Karachi, February 13, 2023 (PPI-OT): IFRS 9 – Shape of banking P and Ls to alter; focus to shift on OCI?
State Bank of Pakistan (SBP) has released a circular, disclosing changes in financial statements of banks post implementation of IFRS 9, applicable from Jan-2023 for banks with asset size over Rs500bn. While the first post-IFRS 9 financials will be available after Mar-2023, we discuss expected changes in bank financials, based on available information.
With regards to asset book, IFRS 9 will alter computation of credit cost of banks – based on expected losses, resulting in, (1) a one-time provision on existing assets, routed through Equity and (2) recurring provisions cost on P/L, prospectively higher than ongoing costs, depending on each bank’s asset book quality.
Existing general provisions carried by banks would also be important to track, as any general provision in excess of required upfront charge will be reversed via balance sheet, creating increase in book value and potentially CAR for some banks.
On equity investment, banks will route all dividends and gain / loss on trading book (FVTPL) through P and L while gains on other equities will route through Comprehensive Income (under FVOCI). This will reduce volatility caused by impairment loss or chunky gain / loss booked against investments carried on historical cost. Any gains on debt instrument under FVOCI would be allowed to route through P/L.
IFRS 9 application to Pak Banks from 1 January 2023
The State Bank of Pakistan (SBP) has released a circular, disclosing changes in banking sector’s financial statements post implementation of IFRS 9, which has become applicable from 1 January, 2023. With the first set of accounts post IFRS 9 releasing after Mar-2023, we discuss the expected changes the said accounting standard would bring to Pakistan’s banking sector’s financials. The said would be applicable for banks with an asset size under Rs500bn from 1 January, 2024.
IFRS 9 would require banks to create provisions for Expected Credit Losses (ECL) through ECL models to be developed by each bank on its own to assess its financial assets and calculate ECL accordingly. This would assist in avoiding delay in identification of any credit deterioration.
The implementation will impact how the sector accounts its lending and Investments, and their respective expected losses. The changes will broadly effect classification of Advances, Investments and relevant accounting treatments reflected in the P/L, Statement of Comprehensive Income and Statement of changes in Equity. We break the explanation in categories.
Introduction of ECL model
On ECL basis, banks will measure loss expectations on investments and loans and classify it under different categories, assigning a probability to compute expected loss based on developing forward-looking scenarios. Banks would be required to build and use:
1. Probability of Default (PD),
2. Loss Given Default (LGD) and
3. Exposure At Default (EAD) models based on forward-looking assumptions.
These would also be adjusted to evolving economic factors. Banks may also need to assess and assign ratings to sectors and obligors separately, which will be the basis of their working. Banks would create three categories under the name of ‘Stages’ and would place assets from least to most risky ranking from Stage 1 to Stage 3.
As these ECL models would be based on each banks’ own workings, data etc., the treatment of a same party may also result in different credit costs on each bank’s books. We await more clarity from regulators regarding uniformity on any level in the future to reduce prospective inconsistencies to the minimum.
Debt instruments classification among three categories
Under the current practice, banks categorize debt instruments into (1) Held-for Trading (HFT) – gains/losses through P and L, (2) Available-for-Sale (AFS) – unrealized gains/losses through equity and realized through P and L and (3) Held-to-Maturity (HTM) – no gains/losses booked during life. The new accounting standard would offer one of the three classifications, which will then be an irrevocable option:
1. Amortised Cost
2. Fair Value through Other Comprehensive Income (FVOCI)
3. Fair Value through Profit and Loss (FVTPL)
The classification will be determined through two tests, (1) Business Model Test and (2) Contractual Cash Flow Characteristics Test, which would help the bank categorize by assessment of the objective of investment. These objectives are (1) Hold to Collect (holding assets in order to collect contractual cash flows), (2) Hold to Collect and Sell Business Model (collecting contractual cash flows and selling financial assets) and (3) Other Business Models (resulting in classification under FVTPL).
In addition, the Contractual Cash Flow Characteristics Test is to understand if the asset is based solely on payments of principal and interest (SPPI), which can then be categorized under Amortised Cost or FVOCI. ECL would be calculated for unlisted debt instruments under Amortised cost and FVOCI. Moreover, exposure (in local currency) guaranteed by the Government and Government Securities are exempted from the application of ECL Framework.
