The new IFRS 9 accounting rules mandate that banks enhance their reserves and coverage ratios before problem loans peak, and Moody’s analysts believe the rules will indeed make banks better prepared to deal with loan losses during a downturn. Jorge Rodriguez-Valez and colleagues at Moody’s Investors Service said in their August 3 research piece that they believe the front-loaded reserves under IFRS 9 will facilitate early recovery in banks’ solvency metrics.

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Banks will front-load provisions under IFRS 9

After analyzing the impacts of the new accounting rules on banks' capital and solvency metrics, Rodriguez-Valez and team underscore that as opposed to the current incurred-loss model, one of the objectives of IFRS 9 is to make banks more robust when downturns occur. For this purpose, the Moody’s analysts simulated the impact of a recession and slow recovery on solvency metrics over a period of 10 years.

As can be deduced from the exhibit on the left side, the NPL profile touches 6.4% before dropping slowly. The analysts highlight that in such a scenario, the aggregate PD would rise from 0.7% to 2.3% before dropping back towards the steady state situation of 0.7%. The exhibit on the right side depicts how under IFRS 9, provisions will increase strongly before a downturn and peak well before NPLs:

Credit costs during downturn

Highlighting the impact of front-loaded reserves, the Moody’s analysts point out that at the beginning of a downturn, stage 1 provisions will drive the initial increase in reserves, followed by a sharp increase in stage 2 provisions. However, the analysts note that these provisions will be released earlier in the cycle, enhancing banks’ bottom lines before the recovery materializes.

The Moody’s analysts point out that when loans migrate from stage 1 to stage 2, PD will increase from around 1% (average PD for stage 1) to almost 30% (average PD for stage 2). Under such a “cliff effect” involving loans moving between different stages, even if new charges for stage 1 loans decline, new provisions for stage 2 loans would continue to drive credit costs higher. However, the analysts point out that in the worst year of the downturn (stage 8, in which PDs touch 2.3%), provisions for stage 1 loans are negative, implying that banks would start releasing provisions for them.Loan provisions

The analysts underscore that such a release of provisions for stage 1 loans would drive a rapid decline in credit costs. They point out that during the worst of the recession and the ensuing recovery, credit costs will be lower under IFRS 9 than under the current model.

IFRS 9 implementation costs pegged at 50-60 bps

Addressing the initial implementation cost of IFRS 9, the analysts said they believe the ratio of tangible common equity to risk-weighted assets for many European banks will drop by around 50-60 bps. However, when viewed from a broader credit perspective, the analysts believe substantial improvements in other metrics of bank solvency will offset this capital impact.

The following chart captures the analysts’ estimates of the initial impacts on TCE for a selection of European banking systems. The analysts attribute the differences across banking systems to various factors, such as banks’ current buffers. The analysts argue that the implementation cost would have larger impact for weaker systems in Europe:IFRS 9 implementation