How new standard will affect banks, customers and economy

Bank customers at an Automated Teller Machine. PHOTO | ADRIAN DENNIS | AFP

What you need to know:

  • Banks will have to evolve and employ innovative risk management tools that robustly estimate credit risk losses.
  • CBK has given banks that might dip below Capital Adequacy Requirements a five-year window to recapitalise.

This year, Kenyan banks adopted the International Financial Reporting Standards 9 (IFRS 9), ushering a significant shift in accounting for financial instruments that, among other things, requires provisions to be made on the basis of expected, rather than realised, loan losses.

IFRS 9 specifies how an entity should classify and measure financial assets and liabilities.

Launched in 2014 with a mandatory global compliance date of January 1, 2018, IFRS 9 replaces the International Accounting Standard (IAS) 39 for organisations that deal with financial assets.

BALANCE SHEET

Seeking to guide accounting treatment of financial assets, IFRS 9 will affect lending institutions the most.

But it is also applicable to non-financial institutions that carry financial assets in their balance sheet.

One of the fundamental changes is the provisioning for expected losses.

This is a forward-looking impairment model requiring banks to set aside funds by provisioning in anticipation of loan losses.

COMPLEX

A loan does not have to slip into non-performing status for a provision to be taken; it can be due to a change in a risk factor, such as forecasted drought for an agricultural sector customer or improved rail transport for a road transport service provider.

The basis of determining the expected losses is somewhat complex but is guided by IFRS 9 in building the appropriate impairment models.

Under IAS 39, provisions were made only after default had occurred and the loan classified as non-performing.

PROCEDURES

Consequently, recognition of value reduction was not possible until the loss trigger events had occurred.

Other IFRS 9 requirements include classifications and measurement of financial instruments, hedge accounting and disclosures.

The shift in provisioning will require financial institutions to relook at their business models with changes in internal procedures and controls to cater for risk growth areas.

APPRAISAL

Banks will have to evolve and employ innovative risk management tools that robustly estimate credit risk losses and establish changes in risk.

As IFRS 9 requires more provisions for sectors or areas deemed as high risk, banks will need to reassess their product offering and risk management, which is likely to lead to tightening of credit scoring and appraisal.

While in the pre-interest rate cap era banks could easily have matched the risk to an appropriate price, the law has taken that option off the table — meaning that, where banks feel the risk is not commensurate to the capped rate, then they will not lend.

POSTPONING

The effect of IFRS 9 will vary among banks and cast a sharper spotlight on capital allocation.

To mitigate expected high impact on capital, especially in this first year, the Central Bank of Kenya has given banks that might dip below Capital Adequacy Requirements a five-year window to recapitalise.

This is, however, not ‘postponing’ implementation but rather a soft landing recovery phase to mitigate capital requirements.

RISK PRICE

Use of the window is optional. But since it takes 18-24 months to plan, test and implement IFRS 9, it is onerous and resource intensive.

As a result of the stringent risk assessment and credit scoring, the vast majority of borrowers categorised as risky will find it challenging to access credit.

Further, the interest rate cap law exacerbates the situation as it incapacitates the lenders’ ability to price for risk.

Nonetheless, IFRS 9 is the reset button for 2018, defining the new normal for the financial sector globally.

TRANSPARENCY

Its sound implementation will contribute to financial sector stability as the standard strengthens banks’ credit risk management systems and greater levels of transparency, which should lead to sustainable returns for shareholders.

Mr Kimathi is group chief finance officer, KCB. [email protected]