Financial instruments — Impairment
During the October 2011 Board meetings, the Boards asked the staff to develop a principle for the measurement attribute of the credit allowance balance of financial assets included in bucket one and develop a principal and indicators for when it is appropriate to transfer financial assets from bucket one to bucket two. The December meeting was spent discussing a variety of topics in the continued development of the three bucket impairment model.
Principle of transfer from bucket one to bucket two
When recognition of lifetime expected losses is appropriate
The IASB and FASB staffs brought the Boards three alternatives for establishing a principle of transfer with the first two alternatives having multiple variations. The first alternative focuses on the extent of deterioration in credit quality since initial recognition, the second alternative focuses on both the extent of deterioration in credit quality expected at initial recognition and the risk of not collecting the contractual cash flows, and the third alternative focuses on deterioration in credit quality such that management changes its objective in holding the financial asset.
The variations for each of the alternatives were presented as follows:
- Alternative 1A – Recognise lifetime losses when there has been meaningful credit deterioration since initial recognition (but without defining meaningful)
- Alternative 1B – Recognise lifetime losses when the entity no longer expects to receive substantially all of the cash flows expected at initial recognition due to deterioration in credit quality
- Alternative 1C – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition
- Alternative 1D – Recognise lifetime losses when the entity no longer expects the same credit risk as at initial recognition due to deterioration in credit quality
- Alternative 2A – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least more likely than not that the contractual cash flows may not be fully recoverable
- Alternative 2B – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least reasonably possible that the contractual cash flows may not be fully recoverable
- Alternative 2C – Recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is remote that the contractual cash flows may not be fully recoverable.
- Alternative 3 – Recognise lifetime losses based on deterioration in credit quality being such that it changes managements objective for managing the asset (e.g., when the holders credit risk management objective changes from merely monitoring and analysing regular performance updates to actively engaging in managing the credit risk exposure to try to address the issues giving rise to the problems with the asset(s) and to allow appropriate re-calibration of the legal framework of the asset(s) taking into account the borrower(s) financial situation).
The Boards discussions focused on the meanings of the phrases or how the specific terms would be interpreted in practice. Most of the members from each Board tended to favour alternative 2 (particularly 2B) although some also supported Alternative 1B. One particular reason mentioned by Board members for favouring alternative 2 over alternative 1 was concern over the trigger being solely based on credit deterioration, citing the example of a AAA asset being downgraded to A as that movement may be meaningful or more than insignificant while an A credit rating would have relative insignificant concerns over collectability.
One FASB member suggested replacing the language in Alternative 2B from ‘at least reasonably possible that the contractual cash flows may not be fully recoverable’ to ‘other than remotely possible that the contractual cash flows may not be fully recoverable’. Other Board members were generally supportive of the use of ‘other than remote’ as they felt that was a lower threshold than ‘reasonably possible’. One IASB member expressed his support for Alternative 2B because it represented a fairly quick trigger to move items in to bucket two, which he mentioned was his takeaway of the Boards’ desire when they shifted from an absolute to a relative credit risk approach. However, some Board members had concern that the use of ‘other than remote’ could be interpreted to be as low as 5% while the Board tended to prefer a range of around 10% as the trigger to bucket two. One FASB Board member suggested moving the language used in Alternative 1B to the second criteria of Alternative 2B (i.e., ‘substantially all’ instead of ‘reasonably possible’ or ‘other than remote’) as he felt the term ‘substantially all’ was generally interpreted around 10%.
The Boards tentatively decided to proceed with the language proposed in Alternative 2B (e.g., recognise lifetime losses when there has been a more than insignificant deterioration in credit quality since initial recognition AND it is at least reasonably possible that the contractual cash flows may not be fully recoverable). The Boards also asked the staff to develop illustrative examples to highlight that the transfer should occur when the ‘risk of default starts to substantially excellerate’.
Whether the transfer should be based on probability of default or expected loss
The staffs asked the Boards to clarify whether the deterioration in credit quality is 1) the likelihood of not receiving the expected cash flows probability of default (PD) or 2) the expected loss using PD, loss given default (LGD) and exposure at default (EAD).
The staffs recommended that loss given default (LGD) information would factor in to the measurement of lifetime losses but would not factor in to the assessment of the transfer between buckets. Instead, the transfer assessment would consider solely probability of default (PD). The staffs also clarified that collateral would not be considered in the assessment of transferring items between buckets but rather the focus is whether the contractual payments will be collected. The staffs also stated their recommendation was based in part because financial institutions are familiar with tracking PD and therefore such an approach would be more operational.
