1. Credit Risk Modelling for IFRS -9
Javed H. S i d di qi
Head of Ri sk M ana gement Di vi si on
S oneri Bank - Paki stan
23-25 May 2016
Singapore

2. The future of bank
risk management
• By 2025, risk functions in banks will likely need to be fundamentally different than they are
today.
• The next ten years in risk management may be subject to more transformation than the
last decade
• Unless banks start to act now and prepare for these longer-term changes, they may be
overwhelmed by the new requirements and demands they will face.
• Regulation will continue to broaden and deepen as public sentiment becomes less and less
tolerant of any appearance of preventable errors and inappropriate business practices
• Simultaneously, customers’ expectations of banking services will rise and change as
technology and new business models emerge and evolve
• The risk function of the future will probably be expected to deliver against all these
requirements and deal with these trends at a lower cost, because banks will in all
likelihood have to reduce their operating costs substantially

3. What will the risk function look like in
2025?
• It is likely to have broader responsibilities, to be very engaged at a strategic level,
and to have much stronger, collaborative relationships with other parts of the
bank.
• Banks talent pool will probably have experienced a massive shift in expertise
toward better analytics and greater collaboration, and away from operating
processes
• IT and data will likely be much more sophisticated, often employing big data and
complex algorithms.
• The risk function may be able to make better risk decisions at lower operating
costs while creating superior customer experiences.
• If banks want their risk functions to thrive during this period of fundamental
transformation, they need to rebuild them during the next decade.

4. The leading institutions will be
distinguished by their intelligent
management of risk.
 In the future . . .

5. Rational for Change (IAS 39 to IFRS 9)
• During the financial crisis, the incurred loss model of IAS 39 for accounting of
credit losses associated with loans and other financial instruments was
identified as one of the main weakness of existing accounting standards
• The current IAS 39 uses an incurred loss model to recognize impairment loss
of a financial asset only after a trigger loss event has occurred.
• Incurred loss mode is “too little too late” because the model delays the
recognition of a credit loss event unit there is objective evidence of
impairment.
• Incurred loss model only consider those losses that arises from past events
and effect of future credit loss events cannot be considered, even when they
are expected.

6. New impairment/ Expected Credit loss
Model
• Measurement of expected credit loss should be based on the
probability of the loss occurring.
• IFRS 9 Impairment Model requires expected losses to be
recognized in profit loss statement upon the conclusion of the
transactions.
• Expected credit loss model is able to provide better relevant
information for decision making at an earlier stage.
• Implementation review and follow-up checks of periodic
changes of the credit quality for allocation within the three-
stage model.

7. Challenges and complexities:
Integration with risk management model
• The primary challenge of implementing this ECL impairment
model of accounting is integrating the model with the
existing risk management system of the banks.
• This forward looking ECL impairment model requires a lot of
estimations including Exposure at default (EAD), probability
of defaults (PD) and loss given default (LGD) which can be
pulled from existing credit models with some essential
adjustments as required.

8. Challenges and complexities
Determination of significant increase in credit risk
• What is considered as significant credit
deterioration ?
• How can you demonstrate consistency?
• What are the controls over application of
significant deterioration?
• Development of lifetime EL, term structure for
PD, LGD and correlation

9. Challenges and complexities
Incorporating forward looking information:
• One of the major change in IFRS 9 from IAS 39 is the consideration of
forward looking information and macro-economic factors to forecast
future economic condition in the expected credit loss estimation
• The standard also mentions that the measurement should reflect
reasonable and supportable information available
• Though the standard does not prescribe any particular method of
measurement, the entity would require to judge individual or group of
assets considering a wide range of quantitative and qualitative
information
• The Basel committee guidelines published in February 2015 recognized
that the implementation of forward looking information will be costly
but this cost should not be avoided and the bank’s experienced credit
judgment must be documented in their credit risk methodology.

10. Leveraging existing Basel II/III Methodologies
In use Probability of Default -PD
IFRS 9 Basel II/III
PD estimates over 12-month horizon for Stage
1; Lifetime Loss calculation for Stage 2 and 3
12-month PD estimation
PD estimates are “point-in-time” measures PD estimates is mostly based on “through-the-
cycle” measure
Definition of default-may adopt regulatory
definitions
Regulatory overrides
Considers forward looking estimates at
balance sheet date.
Routine use of stress testing and scenario
analysis for calibration

11. Leveraging Existing Basel II/III Methodologies
In Use Loss Given Default Model-LGD
IFRS 9 Basel II/III
Current LGD Downturn LGD estimates
Discount rate should be at effective interest
rate
Consideration of certain costs and LGD floors
Collateral valuation and disclosures for
financial instruments with inherent objective
evidence of impairment
Discount rate based upon weighted average
cost of capital or risk-free rate
Treatment of collateral is subject to detailed
rules, haircuts etc.

