AIFRS (IFRS outside Australia) requires collective provisions to be determined based on the observation of objective evidence of impairment. Roll rates are calculated using historical data relating to account arrears, losses and run off rates. The roll rates percentages are applied to the existing portfolio which is broken down into arrears categories. In order for the roll rate to be applied to the current portfolio, AIFRS requires either objective evidence (an impairment trigger) to be identified or an Incurred But Not Reported (IBNR) concept to be applied.
Even if we were to apply the roll rates to the “Zero” arrears bucket under an IBNR concept (given there is no objective evidence of impairment of current receivables), up to what term should we provide the provisioning for? Is it the remaining life of the portfolio, the so call “emergence period” or generically 1 year?
The remaining life can be determined based the time required until the receivables reach zero due to natural attrition or write-offs. If we used the remaining life as the term, how do we ensure that we are not taking future losses into account?
The emergence period is typically defined as the time it takes from the date a loss event occurred to the date the entity identifies it has occurred. Account status is typically updated on a monthly basis or even on a real time basis and payment default may be the only loss event identifiable on an individual exposure basis. Due to the immaterial time difference between the loss event and the identification of the event under the roll rate approach, the concept of emergence period is generally not applicable in retail banking.
Strictly speaking, if we apply the “IBNR” concept under AASB 139.AG90, we generally limit the term to 1 year. However if we do that, it is likely that we would underestimate the provisions required for the “zero” arrears bucket.
I cannot not think of a way that is feasible under the IFRS requirement and also the business requirements. There is always a forward looking component when looking at the portfolio from a business angle. Of course expected losses is not acceptable under IFRS.
I understand roll rate is still the most common provision methodology out there in the market because it really works and simple to use. However the key is to convince how does roll rate may satisfy the requirements of IFRS in retail portfolios, what sort of tweaking might be required to come up with a IFRS compliance roll rate model? Any ideas?
5 comments
14 February, 2007 at 1:59 pm
amar
A way to tackle the problem may be through the initial recognition of the asset i.e. if the market expects that a certain % will default, then it would price it in accordingly and therefore the fair value would incorporate the expected loss on zero arrears assets.
21 January, 2010 at 11:04 pm
Kim
I would like to ask one question on this article, if emergence period is generally not applicable in retail banking due to the short time difference between the loss event and the detection, then bank’s should not calculate impairment for IBNR loans and only calculate for default loans. Is my understanding correct? Im a little bit confused on this part.
22 January, 2010 at 1:11 am
Andrew
Kim,
This piece is quite old, and consensus has moved on a bit. If using an IBNR approach then the period is probably not immaterial, and the method of finding the emergence period is really up to the bank and the auditor – within the bounds of reality.
The difficulty that coldies is identifying with this piece was that the Standard prohibits the identification of an impairment on newly written assets – which will occur on an IBNR approach if you use the outstandings at the balance sheet date.
This can be fixed by the use of the size of the portfolio at the balance sheet date minus the emergence period.
22 January, 2010 at 6:56 pm
Kim
Andrew,
What we are actually doing right now for retail loans is to calculate IBNR for non-default loans since in this case, loss event has yet to be identified (for simplicity we generally use the 91 days past due as the point in time where we identify loss event). When we calculate impairment losses on these IBNR loans/non-default loans we just include in the formula, the emergence period or the loss identification period (LIP) as we call it here.
In order to avoid recognizing day 1 loss on newly written loans, we just exclude those new loans (granted during the past month or two) in the calculation of IBNR losses.
If the emergence period is not applicable to retail loans, as discussed in the article, then we dont have to calculate IBNR losses due to low detection risk (based on my understanding we calculate IBNR losses because of the risk that we have yet to identify loss events on accounts that we still classify as performing/good accounts)because the accounts are updated regularly in the books.
Is my understanding correct. I appreciate your help.
23 January, 2010 at 9:26 pm
Andrew
Kim,
What coldies said applies if you are using a roll rate approach to using the IBNR – one that I would not advise unless you have a full understanding of the method and are correctly applying it.
The absense of a full system to calculate this (which can be tacked on to an advanced Basel II compliance system) the way I would typically advise using the IBNR approach needs a bit of work to get right, but it involves taking a sample (say 30 randomly chosen) of the loans that went bad in each category and examine the files to see how long the emergence period for each really was. This then becomes the emergence period to be used for that portfolio.
The percentage loss on the portfolio is a matter of objective fact once the emergence period is known, but this can be adjusted as per the Standard for changing economic conditions.
The only remaining question is what portfolio to apply it to – and this should be the portfolio as it was as at the balance date minus the emergence period. This solves the problem of recognising losses on day one loans as you are not doing so – you are only recognising losses on the portfolio as it was at a point in the past.
Of course, there are better ways to do it once you have a Basel II Advanced system, or a method of tracking roll rates and perhaps progresion through grades, but the method outlined above complies with the Standard and is fairly simple to apply.