IFRS9: The rise of the economist

Economic forecasts have always played an important – but not critical – part in the running of large banks. Medium term plans tend to be based, often loosely, around a central view of what the economy will do: if the outlook is good banks plan to grow; if it’s bad they tend to be more prudent and scale back investment. Therefore, a change in economic forecast (as opposed to reality) primarily impacts management sentiment, which indirectly impacts the banks’ commercial behaviour.

IFRS9 accounting rules which come into effect from the end of 2017 may fundamentally change this dynamic.

Under IFRS9, impairment provisions will be calculated on an expected rather than an incurred loss basis over the behavioural lifetime of the products in question. Exactly how the standard will be implemented remains to be seen. What’s clear is that impairment models and, therefore, provisions for credit risk will become much more directly sensitive to changes in the economic outlook. Irrespective of the observable behaviour of counterparties, a change in the economic forecast will change a bank’s credit provisions in a manner which did not happen under IAS39.

As well as introducing a number of operational and modelling challenges, IFRS9 therefore poses a number of interesting governance questions, for example:

• How will Boards attest to the economic forecasts on which the banks’ provisions are based, when even professional economists caveat everything they produce?

• How will the independence of banks’ economics departments be impacted, when there is a direct P&L impact associated with changing their forecasts?

It’s likely that either the importance of, and governance over, in-house economic forecasting units will increase or banks will more clearly defer to reputable 3rd parties (OBR, OECD etc…) for their baseline forecasts.

Irrespective of which path the industry takes, IFRS9 has the potential to create an interesting new feedback loop: if the economic consensus worsens, modelled provisions will rise and banks’ capital reserves will be eroded (even if repayment behaviour has not changed); poorly capitalised banks may then be forced to restrict lending growth, initiating or possibly worsening the predicted downturn.

Perhaps the new accounting regime will improve the quality of economic forecasts, simply by virtue of making them self-fulfilling.