12. IFRS 9: Potential Impact & Challenges
• Business Related Challenges
• Methodical Challenges
• Technical Challenges
• Process Related Challenges
• Strategic Challenges

13. IFRS 9 and Regulatory Changes on the Banking Sector
Business Challenges
1. Do we have right clients not enough client
2. How do we have to protect them ?
3. How do we improve our clients and our clients
profitability ?
4. Does our pricing strategy support my full Basel
III/IFRS 9 economics ?
5. Are we prepare for new banking landscape range
across the economic, political, demographic, and
technological arenas ?

14. Practical Challenges
• The new Credit Risk impairment model will have the
most significant impact on financial institutions.
• It is likely to result in greater provisions and earlier
recognition of credit losses
• Implementation will require changes to systems and
processes, greater segmentation of portfolios,
• greater integration of the credit risk management
systems with the accounting systems.
• Statistical verification of these predictions in credit
risk through back testing poses the next analytical
challenge

15. METHODICAL CHALLENGES
• The transition from IAS 39 to IFRS 9 in provisioning will result in an
unprecedented direct influence of statistical methods (the
parameters PD, LGD and EAD) to the P&L
• Required determination of appropriate categorization logics, credit
quality indicators and threshold values for the three-stage model
• Consideration of plausible, future-oriented information and macro-
economic developments for a regulation-compliant recognition of
expected credit losses
• Reduced flexibility in the provisioning process may cause an
increase in the volatility of monthly, quarterly or annual reported
risk costs
• Deeper methodological understanding of the volatility of credit risk
has to be developed to provide adequate mitigation

16. TECHNICAL CHALLENGES
• Review and follow-up checks of periodic changes
of the credit quality for purposes of (re-)allocation
within the three-stage logic
• Definition system-related implementation of
rights of choice regarding trading and leasing
requirements
• Selection and implementation of appropriate
technical impairment solutions, taking the
cost/benefit ratio and the integration into the
existing system environment into account

17. PROCESS-RELATED CHALLENGES
• The selection and implementation of suitable IT impairment
solutions, taking both cost/benefit factors and integration
into existing system and environment.
• Ensuring that the impairment results can be reconciled to
regulatory and other internal credit risk measurement
results
• Prospective PDs and cash shortfalls must be dependent from
future macroeconomic outcomes e.g.. unemployment rates,
GDP, benchmark interest rate, inflation and technology.

18. STRATEGIC CHALLENGES
• The need to identify suitable measures to reduce the size of
impairment provisions and P&L volatility.
• Handling the expected reduction of the equity ratio due to initial
application effects
• Review of the product catalogue and ensuring competitiveness
• Audit assurance for the applied methods or simplifications
• Consistency of methods compared to other areas such as risk or
regulatory

19. Early Warning /KRIs for
“Life Time Expected Credit Loss”
• Change in External Market Indicators
• Credit Ratings
• Adverse change in general economic and/or market
condition
• Significant changes in the operation results or financial
position of the borrow
• Changes in the borrower’s regulatory, economic or
technological environment

20. Early Warning /KRIs for
“Life Time Expected Credit Loss
• Change in the value of collateral or guarantees
• Expected or potential breaches of covenants
• Changes in the expected behavior of the borrower and past
due information
• Material documentation problems
• Inability to clean-up the facilities as per terms and
conditions.
• Diversion of loan proceeds/Excessive inter-company
lending(s)

21. Early Warning /KRIs for
“Life Time Expected Credit Loss
• Industry-specific, economic, and/or political problems, affecting the
obligor’s performance
• Significant declining revenues / profitability
• Severe liquidity crunch or cash flow or late payment of Interest/mark-up
/Installment due or considerable increase in days payable
• Increase leverage and /or weakening net-worth
• Concerns about the obligor’s management competence , emergence of
succession risk
• An inability to obtain current financial information

22. Early Warning /KRIs for
“Life Time Expected Credit Loss
• Exhibit of adverse trend in sales and cost of good sold
• Significant increase in receivable and inventory build-up with decline
sales
• Negative cash flow from operations during last two years
• No movement/slow movement in pledged stocks
• Shortage in pledge Stock/margin or pilferage or unauthorized stock
lifting.
• Dispute among the sponsors/partners

23. Early Warning /KRIs for
“Life Time Expected Credit Loss
• An actual or expected internal credit rating downgrade for the borrower or
decrease in behavior scoring used to assess credit risk internally
• A significant credit determination on the other financial instruments of the same
borrower
• A Significant change in the borrower’s ability to meet its debt obligations, such as
a decline in the demand for borrower’s sales product because of shift in
technology
• A Significant expected reduction of the borrower’s economic incentive to make
scheduled contractual payments.
• Contractual payments are more than 30 days past-due information.

