IFRS 9 Impact on Sri Lankan Banks August

IFRS 9: Impact on Sri Lankan Banks August 2014 Sujeewa Mudalige Managing Partner - Pw. C

Agenda 1. IFRS 9 overview 2. Expected credit losses 3. Challenging times ahead Pw. C Slide 2

IFRS 9 Overview 1 IFRS 9: Financial Instruments Pw. C August Slide 3

Timeline of IFRS 9 Nov 2009 Oct 2010 Nov 2013 IASB issues IFRS 9 (2009) – classification and measurement of financial assets IASB issues IFRS 9 (2010) – financial liabilities and derecognition General Hedging amendments to IFRS 9 Nov 2009 Jan 2011 March 2013 2018 IASB issues ED on impairment FASB and IASB issue supplementary document on impairment IASB re-exposes impairment and issues limited amendments to IFRS 9 (2010) Effective date IFRS 9: Financial Instruments Pw. C July 2014 Final Standard August Slide 4

Key Highlights of IFRS 9: Financial Instruments Pw. C Slide 5

Audit Committees need to be active now IFRS 9: Financial Instruments Pw. C Slide 6

Key Highlights of IFRS 9: Financial Instruments Pw. C Slide 7

IFRS 9 – Key changes It will replace the existing standard IAS 39 in 2018 and will introduce important changes to accounting rules for financial instruments in three main areas: Classification; and Measurement Impairment Hedge Accounting The largest impact is likely to be due to the new approach in measuring impairment IFRS 9: Financial Instruments Pw. C August Slide 8

Key Highlights of IFRS 9 Background • It will change the way banks book provisions on financial assets like loans and bonds. Key considerations • IFRS 9 requires banks to make appropriate provisions in anticipation of future potential losses, rather than the current practice of providing only when losses are incurred. • This means that banks will have to recognise provisions from the day they extend any loan, including undrawn commitments. IFRS 9: Financial Instruments Pw. C Slide 9

SL Banks may have higher provisions It will lead to banks, in some cases, having to make substantially higher provisioning, which could hurt earnings and weigh on their capital. It could also potentially affect dividend payouts. The day 1 impact of IFRS 9 adoption, provisioning could potentially jump by more than 50% for some of the banks!! Pw. C Slide 10

SL Banks may have many challenges Pw. C Slide 11

Impact on SL Banks Pw. C Slide 12

Expected credit losses 2 IFRS 9: Financial Instruments Pw. C August Slide 13

IAS 39 vs IFRS 39 Pw. C Slide 14

From incurred loss to expected loss model Incurred Loss Expected Loss • Used by IAS 39 • Used by IFRS 9 • An entity is not permitted to consider the effects of future expected losses • Requires earlier recognition of credit losses in many cases • Credit losses recognised when an event has occurred that has a negative effect on future cash flows & the effect can be reliably estimated Pw. C • Requires an entity to make an ongoing assessment of expected credit losses Slide 15

Financial Assets - A principles based approach IAS 39 Classification IFRS 9 Classification • Rules based • Principles based • Complex and difficult to apply • Classification based on business model and the nature of the contractual cash flows • Multiple impairment models • Complicated reclassification rules IFRS 9: Financial Instruments Pw. C • One impairment model • Business model driven classification August Slide 16

Expected credit losses General model Change in credit quality since initial recognition Recognition of expected credit losses 12 month expected credit losses Lifetime expected credit losses Effective interest on gross carrying amount Effective interest on amortised cost carrying amount Interest revenue Effective interest on gross carrying amount Stage 1 Performing (Initial recognition*) Stage 2 Underperforming (Assets with significant increase in credit risk since initial recognition*) Stage 3 Non-performing (Credit impaired assets) *Except for purchased or originated credit impaired assets Pw. C Slide 17

Lending landscape may change IFRS 9: Financial Instruments Pw. C August Slide 18

Expected credit losses General model Information to take into account for assessment of increased credit risk Changes in external market indicators Changes in business Changes in internal price indicators Changes in credit ratings Other qualitative inputs Changes in operating results 30 days past due rebuttable presumption However…. Pw. C Slide 19

Lending landscape may change • To deal with the potentially higher provisioning, banks may reprice or restructure the loans, making it more expensive for borrowers with riskier credit profiles. Additional quantitative disclosures are required on transition • Banks will likely be revising their business strategy. For example, they might think twice about extending certain types of loan facilities if they are deemed too risky or no longer profitable. These could include reducing the limit of undrawn facilities such as overdrafts. IFRS 9: Financial Instruments Pw. C August Slide 20

Expected credit losses (ECL) General model Overview – Stage 1 • For accounts that fall under Stage 1, the bank has to provide 12 -month forward-looking expected credit losses. • 12 -month ECL are the expected credit losses that result from default events that are possible within 12 months after the reporting date. • Borrowers with good credit risk profile will likely fall under Stage 1. IFRS 9: Financial Instruments Pw. C August Slide 21

Expected credit losses (ECL) General model Overview – Stage 2 • When accounts fall under or get into Stage 2 that it gets more problematic for banks, as this is where the provisioning gets heavier. (could be 4 to 5 times more than that for Stage 1 depending on the product). For Stage 2 accounts, banks have to provide lifetime ECL. • Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the loan. If a mortgage loan has an expected maturity of 20 years and it has gone into Stage 2, you have to provide (over) 20 years ECL, instead of 12 months. Pw. C Slide 22

Expected credit losses (ECL) General model Overview – Stage 2 • Accounts generally fall under Stage 2 when there is “significant increase in credit risk” since the loan was extended. • The standard has 16 criteria, including if the borrower is 30 days past due, so if you miss your one-month payment, you come to Stage 2. • But banks can rebut this, with a 30 -day rebuttable presumption, if they feel it doesn’t warrant going to Stage 2. Banks have to build a model to argue that even though the borrower is one-month past due, a downgrade is not required. Pw. C Slide 23

