Compliance Challenges facing the requirements of IFRS9

8 October 2017, Revised by Bachir El Nakib (CAMS), Senior Consultant Compliance Alert (LLC) 

Migration to International Financial Reporting Standard (IFRS) 9, or its local equivalent, is likely to create operational challenges across many of banking systems across the globe. These issues would have a negative initial effect on capital, and potentially raise the volatility of earnings and regulatory capital ratios, says Fitch Ratings. IFRS 9 is one of the more significant accounting changes that banks are facing, and will be implemented in 2018 for most major financial markets. It requires banks to switch to recognising and providing for expected credit losses (ECL) on financial assets, rather than the current practice of providing only when losses are incurred. IFRS 9 will also change the way that banks account for a wide range of financial assets. Fitch expects the adoption of the new standard to lead to greater provisioning and earlier recognition of credit losses, which will have an impact on banks' financial statements and regulatory capital. Moving to an expected-loss approach will require significant process changes, including greater integration of credit risk management and internal accounting systems. Banks will also need more data on how portfolios perform though the credit cycle, and will need to build complex models of expected losses. 

International Financial Reporting Standard 9 (IFRS 9) will soon replace International Accounting Standard 39 (IAS 39). The change will materially influence banks’ financial statements, with impairment calculations affected most. IFRS 9 will cover financial institutions across Europe, the Middle East, Asia, Africa, and Oceania.

IFRS 9 will align measurement of financial assets with the bank’s business model, contractual cash flow of instruments, and future economic scenarios. In addition, the IFRS 9 provision framework will make banks evaluate how economic and credit changes will alter their business models, portfolios, capital, and the provision levels under various scenarios.

Given the IFRS 9 requirements in terms of classification, measurement, and impairment calculation and reporting, banks should expect to be required to make some changes to the way they do business, allocate capital, and manage the quality of loans and provisions at origination. Banks will face modeling, data, reporting, and infrastructure challenges in terms of both:

  1. Reassessing the granularity (e.g., facility-level provisioning analysis) and/or credit loss impairment modeling approach (e.g., consistency regarding the definition of default between Basel and IFRS 9 models).
  2. Enhancing coordination across their finance, risk, and business units.

Effectively addressing these challenges will enable bank boards and senior management to make better-informed decisions, proactively manage provisions and effects on capital plans, make forward-looking strategic decisions for risk mitigation in the event of actual stressed conditions, and help in understanding the evolving nature of risk in the banking business. In the end, a thoughtful, repeatable, consistent capital planning and impairment analysis should lead to a more sound, lower-risk banking system with more efficient banks and better allocation of capital. To help minimize the challenges faced by financial institutions when transitioning to IFRS 9, we conducted the Moody's Analytics 2015 IFRS 9 Survey to give practitioners a snapshot of the "current state" of the industry. Moody's Analytics has also included a series of comments on best practices and industry trends.

Survey Findings: Implications for Financial Institutions

IFRS 9 will affect the business models, processes, analytics, data, and systems across several dimensions.

