The main objective of this chapter is to get familiarized with the various functions of the OFS Loan Loss Forecasting and Provisioning application through the process flow. The logical order, in which the OFS Loan Loss Forecasting and Provisioning application functionalities are executed, helps in understanding, executing, and maintaining data in the OFS LLFP Application.
This illustration shows the process flow of the OFS LLFP application with the first process is the loading of data, then the Segmentation Run, then the Transition Matrix Run, then the Loss Rate Computation Run, then the Classification & Stage Determination Run, then the EIR Computation Run, then the ECL Computation Run, and the Interest Adjustment Run.
Figure 1: The Process Flow of the Key Features in the LLFP Application
This illustration shows the process flow of the LLFP (CECL standard) application with the first process is the loading of data, then the Segmentation Run, then the Transition Matrix Run, then the Loss Rate Computation Run, then the EIR Computation Run, then the ECL Computation Run, and the Interest Adjustment Run.
Figure 2: The Process Flow of the Key Features in the LLFP (CECL Standard) Application
NOTE:
This process flow diagram highlights only the key features and does not depict the entire product features.
During the financial crisis, the delayed recognition of credit losses on loans and other financial instruments is considered a weakness because of the existing accounting standards. Specifically, the existing model in IAS 39, an incurred loss model delays the recognition of credit losses until there is evidence of a trigger event. Post the crisis, the International body for accounting standards (IASB) saw the need to be proactive in recognizing the losses. Hence, IASB has issued a fresh set of guidelines for Financial Instruments - IFRS 9 related to three areas. Impairment is one of the phases or areas covered by the IFRS 9 guidelines to handle expected credit losses.
The expected credit loss guidelines of IFRS 9 are more proactive and forward-looking in terms of loss recognition. To be compliant with the IFRS 9 guidelines, OFSAA has upgraded its existing Loan Loss Forecasting and Provisioning application.
The IFRS 9 Run includes the following processes:
· Stage Determination
· Manual Reassignment (Optional)
· Expected Credit Loss Calculation
· Segmentation Run: In LLFP, Segmentation Run refers to the process of grouping together accounts into a Portfolio for further processing. Financial institutions generally process accounts that have similar risk characteristics and profiles together as if there were a single block or record, such as Credit Cards. Segmentation provides volume efficiency as opposed to processing records individually.
· Transition Matrix Run: Through a sequence of UIs, the Transition matrix user can manually feed in Probability of Default (PD) values to be later consumed in the Run apart from the application's built-in capability to compute historical PD values based on Credit Rating or DPD transitions over a period of time.
· Loss Rate Computation Run: this run computes the PD value basis Roll Rate Methodology built in the application.
· Classification and Stage Determination Run: The Stage Determination Run starts with the data population to obtain the data required for Classification, Stage Determination, and ECL computation. The non-standard or external data formats are now reclassified to standard or internal data formats. The final subprocess is to assign a stage at an account level granularity, either through an individual or collective basis, based on the data provided and rules configured. After this, the reclassification subprocess is executed to convert non-standard or external data formats to standard or internal data formats. The next process is to conduct the Business model and Cash Flow Characteristics (SPPI) test to identify the classification for each instrument or account. The final stage is to evaluate the change in credit risk and macroeconomic factors to determine the stage at an account level granularity with the stage determination subprocess. Upon successful execution of the stage determination run, the application provides an option for the manual reclassification of the stages assigned to accounts, based on various parameters.
· Manual Reassignment: This optional step enables the financial institutions to override the outcome of the Stage Determination Run and reassign the stage. This process goes through a Maker- Checker workflow with an audit trail. It caters to any judgmental or qualitative factors that need to be considered plus any reputable presumptions.
· ECL Run: The ECL Calculation Run begins with the Methodology Selection subprocess to assign a specific calculation methodology for each of the accounts processed by the application. The selection of methods is based on specific factors that are taken into consideration by the application. Post methodology selection, the application then calculates the Expected Credit Loss, again at an account level granularity, either through an individual or collective basis, based on the approach as per the method selected. The ECL values are also calculated for off-balance-sheet accounts, undrawn portions, POCI accounts, and so on.
· Interest Adjustment Run: IFRS9 requires interest income recognition at Effective Interest Rate. Adjustment value will be posted after factoring in the contract interest amount.
The methodologies to calculate the Expected Credit Loss for different instruments under various Credit Risk scenarios are provided by the IFRS 9 guidelines. Following are those instruments that fall under the scope of IFRS 9 Impairment standards:
The methodologies to calculate the Expected Credit Loss for different instruments under various Credit Risk scenarios are provided by the IFRS 9 guidelines. Following are those instruments that fall under the scope of IFRS 9 Impairment standards:
· Lease Receivables and Trade Receivables
· Contract Assets, Loan Commitments, and Financial Guarantees
The following are the different methodologies highlighted by the standards:
· Approach for Purchased or Originated Credit Impaired (POCI) Accounts
· Determining Significance of Increase in Credit Risk
The General Approach is for all instruments that are within the scope of IFRS 9 except for Lease Receivables, Trade Receivables, Loan Commitments, Contract Assets, and any other instruments that are Purchased or Originated Credit Impaired.
Under this approach, the standard requires the entity to measure the significance of an Increase in Credit Risk of the instrument, from its initial recognition. Based on the outcome, the entity provides for a 12 Month Expected Credit Loss or a Lifetime Expected Credit Loss.
· If the entity decides that there is No Significant Increase in Credit risk, then the Allowance is equal to the 12 Month Expected Credit Loss.
· If the entity decides that there is a Significant increase in Credit Risk, then the Allowance is equal to the Lifetime Expected Credit Loss.
The standard also provides detailed guidance on the factors to be considered to decide the significance of an increase in the credit risk of an Instrument. If the instrument becomes impaired, the Allowance is equal to the difference between the Gross Carrying Amount and the present value of the expected cash flows.
IFRS 9 standards state that, for certain specific instruments, it is not essential to determine the significance of an increase in Credit risk. Instead, an Allowance equal to the lifetime Expected Credit Loss can be directly provided.
The instruments in the scope of the simplified approach are the following:
· Lease Receivables
· Trade Receivables, Loan Commitments, and Contract Assets without significant financing component
· Trade Receivables, Loan Commitments, and Contract Assets with significant financing component, and the entity follow the simplified approach.
NOTE:
For Trade Receivables, Loan Commitments, and Contract Assets with significant financing components, the entity has the option to choose either the general approach or the simplified approach.
The Allowance calculation of POCI accounts under this approach requires the calculation of the Lifetime Expected credit loss for each account, using the Credit Impaired EIR as the discount rate. The allowance is the cumulative change in the lifetime expected credit loss for the account from the date of initial recognition.
The standard also provides a viewpoint on the various factors that an organization must take into account to determine if a particular instrument, that is not Purchased or Originated Credit impaired, has seen a significant increase in credit risk or not. Some of the factors suggested by the standard are the following:
· Internal Price indicators of Credit Risk
· Attributes of Financial Instruments such as Covenants, Collateral, and so on.
· Credit Spread, Credit Default Swaps, Fair Value less than Amortized Cost
· External Credit Rating
· Internal Credit Rating
· Forecast of Financial Conditions
· Forecast of Economic Conditions
· Forecast of Business Conditions
· Increased Credit Risk on other financial instruments of the borrower
· An adverse change in the Regulatory, Technology environment of the borrower
· Change in value of the collateral
· Change in quality of guarantee
· Support from the Parent organization
· Expected changes in the Loan documentation
· Expected changes in the performance and behavior of the borrower
· Past due information
· Qualitative and non-Statistical Factors