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The post IFRS9 era for the lending industry – the survival of the fittest
A new accounting standard is about to reset the way banks are operating their business. The change is needed as savings are to be kept safe and the lessons learn from previous crisis should be put into practice.
A safer bank comes with a cost. CEOs across all Europe are reflecting how to mitigate the impact and adjust the way they are running the business. Decisions that are taking now are to decide the profit and market position for the next couple of years.
New business model and key strategy questions for a CEO
Post IFRS9 era – underestimating the standard
IFRS9 entered into full effect for the banking industry in January 2018. As the banks are still struggling to finalize their risk models and to complete implementing new reporting systems, one thing is for sure: January 1st 2018 was just the beginning for IFRS9 and 2017 represented only the prelude for what was expected to reshape the lending industry.
What is the real impact of IFRS9?
The IFRS9 implementation and impact on provisions are based on a “first effort” of each bank to interpret the standard and transform its credit risk models accordingly. It will take at least two more years for the banks and their supervisors to benchmark, scrutinize, validate and stress test both methodology and risk models in order to conclude an industry-wide application that will define not just the impact on provisions but most importantly the business model of the “European Bank”.
The final outcome? The transformation of the risk culture and appetite in the lending business and the definition of the business model of the “European Bank”. In most cases, for non-complex universal banks with no investment banking and asset management activities, the final IFRS9 approach is expected rationalize the return on equity (ROE) and profitability downwards, urging the industry to consolidate significantly.
The key strategy questions a CEO has to ask
The major changes introduced by the IFRS 9 standard are the lifetime loss and the forward-looking requirements to calculate provisions. Even though most lenders have focused on the preparations of complex statistical models and reporting technology platforms, the real impact of the standard lies on the ability of the existing business model and risk appetite framework to sustain profitability. IFRS9 abandons the traditional performing/non performing segregation and adapts the approach of a three stage model that forces the bank to realize significant provisions even on performing loans for the entire lifetime of the loan based on a predictive statistical approach of early distress. If the bank does not manage to change its entire business model and lending strategy on time, 2018 will result in significant losses even if the non-performing rates stay unchanged.
Five Key strategy topics for the bank CEO and the Management Body
1. How does my overall business model, strategy and portfolio allocation need to transform to reach my profitability targets and ROE for my shareholders?
Given that the bank needs to recognize provisions from the underwriting of the loan and consider the change in expected default risk for the entire lifetime of the loan, the main cost drivers become the risk profile of the borrower and the maturity of the loan. Such drivers will define the portfolio allocation model. How do you allocate your capital to minimize cost and maximize return?
2. How are the new cost drivers affect my new pricing strategy?
Under a revision of the cost side, the bank will need to consider how to treat that cost in order to maintain current profitability. Do you absorb all or part? Do you roll over to the client all or part? How is that affecting the commercial strategy of the bank vis-a-vis competition?
Each client’s profit and loss profile is different under IFRS9 and the bank needs to re-decide what lending solutions to promote, to which client, in which industry and how to price them.
3. How a transformation in risk management will decrease the probability of additional provisions?
The main increase in provisions, compared to old standard, is for performing loan with increased probability of default compared to expectation at loan origination.
The target would be to identify problematic loans before they deteriorate and are transferred to high-risk stage and address them before being forced to book additional provisions. This requires restructuring product design and covenants, refinement of the IFRS9 model segmentation and most importantly, the development of predictive lifetime underwriting models.
4. How is IFRS9 affecting my M&A strategy?
The valuation methodology of performing portfolio changes
Each portfolio may result in different provisions, depending on the IFRS9 methodology one applies. The buyer will need to apply his own methodology to recognize the true cost to him. It is of critical importance to have accurate estimation of the lifetime expected risk for the acquired portfolio.
5. How is IFRS9 affecting my compensation strategy?
Do I compensate over revenue or profit?
Revenue may stay the same, but profitability changes. If IFRS9 provisions and relationship manager’s variable compensation are not aligned on time, the bank runs a risk of compensating for loss making revenue.