  • Provision levels are expected to substantially increase under IFRS 9 versus IAS.
  • Further equity issuances may be needed, with the potential for greater pro-cyclicality on lending and provisioning owing to IFRS 9. Capital levels and deal pricing will be affected by the expected provisions, but must be evaluated under different economic cycles and scenarios.
  • Banks will have to estimate and book an upfront, forward-looking expected loss over the life of the financial facility and monitor for ongoing credit-quality deterioration.
  • Rating and scoring systems may have to be updated, especially for those banks without Internal Ratings-Based (IRB) models.
  • Banks will need to reclassify assets and reconcile them with IAS. They will also need to map products that can be categorized before the calculation (contractual cash flow test) or create a workflow to capture the purpose (business model test). An additional effort could be required to identify those products that can be considered out of scope (e.g., short-term cash facilities and/or covenant-like facilities).
  • Institutions will have to align, compare, and reconcile metrics consistently (e.g., Basel vs. IFRS 9).
  • Financial institutions will have to coordinate finance, credit, and risk resources for which current accounting systems are not equipped.
  • The IFRS 9 provision model will make banks evaluate, at origination, how economic changes will affect their business models, capital plans, and provisioning levels.
  • A methodology to calculate a forward-looking measurement will have to be developed and/or updated (e.g., transformation from TTC to PiT), while the cash flow valuation analysis must be scenario-driven.
  • IFRS 9 will affect the existing documentation and hedge accounting frameworks.
  • Systems will need to change significantly to calculate and record changes requested by IFRS 9 in a cost-effective, scalable way.
  • Data requirements will increase to meet IFRS 9-related calculations and ongoing monitoring.
  • Retrieval of old portfolio data will also be needed, especially for the transactions originated before the A-IRB models have been introduced.
  • IFRS 9 impairment calculation requires higher volumes of data than IAS, which may substantially increase the performance and computational requirements of a credit-loss impairment calculation engine.
  • Financial reporting and reconciliation will be needed to align with other regulatory requirements.
  • IFRS 9 makes the provisioning exercise a cross-functional activity, with coordination needed across the risk, finance, accounting, and business functions.

IFRS 9 is a Game Changer

IFRS 9 is the International Accounting Standards Board’s (IASB) response to the financial crisis, aimed at improving the accounting and reporting of financial assets and liabilities. IFRS 9 replaces IAS 39 with a unified standard. In July 2014, IASB finalized the impairment methodology for financial assets and commitments. The mandatory effective date for implementation is January 1, 2018; however, the standard is available for early adoption (e.g., via local endorsement procedures). IFRS 9 introduces changes across three areas with profound implications for financial institutions:

  • The classification and measurement of financial assets
  • The introduction of a new expected-loss impairment framework
  • The overhaul of hedge accounting models to better align the accounting treatment with risk management activities

Replacing IAS 39 with IFRS 9 will significantly impact banks’ financial statements, the greatest impact being the calculation of impairments:

  • IAS 39 – A provision is made only when there is a realized impairment. This results in “too little, too late” provisions and does not reflect the underlying economics of the transaction.
  • IFRS 9 – Aligns the measurement of financial assets with the bank’s business model, contractual cash flow characteristics of instruments, and future economic scenarios. Banks may have to take a “forward-looking provision” for the portion of the loan that is likely to default, as soon as it is originated.

IFRS 9 has also several common characteristics with the Financial Accounting Standards Board’s (FASB) Current Expected Credit Loss (CECL) model provisioning framework to be implemented in the US.

Who will be subject to IFRS 9?

IFRS 9 will be required for financial institutions in Europe, the Middle East, Asia, Africa, and Oceania. Specifically:

  • Companies listed on EU stock markets and EU banks must use IFRS reporting standards in preparing their consolidated financial statements.
  • Europe: More than 230 banks (banks of significant importance)

  • Asia, Americas (excluding the US), Oceania, and Africa will be implementing IFRS either through a local-endorsement process or convergence of the respective country-specific standard.
  • Asia and the Middle East: More than 370 banks (banks of significant importance)

Institutions in the US will not be subject to IFRS 9 (GAAP is mandatory for those institutions). However, FASB will introduce a similar analytical framework (CECL) if the current proposal is approved under the proposed form without major modifications.

Industry Snapshot: Current State

With all eyes on IFRS 9, Moody’s Analytics carried out our first IFRS 9 survey to help practitioners better understand how their peers are preparing for the implementation. Overall, banks that participated in the survey are accelerating their planning, budgeting processes, and road-mapping activities for full-scale implementation projects, given the finalization of the IFRS 9 standard.

Industry Snapshot

Compliance has become a greater challenge for corporate treasurers in recent years. Treasurers are currently facing a wide range of new and evolving requirements, although the specific challenges will be different for every company. How can treasurers best overcome these issues – and what role is technology playing in supporting compliance activities?

