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Methodological thoughts on expected loss estimates for IFRS 9 impairment: hidden reserves, cyclical loss predictions and LGD backtesting

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  • Wolfgang Reitgruber

Abstract

After the release of the final accounting standards for impairment in July 2014 by the IASB, banks will face the next significant methodological challenge after Basel 2. In this paper, first methodological thoughts are presented, and ways how to approach underlying questions are proposed. It starts with a detailed discussion of the structural conservatism in the final standard. The exposure value iACV(c) (idealized Amortized Cost Value), as originally introduced in the Exposure Draft 2009 (ED 2009), will be interpreted as economic value under amortized cost accounting and provides the valuation benchmark under IFRS 9. Consequently, iACV(c) can be used to quantify conservatism (ie potential hidden reserves) in the actual implementation of the final standard and to separate operational side-effects caused by the local implementation from actual credit risk impacts. The second part continues with a quantification of expected credit losses based on Impact of Risk(c) instead of traditional cost of risk measures. An objective framework is suggested which allows for improved testing of forward looking credit risk estimates during credit cycles. This framework will prove useful to mitigate overly pro-cyclical provisioning and to reduce earnings volatility. Finally, an LGD monitoring and backtesting approach, applicable under regulatory requirements and accounting standards as well, is proposed. On basis of the NPL Dashboard, part of the Impact of Risk(c) framework, specific key risk indicators are introduced that allow for a detailed assessment of collections performance versus LGD in in NPL portfolio (bucket 3).

Suggested Citation

  • Wolfgang Reitgruber, 2014. "Methodological thoughts on expected loss estimates for IFRS 9 impairment: hidden reserves, cyclical loss predictions and LGD backtesting," Papers 1411.4265, arXiv.org, revised Aug 2015.
  • Handle: RePEc:arx:papers:1411.4265
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    References listed on IDEAS

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    1. Wolfgang Reitgruber, 2012. "The Calculus of Expected Loss: Backtesting Parameter-Based Expected Loss in a Basel II Framework," Papers 1211.4946, arXiv.org, revised Aug 2013.
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    Cited by:

    1. Petr Polak & Jiri Panos, 2019. "The Impact of Expectations on IFRS 9 Loan Loss Provisions," Research and Policy Notes 2019/03, Czech National Bank.
    2. Cheng, Dan & Cirillo, Pasquale, 2018. "A reinforced urn process modeling of recovery rates and recovery times," Journal of Banking & Finance, Elsevier, vol. 96(C), pages 1-17.
    3. Ioan-Codruț ȚURLEA, 2021. "Development of Rating Models under IFRS 9," CECCAR Business Review, Body of Expert and Licensed Accountants of Romania (CECCAR), vol. 2(7), pages 64-72, July.
    4. Achim Luminita-Georgiana & Mitoi Elena & Turlea Ioan-Codrut, 2021. "A methodological approach to developing and validating IFRS 9 -LGD parameters," Proceedings of the International Conference on Business Excellence, Sciendo, vol. 15(1), pages 683-694, December.
    5. Kund, Arndt-Gerrit & Rugilo, Daniel, 2023. "Does IFRS 9 increase banks’ resilience?," Working Paper Series 2792, European Central Bank.

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