24. Impact of IFRS-9
• Profitability
• Capital acquisition
• New technology
• Liquidity Needs
• Limits on Lending
• Bank Consolidation
• Pressure on yield on Assets
• Pressure on Return on Equity
• Stability in Banking System
• Risk Management throughout the organization
• Corporate governance
• Executive pay backlash

25. Impact of IFRS-9 Impairment
Dimensions Implications
Decrease in Loan Book Due to decease in net interest margin,
banks could reduce their lending
activities and focus other more profitable
activities i.e. financial markets, advisory
etc
Financial Disintermediation As banks reduce their lending activity,
the demand for loans is likely to shift to
other financial players. Corporates will
probably rely more on the financial
markets.
Decrease in Regulatory Capital IFRS -9 das a considerable impact on
capital recourse planning due to
significant increase the provisions at
stage 1 & 2 which will in turn reduce the
Tier 1 capital ratio.

26. Impact of IFRS-9 Impairment
Dimensions Implications
Increase volatility of the P&L account Increase the volatility of the P&L
account, with financial assets moving
from a 12-month EL to a lifetime EL, and
its reverse .
Stress on ROE Compliance with the IFRS -9
requirements may have a substantial
negative impact on bank profitability.
The IFRS-9 would cause a reduction of
the leverage ratio, thus also reducing
ROE
Loan –to- deposit Ratio Empirically there is a negative correlation
between IFRS -9 and the Loan –to-
deposit ratio.

27. Impact of IFRS-9 Impairment :
Dimensions Implications
Impact on GDP In order to meet the IFRS-9 , banks will
will cause a reduction in profitability,
which banks will tend to restore via an
upward pressure on lending margin
Interbank lending and borrowing Both interbank lending and borrowings
facility will also affect a bank’s IFRS-9
Implementation
Global banks Global banks with lower capital buffer or
higher leverage ratio and excessive
structural funding mismatches were
likely to fail.

28. Tuning of Basel II/III Credit Risk Models for IFRS 9
Factors Basel II IFRS 9
Time Horizon One year (for 12 moths) PD 12 months PD or
Lifetime PD
Observation period Five years for retail exposure and seven
years for corporate , bank and sovereign
exposure
No specific
Statistical approach Hybrid of point-in-time to through-the –
cycle to get the historical long-run
average default rates
Point –in time
Default if obligor 90 days past due or earlier No specific definition,
nut usually not beyond
90 days past due
Floor PD and LGD are subject to floors No floor prescribed
Expected Loss (EL) PD*LGD*EAD PD*PV of cash shortfalls
(PD is 12 months or
lifetime)

29. Conclusion
The banking sector must serve as a stabilizing force and
not as an amplifier of the shocks.
Challenge on delivering on the promise for the next
decade – ‘think global and act local’
IFRS 9 implementation, is a journey not the destination,
is a road not a end of the road.
29

30. 30
Effective Management of IFRS 9 Credit Risk Modelling benefits
the bank..
• Efficient allocation of capital to exploit different risk / reward pattern
across business
• Better Product Pricing
• Early warning signals on potential events impacting business
• Reduced earnings Volatility
• Increased Shareholder Value
No Gain!
No Risk …
To Summarise….

31. “We have no future
because our present
is too volatile. We
have only risk
management. The
spinning of the given
moment’s scenario.
Pattern recognition.”
--- Willian Gibson

33. • References
• [1] “Basel III: A global regulatory framework for more resilent banks and
banking systems,” Basel Committe on Banking Supervision, pub., Dec.
2010, (rev June 2011).
• [2] Edward Wyatt (December 20, 2011). “Fed Proposes New Capital
Rules for Banks”, New York Times.
• [3] (July 21, 2010). “Dodd-Frank Wall Street Reform and Consumer
Protection Act”, Public Law 111-203.
• [4] (December, 2012). “Commission Delegated Regulation (EU)”, No
149/20, Official Journal of the European Union, European Market
Infrastructure Regulation (EMIR) Technical Standards.
• [5] J. Gregory, Counterparty Credit Risk and Credit Value Adjustment: A
Continuing Challenge for Global Financial Markets, 2nd ed. Wiley, 2012.
• [6] S. H. Zhu and M. Pykhtin, “A guide to modeling counterparty credit
risk,” in GARP Risk Review, Jul./Aug. 200