Compliance has long been an area of concern for corporate treasurers. However, the recent wave of new regulation has made this area more pressing – and challenging – than ever before. “In the last few years, treasurers have realised that, given the speed and complexity of regulations that are coming out of Europe, the US and other jurisdictions, they need to be much more alert to regulation itself,” says Ruth Wandhöfer, Global Head of Regulatory and Market Strategy at Citi.

While compliance is a challenge for treasurers around the world, the nature of those challenges – and the way in which treasurers address them – varies considerably between companies. A recent market study published by FIS asked how treasurers currently approach risk management and regulatory compliance. “In the FIS Treasury Risk Management and Regulations study we recently completed, we learned Basel III was expected by treasurers to have a significant impact on depository relationships, short-term cash management strategies, and financial services pricing,” says Andrew Bateman, Head of Treasury, Payments, Receivables Solutions at FIS.

“With most Dodd-Frank rules either finalised or close to being finalised, treasurers are getting settled into the new normal – we’re seeing greater efforts required to record and report data, especially data related to derivatives. Corporates are still in the process of understanding the implications of moving away from IAS 39, so that attention can be turned to reducing operational complexity and capitalising on possible new hedging opportunities presented in IFRS 9.”

Areas of focus

Treasurers are facing compliance challenges in a number of different areas. While the implications of Basel have been written about extensively, other regulatory topics are also significant – including the introduction of IFRS 9. However, the FIS study found that almost half of respondents were unclear about the impact IFRS 9 would have on reporting and accounting for derivatives. The survey noted, “Key IFRS 9 implications for treasurers include changes in hedge accounting effectiveness thresholds, an expansion in items which qualify for hedge accounting, as well as benefits for those organisations engaging in economic hedging activities.”

Where the securities space is concerned, Wandhöfer says that MiFID II could lead to some compliance challenges that are quite specific to large corporates that are very active in the trading business. “Of course these businesses have already been on the case for some time,” she says. “They have made presentations to the EU to help advocate on the technical side, but they will need to focus quite specifically on what these changes mean from a compliance point of view when it comes to topics such as reporting and transparency.”

Wandhöfer adds that a key pain point is the Know Your Customer (KYC) account opening process, which is highly paper based. “The country differences lead to problems when it comes to filling out different types of forms. But there is also the ongoing KYC effort which has to be constantly refreshed.”

Wandhöfer points out that banks are under pressure to have the right data for their clients at all times, so if anything changes – for example, if a board member is replaced – KYC will need to be refreshed. “The question there is how you can create a KYC model whereby the corporate has an automated process for pushing updated data to the bank, rather than the bank phoning the corporation and asking for paper copies of passports.”

Other areas of focus include EMIR and the Dodd-Frank Wall Street Reform and Consumer Protection Act. However, a question mark exists over the fate of Dodd-Frank following the election of Donald Trump, who has pledged to dismantle the regulation.

While the compliance challenges that companies face are numerous and varied, treasurers should be aware that not all new regulation comes to pass – at least not in its original form. Section 385 of the Internal Revenue Code had been widely expected to have a negative impact on cash management structures such as cash pooling and in-house banking. However, following a consultation period, the final and temporary regulations published on 13th October included exemptions for arrangements such as cash pooling.

By the same token, some regulations can have a positive rather than a negative effect on corporations, as illustrated by the introduction of SEPA.

What determines compliance challenges?

While there are many areas of compliance to consider, not all companies are affected in the same way. As David Stebbings, Director, Head of Treasury Advisory at PwC explains, “Corporates do not only need to understand their own compliance requirements – they also need to understand how different regulations affect their banks and their financial services providers.”

For example, Stebbings points out that corporate treasurers may have some compliance challenges around accounting standards and EMIR – but the more significant concern may be about how banks are affected by developments such as Basel III. “Companies will need to understand how the price of structures such as notional pooling might increase because of regulation on the banks,” he adds.

Compliance challenges will also vary from market to market. “From an Africa perspective, the diverse regulations surrounding centralised or regional liquidity management remain a critical focus area to manage – something which [companies] would also look to their banks to support them in doing,” comments Jason Marsden, Head of Client Solutions – TPS International at Standard Bank. “In addition, international payments regulations, including the availability for foreign currency in some of the markets, remains a challenge.”

