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Investing in financial stocks? They could be more volatile, come 2018.

That’s because new accounting rules are coming out next year that could negatively impact the loan books and capital adequacy of banks and other financial institutions.

The new rules, known as IFRS 9, are set to come into effect for reporting years starting January 1, 2018. Since Canadian banks start their fiscal years on November 1, they get an extra 10 months to prepare for the impact. But many international banks start their fiscal years in January, meaning they’ll be the first to report these major changes affecting their results.

As such, the likes of Deutsche Bank, UBS and Barclays will offer an early warning of what to expect when IFRS 9 lands in Canada.

Response to the financial crisis

IFRS 9 is broad, covering the measurement of financial assets, hedge accounting and the impairment of financial assets, which applies to all companies. However, it’s the impact on financial institutions—in their estimates and reporting of impairment of financial assets, like retail loans—that is relevant for investors.

The rules for measuring impairments are being changed in response to the financial crisis. Under current rules, companies can delay the recognition of credit losses and impairments on non-specific assets. That means they do not recognize an impairment until there is a trigger event or indication that an asset’s credit quality has deteriorated. Essentially, this is when the bank is no longer sure it will collect the full principal and interest. Currently, banks group together similar retail assets and consider them for impairment losses that are “incurred but not identified.”

New methodology

Under the new rules, companies will move to a model based on expected credit losses (ECLs) and assess each loan when it is first recognized. Initially, each financial instrument will normally start in Stage 1, at which time the bank records a probability-weighted credit loss based on the expected impairment of the asset over the next 12 months. That is, the bank will record the amount of expected loss based on events that could occur over the next year.

When the bank estimates that an instrument’s credit profile has significantly increased in risk, the instrument moves to Stage 2, at which point the bank records the expected lifetime loss. Stage 3 is for non-performing loans, for which the bank records the expected lifetime loss (Stage 3 is similar to the current rules).

The new rules require ECLs to be estimated based on probability-weighted expected outcomes that consider a range of different scenarios, and take into account past, present and future indicators.

Also, under the new rules, banks will recognize ECLs in net income in Stage 1, before any loss event has occurred. This will lead to banks recognizing credit losses earlier than under the existing rules. Some Canadian bank CEOs have said this will lead to greater volatility in reported results.

Criticism

Pundits have highlighted more potential problems with the new rules. For instance, Stage 1 assets could easily slip into Stage 2 after a material, but seemingly normal, shift in credit profile.

While the rules were designed to adequately warn of another financial crisis, it seems banks might be called out for more typical cyclical ebbs and flows.For instance, the recessionary downturn experienced in Canada since mid-2014 would have likely tipped the balance and triggered a change in credit risk for many retail loans. This could have resulted in a cascade of assets from Stage 1 into Stage 2.

The general fear is that the new rules could generate hyper-cyclicality, with a wave of expected (but not incurred) losses hitting the books and affecting the measurement of regulatory capital.

However, the assessment of regulatory capital by OSFI does not necessarily follow IFRS guidelines. While the regulator generally likes the direction of the new rules, it might refine its approach in advance of them becoming a problem in Canada. It’s likely regulators are closely watching European banks, plus the results of any stress tests.

At the same time, regulators must consider the impact of new Basel III requirements on reported regulatory capital.

What’s to come?

At this point, Canadian banks are generally at an earlier point in their assessment and implementation of IFRS 9, whereas European banks are further along the process. As such, Canadian banks are saying the new rules “might” result in increased credit losses, as compared to European banks, which state that reported losses will definitely increase.

Both Deutsche Bank and UBS expect the new rules to increase the recognition of credit losses, affecting reported income and creating greater volatility in results. This is due to a combination of reporting losses as soon as loans are originated or acquired and the inclusion of a larger number of loans in the calculation relative to current rules.

The banks also warn of increased subjectivity in their reported results.

On the whole, the European banks should provide more details on the expected impacts of the new rules in their 2017 annual reports. The reports should contain valuable insights into the likely impacts for Canadian banks.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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