Expected credit losses (ECL) • A 10 -year loan versus a 5 -year loan will carry different provisioning. With the longer tenure, provisioning will be higher. • In the past, where banks would give a loan and would like to stretch it because it gives them recurring income, now they will have to think it through for borrowers with not a very good rating. • An SME customer, for example, to get a longer tenure loan can be more expensive, going forward. • Banks may have to re-look at the basis on which loans are re-scheduled at present. Slide 24 Pw. C

Expected credit losses (ECL) General model Overview – Stage 2 • In general, banks are likely to rebut retail loans rather than corporate loans. • If corporates miss a payment, it’s usually not a good sign and an indication that they are underperforming. It would be difficult to rebut corporate and SME accounts. • To avoid having assets fall to Stage 2 because of a missed payment, the banks’ collection department is going to play an increasingly important role, going forward. Early payment alert will become a key strategy for banks. Pw. C Slide 25

Expected credit losses (ECL) General model Overview – Stage 2 • If you’ve gone to Stage 2, banks may seek legal advice on whether, based on the existing contract with the borrower, they can ask for additional interest or additional collateral. • Banks should explore what else they can do when accounts go to Stage 2. • It is important to ensure that customers don’t go from Stage 1 to Stage 2. Pw. C Slide 26

Expected credit losses (ECL) General model Overview • Banks now have to make a provision for un-utilised credit lines. • Overdraft limit and bank guarantees — which are all off the balance sheet — will need to be provided for. • Your credit card limit will now carry a provision. This means banks are going to be very careful about credit card customers and some may consider reducing the limit. • Interestingly, apart from loans, banks will now also have to make provisions for bonds that they invest in. Bonds also have to be put in Stage 1, 2 or 3. That means that the treasury department also gets affected. Pw. C Slide 27

IFRS 9 – Implementation projects Scope Development of ECL Model for the Loans & Advances Portfolio • 12 months Expected Credit Loss (ECL) • Lifetime Expected Credit Loss (ECL) • Multiple economic scenarios • Exposure at Default • LGD Computation • Disclosure requirements • Establish the financial asset classification for financial instruments Training of Staff members : Pw. C • Financial Asset Classification • Expected Credit loss modelling Slide 28

IFRS 9 – Rank the following in order of difficulty (encountered or expected) when designing and implementing your IFRS 9 provision and impairment solution. Pw. C Slide 29

Expected credit losses Disclosures Quantitative Reconciliation of opening to closing amounts of loss allowance showing key drivers of change Write off, recovers and modifications Reconciliation of opening to closing amounts of gross carrying amounts showing key drivers of change IFRS 9: Financial Instruments Gross carrying amounts per credit risk grade Pw. C Qualitative Inputs, assumptions and estimation techniques for estimating ECL Write off policies, modification policies and collateral Inputs, assumptions and estimation techniques to determine significant increases in credit risk and default Inputs, assumptions and techniques to determine credit impaired August Slide 30

IFRS 9 – Rank the following in order of difficulty (encountered or expected) when designing and implementing your IFRS 9 provision and impairment solution. Pw. C Slide 31

IFRS 9 – Data requirements Pw. C Slide 32

Challenging times ahead 3 Pw. C Slide 33

A silent revolution in banks’ business models What should banks do to get ahead? ? 1. Adjusting portfolio strategy to prevent an increase in P&L volatility 2. Revising commercial policies as product economics and profitability change 3. Reforming credit-management practices to prevent exposures from deteriorating 4. Rethinking deal origination to reflect changes in risk appetite 5. Providing new training and incentives to personnel to strengthen the commercial network (source: Mc. Kinsey) Pw. C Slide 34

Challenging times for SL Banks 2018 -2020 Factors to be considered? Basel III New Taxes ? New IRA Pw. C IFRS 9 SL Banks Debt Repayment Levy Slide 35

Capital requirements • The banks are expected to disclose the full effects of IFRS 9 on provisions, profitability and capital in their 2017 annual reports • In SL, the change in accounting standards is happening at a time when some banks are struggling to meet progressive increases in minimum capital requirements as Basel III is phased in. Pw. C Slide 36

What are the challenges for SL banks? • Sri Lanka does not have enough instruments that qualify for Additional Tier I capital (AT 1) apart from Common Equity Tier 1 (CET 1) capital. • This means that banks will depend heavily on the capital market to raise additional capital and this can pose some challenges. • This can be aggravated where existence of common shareholders prevail in a shallow capital market. Pw. C Slide 37

What is the Indian Government doing? USD 32 billion capital infusion Indian State Banks Pw. C 1 Government providing USD 24 billion. 2 The banks are expected to raise the rest through, fresh equity issuance, 3 Indian Government willing to accept a dilution of its ownership to 52% Slide 38

What are the SL banks doing? Developments: SL Banks Pw. C 1 Government willing to broad base ownership of Bo. C and PB 2 Some licensed commercial banks have raised capital through rights issues in 2017 3 Most banks would require to raise capital on an annual basis for the next 3 -4 years. Slide 39

How much is enough? Equity (Rs Mn) Debt (Rs Mn) Bank Raised Proposed HNB Com Bank Sampath Seylan NTB 14, 545 10, 143 7, 602 *6, 000 **10, 000 3, 500 3, 208 * Rs 4 Bn in sub convertible debentures with an option to issue a further Rs 2 Bn ** Rs 6 Bn in subordinated debentures with an option to issue a further Rs 4 Bn Pw. C Slide 40

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