Marsden adds that the trapped cash issue can often be further complicated by the way in which a company is set up, and the way in which it invests in certain markets. “Not getting the right approvals may also hinder capital and dividend repatriation,” he notes.

Nevertheless Bateman points out that while compliance challenges vary between different regions and industries, the treasurers addressing these challenges have one thing in common: resource constraints. “Increased demand on treasury operations, and the expanding scope of treasury, has resulted in resource constraints for many treasurers,” he explains. “Finding domain expertise and maintaining a trained team has never been more challenging. Because of these resource constraints, staying up-to-date with frequent post-recession changes in the regulatory environment has been all the more challenging.”

Tackling compliance

With so many regulations and variations to consider, where should treasurers start when it comes to overcoming compliance challenges?

First and foremost, it is important to address any issues promptly. “If you’re going to wait and sit on your hands before the new rule is actually there, you’re simply too late,” advises George Dessing, SVP, Treasury and Risk at Wolters Kluwer. “Make sure you’re ahead of the curve – be proactive, speak to your peers, speak to your advisors, speak to your auditors. Try to get more information out of your network.”

Different companies are addressing the challenges in different ways. Bateman observes that some treasurers of large corporates have staffed up in order to help manage regulatory changes. Meanwhile, Marsden says that real time liquidity visibility and management can play a critical role in managing some of the compliance challenges faced by treasurers, “enabling the treasurers to be more agile in their approach to treasury management.” In addition, he says that a number of treasurers are also looking to “localise” their costs as much as possible by leveraging localised supply chains and infrastructures.

Tax compliance

One area which presents particular challenges is that of tax compliance. “Global treasurers and global businesses now have a lot of focus within their tax department on staying on top of domestic and cross-border developments,” says Ruth Wandhöfer, Global Head of Regulatory and Market Strategy at Citi. “There is now a whole raft of obligations on global corporations to disclose tax matters – namely where profits have been earned, and where money has been moved to. We are starting to see the net closing on the tax matter – even Panama has recently announced that it will participate in the tax transparency initiative.”

Wandhöfer says that treasury has a key role to play in understanding where the company’s tax-related liquidity activities may have to change, what type of reporting is needed and how banks can facilitate the new demands which are emerging.

“On the flipside, banks are spending a lot of time in understanding where global tax rules are going, when something starts to be applicable, and whether changes will need to be made to their products, so that clients can be better supported, for example in the space of liquidity solutions.” Wandhöfer adds, “In a positive sense, this is almost a collaboration space, because every business wants to make sure they are doing the right thing – and so do the banks.”

Regardless of the chosen approach, it is important for treasurers to understand what they are up against. “Treasurers have to have an understanding of the regulatory landscape, as well as the right treasury technology and resources required for process reengineering, where necessary,” says Bateman. “Without any one of these, treasurers are more likely to lose sleep at night.”

He adds that insight into the regulatory landscape is typically a combination of internal and external expertise. “Technology should be best-of-breed treasury technology, specialising in regulatory compliance, which will allow for the department to achieve that compliance in an automated fashion,” he says. “Lastly, treasurers need resources to achieve compliance – the resource problem can be partially alleviated with treasury technology, and a reliance on third-party experts/specialists for implementation.”

These third-party experts might include consulting partners, banks and treasury technology providers. Bateman explains, “Our role at FIS has changed over the years from just a technology provider, to more of a consultative partner. Treasurers are expecting us to not only deliver technology, but also to help navigate the regulatory and compliance environment, both through the technology solutions themselves and through advice and thought leadership.”

Meanwhile, TMS providers are working to support treasurers in meeting their compliance requirements. “While compliance challenges continue to evolve, treasury technology enables even small treasury teams to be more strategic,” says Bob Stark, VP Strategy at Kyriba. “This allows them to get beyond basic compliance and contribute to business performance such as reducing cost of goods and services by optimising cash flow hedging programmes.”