Changes in equity investment accounting
Equity investments are currently categorized under (1) HFT and AFS. As per IFRS 9, listed equities will be classified as FVTPL or FVOCI – which will then be an irrevocable option. With a daily mark to market mechanism, gains/losses on FVTPL and dividends on total portfolio will continue to route through the P and L. Gains/Losses on FVOCI will however reflect in Statement of Comprehensive Income and not the P and L.
Likely to skew towards D/Y plays
We expect banks to place most of its high D/Y equity investments under FVOCI, in order to reflect stable earnings from the portfolio (by way of dividends) in the P/L. Any high-risk/high-upside equity investments would likely be placed under the FVTPL, routing any gains/losses from the same to Income Statement. Impact on BV would remain unchanged, when compared to present accounting treatment.
Loan book – Building ECL models to assess credit cost for all loans
The banking sector currently follows guidelines sketched in the Prudential Regulations (PR) to identify and classify Non-Performing Loans (NPLs). The existing requirement is broadly based on overdue of loan/interest payment, categorized under Specific Provisions. Hence, any credit cost related to Performing Loans are subjective and categorized under another provision category, General Provisions.
Application of IFRS 9 will modify the measurement of NPLs, following its credit cost on ECL basis. Moreover, as the ECL model would not just limit to NPLs and extend to each loan, credit loss for the period would be reported pertaining to Performing and Non-Performing Loans, both.
Stage 1 would categorize Performing Loans, Stage 2 would have Loans with higher risk and Stage 3 would have Non-Performing Loans. Also, provisions under Stage 3 would be higher of as per ECL model and PR requirements.
Buffer through general provisions may come in hand
With regards to the loan book, application of the ECL models, leading to adjustments in credit cost of banks post implementation of IFRS 9 would broadly result in two things, (1) a one-time increase in provisioning stock to account for the changes, the increase being routed through Equity and (2) a recurring provisioning cost in P/L that would depend on each bank’s loan book quality. As banks have built ECL models with respective workings, it would be difficult to quantify the impact on earnings through recurring provisioning expenses before financial statements release.
With existing specific and general provisions coming under one stock post IFRS 9, we expect banks that currently maintain a larger general provision stock to use current buffer built through booking general provisions over time. Hence, those banks are likely be shielded by the impact of additional one-time adjustment on its earnings and book value.
Having said that, banks that result in higher existing general provisions as compared to the one-time increase in provisioning stock may have to reverse the excess general provisions, resulting in a one-time net reversal impact on its equity.
To recall, Pakistan banks have been taking support from General provisioning reserves to build a cushion for any unforeseen or probable credit costs. This trend was evident during the pandemic, where banks opted to build General provisions in anticipation of bulk non-performing loans over economic slowdown. We highlight, General provisions are also a prerequisite as per Prudential Regulations of the State Bank of Pakistan for NPLs in consumer financing, etc.
To limit prospective impact on CAR
The implementation of IFRS 9 is expected to bring some adjustments to adequacy ratios of banks. While for some banks the CAR may decline over net decline in BV owing to higher one-time provisioning adjustments through balance sheet, some banks may also witness a net increase in CAR owing to other adjustments.
The net increase can be led by availing the transitional arrangement offered by SBP (refer to the table on right). In order to mitigate the impact of ECL provisioning on capital, this arrangement has been offered to banks, leading to spreading out the impact of additional one-time adjustment on CET I by application of ECL models in the next five years. The net impact, however, may only be recorded by banks that already have enough buffer built in their existing general provision stock.
Banks would also be allowed to include provisions for Stage 1 and Stage 2 in Tier 2 capital up to 1.25% of total Risk Weighted Assets (RWAs). This is in-line with present applicable Basel III regulations where banks can include General Provision losses of up to 1.25% of RWAs.
Sector multiples remain attractive
While we have incorporated a 100bp credit cost in our CY23 earnings projections, normalizing it thereon, we believe IFRS 9 application from 1QCY23 accounts would alter our projections to some extent.
The sector’s attractive multiples however reiterate our Overweight stance. Pak banks trade at CY23F P/B of 0.6x, where we believe current valuations are unjustified and provide an attractive entry level to investors over (1) double-digit growth in deposit mobilization, (2) decline in cost of deposits and (3) sound asset quality, leading to the sector’s sustainable Tier I ROE averaging at 23%. We flag UBL, MEBL and BAFL from our sector coverage as our preferred plays in the sector. We also highlight UBL, MCB, ABL, BAFL and HMB as top D/Y picks from the sector.