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In brief Despite an upturn in the economic outlook, uncertainty remains ingrained into business operations today. As a result, most corporate treasuries are
Find out moreCredit Risk Suite – Expected Credit Losses Methodology article
The IFRS 9 accounting standard has been effective since 2018 and affects both financial institutions and corporates. Although the IFRS 9 standards are principle-based and simple, the design and implementation can be challenging. Specifically, the difficulties that the incorporation of forward-looking information in the loss estimate introduces should not be underestimated. Using our hands-on experience and over two decades of credit risk expertise of our consultants, Zanders developed the Credit Risk Suite. The Credit Risk Suite is a calculation engine that determines transaction-level IFRS 9 compliant provisions for credit losses. The CRS was designed specifically to overcome the difficulties that our clients face in their IFRS 9 provisioning. In this article, we will elaborate on the methodology of the ECL calculations that take place in the CRS.
An industry best-practice approach for ECL calculations requires four main ingredients:
The overall ECL calculation is performed as follows and illustrated by the diagram below:
The CRS consists of multiple components and underlying models that are able to calculate each of these ingredients separately. The separate components are then combined into ECL provisions which can be utilized for IFRS 9 accounting purposes. Besides this, the CRS contains a customizable module for scenario-based Forward-Looking Information (FLI). Moreover, the solution allocates assets to one of the three IFRS 9 stages. In the component approach, projections of PDs, EADs and LGDs are constructed separately. This component-based setup of the CRS allows for customizable and easy to implement approach. The methodology that is applied for each of the components is described below.
For each projected month, the PD is derived from the PD term structure that is relevant for the portfolio as well as the economic scenario. This is done using the PD module. The purpose of this module is to determine forward-looking Point-in-Time (PIT) PDs for all counterparties. This is done by transforming Through-the-Cycle (TTC) rating migration matrices into PIT rating migration matrices. The TTC rating migration matrices represent the long-term average annual transition PDs, while the PIT rating migration matrices are annual transition PDs adjusted to the current (expected) state of the economy. The PIT PDs are determined in the following steps:
The result of this is a forward-looking PIT PD term structure for all transactions which can be used in the ECL calculations.
For any given transaction, the EAD consists of the outstanding principal of the transaction plus accrued interest as of the calculation date. For each projected month, the EAD is determined using cash flow data if available. If not available, data from a portfolio snapshot from the reporting date is used to determine the EAD.
For each projected month, the LGD is determined using the LGD module. This module estimates the LGD for individual credit facilities based on the characteristics of the facility and availability and quality of pledged collateral. The process for determining the LGD consists of the following steps:
Once all expected losses have been calculated for all scenarios, the weighted average one-year and lifetime loss are calculated for each transaction , for both 1-year and lifetime scenario losses:
For each scenario , the weights are predetermined. For each transaction , the scenario losses are weighted according to the formula above, where is either the lifetime or the one-year expected scenario loss. An example of applied scenarios and corresponding weights is as follows:
This results in a one-year and a lifetime scenario-weighted average ECL estimate for each transaction.
Lastly, using a stage allocation rule, the applicable (i.e., one-year or lifetime) scenario-weighted ECL estimate for each transaction is chosen. The stage allocation logic consists of a customisable quantitative assessment to determine whether an exposure is assigned to Stage 1, 2 or 3. One example could be to use a relative and absolute PD threshold:
If either of the criteria are met, Stage 2 is assigned. Otherwise, the transaction is assigned Stage 1.
The provision per transaction are determined using the stage of the transaction. If the transaction stage is Stage 1, the provision is equal to the one-year expected loss. For Stage 2, the provision is equal to the lifetime expected loss. Stage 3 provision calculation methods are often transaction-specific and based on expert judgement.
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