Compliance: a treasurer’s eye view

“A few years ago, compliance was limited to some standard forms – bank account opening and the like, and making sure you knew your relationship manager,” says James Kelly, Group Treasurer of AB Ports. “We then went through a bit of a chaotic phase where new regulations came in and banks set up their own processes, often without sharing with customers the detail of the new requirements, which made it difficult to develop any standard process.

“Banks took on armies of compliance people but typically, corporates have tried to muddle through without increasing staff numbers, which has increased the pressure on transactions which have to be executed quickly, like acquisitions.

“Happily, the rules have now been reasonably established in developed markets like the UK. As a result, not only are customers able to begin to develop a standard response per bank, but the banks are also sharing standards by joining together on initiatives like the Markit KYC platform. Meanwhile, other providers like Thomson Reuters have developed platforms and asked banks to sign up.

“As a direction of travel this is helpful, although the very bank-focused roll out (saving costs but not necessarily enhancing the customer experience) means take-up has been slow from what I have seen.

“The multitude of rules, depending on bank and jurisdiction, has meant that during my time at Rentokil Initial we tried to build a library of what was required for transactions in each jurisdiction. This can then be used to develop systems, rather than adopting ad hoc processes. Interestingly this is an area which the TMSs have not really focused on to date, leaving customers to develop their own platforms.

“With the potential demise of Dodd-Frank, we may be entering a period with a little more stability, allowing systems to catch up with the various compliance demands.”

The rise of RegTech

Indeed, the role played by technology in supporting compliance is continuing to evolve. “Technology has a key role to play in supporting compliance,” says Matt Tuck, Head of Global Transaction Banking, Barclays Corporate Banking. “Compliance requires a huge amount of data and individuals can only process that information when it is easily accessible and sorted efficiently.”

Wandhöfer notes that technology innovation is starting to focus on elements of RegTech, where innovation aims to help banks and, increasingly, corporations navigate compliance challenges by allowing for more automation of data feeds and data reporting.

She adds that the manual work involved in data reporting can be almost impossible to achieve, given the raft of different requirements. “Taking tax as an example, you could have multiple jurisdictions asking for slightly different things,” she explains. “Even though OECD principles are harmonised, local implementation tends to be different. Technology is becoming increasingly important as a means of helping automation in that space.”

Wandhöfer says that some solutions which initially focused on helping banks fulfil reporting requirements are now also starting to venture into the corporate reporting space.

“Distributed ledger technology could be a real answer to some of this, but at that moment we are still in the experimentation stage,” she says. “We haven’t even got clarity as to whether some of these solutions can be acceptable from a regulatory point of view.”

In addition, Wandhöfer says that smaller, innovative businesses are emerging with various solutions. For example there are fintechs focusing on helping corporates understand the different FX rates that they get from different providers, in order to help optimise for the cheapest choice. She notes that not all such solutions are aimed specifically at compliance – a lot of these focus on improving a company’s business performance – “which I think is quite important, because otherwise you don’t have any money left for compliance.”

One way in which treasurers can overcome the resourcing challenges associated with compliance is by introducing efficiencies and cost savings – often through the strategic use of technology. As Bateman explains, “Without the right treasury technology in place, we find treasury departments spend a disproportionate amount of their time performing the daily ‘blocking and tackling’, something which hampers the treasurers ability to achieve compliance.”

Looking forward

As the regulatory environment continues to change, new compliance challenges emerge. As such, treasurers need to continue monitoring this area, introducing new solutions and strategies as the need arises.

“We’re always anticipating changes and new regulatory requirements for our clients,” says Bateman. “Here in the US, for example, we expect certain changes as a result of the recent election, with the Trump transition team pledging to dismantle, or modify Dodd-Frank.”

Bateman adds that he expects cybercrime to be a greater area of focus and responsibility for treasurers as well, due to the rampant cyber-attacks of the past two years. “We expect treasurers will continue to feel the squeeze on resources as well,” he concludes. “It’s our job as a technology and consultative partner to stay ahead of the regulatory curve, in order to help our clients better navigate the regulatory and compliance landscape.”

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