new ‘staging’ requirements and incorporation of forward-looking macroeconomic variables. Similarly, majority (7 out of 11) of the covered banks in the Philippines saw a net increase in total allowance ranging from less than 1 percent up to as much as 30 percent. However, there were still banks that showed a net decrease in allowance.

The differing results reflect the complexity of the credit methodology and the significance of management judgment in the estimate. Some of these judgments include how banks define a significant increase in credit risk (SICR) and a defaulted or credit-impaired financial instrument. These concepts are critical in determining the ‘stage’ of a financial instrument, which is triggered when an allowance equivalent to lifetime expected credit loss is recognized. While the standard includes rebuttable presumptions on these areas (e.g. 30 days past due for SICR and 90 days past due for definition of defaulted accounts), covered banks have used a combination of these with other qualitative and quantitative measures (e.g., changes in probability of default and downgrade of internal credit risk rating).

When reviewing how these judgments have affected the covered banks, it is apparent that the newly introduced concept of stage 2 financial instruments (or those not yet defaulted but have already experienced significant increase in credit risk) may have had the greatest impact. Most banks that have allowance for credit loss coverage ratio for stage 2 accounts at double digits posted the highest increases in allowance for credit losses upon transition. Interestingly, NPLs of covered banks do not fully correlate with the amounts classified as stage 3 (or defaulted) under PFRS 9, despite the similarities in the definition of the two concepts, likely due to the effect of the other qualitative factors considered in the banks’ assessment.

Another area of judgment in impairment provisioning is the consideration of forward looking macroeconomic variables. Most of the covered banks used inflation rate and gross domestic product as key macroeconomic factors affecting defaults, but unemployment rates, interest rates, stock market indices and foreign exchange rates were also considered. Aside from these specific variables, banks are also required to consider future events which might have an effect on the behavior of their portfolio. Some international banks have even considered “specific” economic overlays in their impairment assessment, such as the US-China Trade War or Brexit. In contrast, none of the banks have applied similar specific overlays on their existing allowance for credit losses. It is possible though that the banks considered these in their assessment of macroeconomic variables and not as a separate economic overlay.

Looking back, the new financial standards significantly affected the listed commercial banks in terms of their reported balances, not to mention the considerable amount of effort they put in for the implementation. Having seen how these banks have fared prove the resiliency and capital strength of the industry.

While it is premature to determine how the standard is performing and whether IASB has been successful in their goals when they drafted it, it will be interesting to see how an ‘accounting standard’ will influence the investing and credit practices of banks in the long run. This is relevant as banks face more challenges and uncertainties in the market, and as investors clamor for more transparency in financial reporting.