The Boards were supportive of using PDs as the basis for the trigger of transfers between buckets. However, one IASB member had significant concerns with not also including consideration of LGDs. Several Board members noted that PDs would be impacted by changes in LGDs information. However, the IASB member with the concern referenced certain scenarios where he felt PDs would not reflect increases in LGDs such as a debt restructuring. Other Board members acknowledged they felt PDs should be the primary driver but could understand the concerns being raised and didn’t want the guidance to be so strict that assessment of other information should not be considered.
The Boards tentatively decided that probability of default should be the primary driver in determining when to transfer financial assets between buckets. However the Boards asked the staff to also include language that would not ignore other information indicating the potential for loss (such as LGD information).
Indicators for when the recognition of lifetime expected losses is appropriate
The staffs presented the Boards with potential indicators of when a financial asset may have experienced deterioration in credit quality. Those indicators include changes in: 1) general economic conditions, 2) industry conditions, 3) market indicators of credit risk, 4) re-origination rates, 5) management approach, 6) company performance, 7) company prospects, 8) collateral values, 9) credit quality enhancements/support, 10) loan documentation, 11) expected performance of the borrower and 12) other changes.
One FASB member questioned the inclusion of collateral values given the previous decision that the trigger would primarily be based on PDs. The staff noted that decreases in collateral values (for example a home value less than the outstanding loan balance) could provide incentive for borrowers to walk away from the debt and that incentive is tied to PDs rather than consideration of the recovery from the collateral which would be tied to LGDs.
Both Boards tentatively decided to include the guidance around potential indicators in the impairment proposals.
Bucket one allowance
The staffs asked the Boards to determine the objective of the allowance and its measurement attribute for financial assets in bucket one of the impairment model.
The staffs first asked the Boards to decide on the objective of the bucket one allowance by considering either 1) the approximation of a yield adjustment or 2) capturing expected losses which have not yet materialised (or no meaningful credit deterioration has occurred). No Board members expressed support for a yield adjustment approximation approach. However, the Board had difficulty in determining how to articulate the capturing of expected losses not yet materialised. One IASB member expressed concern with use of the term ‘materialised’. He also questioned whether the expected losses referred to PD (e.g., shortfall in cash flows) or LGD (including recovery of collateral). The staff clarified that the intention was to measure the shortfall in cash flows but that would also include LGD so recovery on collateral would be part of the consideration. The Boards then engaged in a debate over whether the objective of the bucket one allowance is to capture credit deterioration not yet identified or whether it is losses that are inherent in a portfolio based on original pricing and information. However, one IASB member felt that the only way to describe the objective of the bucket one allowance is one of ‘prudence’.
Given the difficulty in deciding on an objective, the Boards decided to focus on the measurement attribute for the bucket one allowance to see if that provided any better basis for determining the objective.
The staffs presented the Boards with three alternatives for the bucket one allowance:
- Shortfalls in cash flows expected to materialise in the next 12 months,
- Shortfalls in cash flows expected to materialise in the next 24 months, or
- Shortfalls in cash flows expected to materialise over an emergence period (the emergence period could be either 1) no established boundaries, 2) a minimum of 12 months and no upper boundary and 3) defining a range of between 12 and 24 months).
One IASB member started the discussion by acknowledging that the trigger for transfers to bucket two (and recognition of lifetime expected losses) that the Boards have established should result in an allowance balance larger than that currently under the incurred loss models in either IAS 39 or US GAAP. Therefore the allowance for bucket one is an additional provision. He noted that concerns that allowance balances in certain jurisdictions may go down as a result of the three bucket model is a result of regulatory overlays to existing impairment requirements and that the Boards cannot guess what regulators in each individual jurisdiction would want for bucket one. Another IASB member agreed that the Boards cannot consider all regulatory requirements around the world. The IASB Chair agreed that the bucket one allowance was an expedient and that it should not be too big nor too complex. A FASB member also agreed that in some jurisdictions reserves may go down simply because of the regulatory overlay aspect.
However, the FASB Chair said she did not believe that the bucket one allowance was a regulatory issue but rather an acknowledgment that there are future losses that exist in performing loans. Several IASB members showed support for use of a 12 month period for the bucket one allowance. One of those stated he could not support use of an emergence period.
One of the IASB members said that he would use the income statement amounts expected to be transferred to bucket two or three in the next twelve months and adjusted for known or other expected factors. The staff responded that their proposed approach would be 12 months of PDs multiplied by the lifetime losses and that may yield a similar approach as to that described by the Board member but this approach was seen as operational by financial institutions. The FASB Chair clarified that the PDs would need to be adjusted for changes in circumstances and for migrations to bucket two.
The Board tentatively decided to require a measurement for the bucket one allowance of shortfalls in cash flows expected to materialise in the next 12 months. The Board also decided the objective of the bucket one allowance would be to recognise 12 months of expected losses.
The Boards discussed two pervasive issues that needed to be addressed in order to continue development of the three bucket impairment model. The first issue relates to aggregation of individual financial assets for collective evaluation of credit deterioration. The second issue relates to the purpose and differentiation of bucket three as compared to bucket two.
Grouping of financial assets for impairment evaluation
Providing guidance on the appropriate level of aggregation for evaluating credit impairment is an important consideration for evaluating credit deterioration, particularly in the context of transferring entire portfolios from bucket one to bucket two.
The staffs noted that the existing guidance in US GAAP and IFRS, as well as the proposals in the supplementary document, emphasize ‘shared risk characteristics’ for determining how to aggregate individual financial instruments into groups.
The staffs recommended including the following guidance in the impairment model:
The objective of grouping is to segregate the financial assets into sub-populations of sufficient granularity to evaluate the groups for impairment (that is, to identify whether the recognition of lifetime losses is appropriate for that sub-population as of the assessment date).
An entity may not group financial assets at a more aggregated level if there are shared risk characteristics for a sub-group that would indicate whether recognition of lifetime losses is appropriate.
(a) Shared risk characteristics may include the following: asset type, credit risk ratings, past-due status, collateral type, date of origination, term to maturity, industry, geographical location of the debtor, the value of collateral relative to commitment for non-recourse assets (which may influence likelihood of debtor electing to default), and other relevant factors. Groups shall be created based on shared risk characteristics as of the assessment date (that is, the groupings may change each period).
If a financial asset cannot be included in a group because the entity does not have a group of assets that share the risk characteristics of that asset, or if a financial asset is individually significant, an entity is required to individually evaluate whether the recognition of expected lifetime losses is appropriate for the financial asset.
If a financial asset shares risk characteristics with other assets held by the entity, an entity is permitted to individually evaluate a financial asset within that group or include it in a collective evaluation of a group of financial assets with shared risk characteristics to determine whether the recognition of expected lifetime loss is required.
One of the FASB Board members asked whether the issue of grouping was related to the assessment for transferring buckets or the measurement of expected losses. The staff responded that for today’s purpose the scope was limited to grouping of financial assets for the evaluation of credit deterioration in determining bucket classification but that the staffs would need to come back to the Boards on the grouping for measurement purposes.
The Boards tentatively agreed to include the guidance as recommended by the staff above.
Differentiation between buckets two and buckets three
The Boards also discussed the issue of how bucket three should be differentiated from bucket two given that both buckets share the same measurement attribute (e.g., lifetime expected credit losses). The Boards considered three alternatives for bucket three. The first alternative would use a deterioration principle such that assets that have continued to deteriorate in credit quality beyond those assets in bucket two would then be transferred to bucket three. The point of transfer would be based on either the degree of credit deterioration since initial recognition or once deterioration has reached a particular level. The second alternative would differentiate bucket two and bucket three based on a unit of evaluation such that bucket two would include assets evaluated collectively while bucket three would include only assets evaluated individually. The third alternative would merge buckets two and buckets three since they share a similar measurement attribute.
The FASB members were generally supportive of alternative two while the IASB members were generally split between alternatives two and three although a couple of IASB member expressed support for alternative one. Certain FASB members felt there was important information provided by stratifying assets between buckets two and three while certain IASB members questioned whether any benefit was gained from stratification other than for disclosure purposes. This led to a debate over whether bucket three was a measurement issue or simply a disclosure issue. Certain FASB members felt, in addition to information for disclosure purposes, there could be measurement implications as individual assets are transferred out of bucket two and in to bucket three could result in measurement difference in the PDs and LGDs of those remaining assets in bucket two.
The Boards tentatively decided that bucket three would be differentiated from bucket two in that bucket three would relate to assets evaluated for credit deterioration individually rather than collectively.