This article first appeared in The Edge Malaysia Weekly on September 11, 2017 - September 17, 2017

A new accounting standard — known as International Financial Reporting Standard 9 (IFRS 9) — that comes into force next year will have a significant impact on banks and inevitably affect borrowers and investors too, say experts.

IFRS 9, or MFRS 9 as the Malaysian equivalent is known, requires banks to change the way they make loan loss provisions. Banks will have to make provisions in anticipation of future losses rather than the current practice of making provisions only when loans have been classified as impaired.

This means that lenders will have to make provision for any new loan they extend, including undrawn facilities.

Given the drastic change in methodology, banks will see a jump in provisions, which could hurt earnings, weigh on their capital ratios and potentially affect dividend payouts. At least one banking group, Affin Holdings Bhd, tells The Edge that dividends are likely to be marginally lower, post-MFRS 9.

For the borrower, loans could eventually get more expensive.

Elaine Ng Yee Ling, a partner and leading expert on MFRS 9 at PwC, says that in trying to deal with the higher provisioning, it is possible banks may reprice or restructure loans, making it more expensive for borrowers with riskier credit profiles.

PWC, which is understood to be the market leader in advising banks on MFRS 9 implementation, estimates that for Malaysian banks, provisions could jump by between 25% and 50% on the first day of MFRS 9 adoption (known as Day One impact). Ultimately, the impact would vary from bank to bank, depending on their loan composition, customer  risk profiles and regulatory reserve buffers.

“For every bank, the degree of the impact will be different. Even if the increase in provisions comes in at the higher end of the 20% to 50% range, Malaysian banks are quite well capitalised, so it’s not going to be an immediate concern. The only thing here is the impact on profitability subsequently. That’s the main concern,” Ng says.

PwC’s estimated 25% to 50% range for Day One impact suggests that the jump might be higher than that for most banks in Europe.

The European Banking Authority, which oversees regulators across the European Union, said two months ago that the majority of banks there expect their provisions to go up by as much as 18% after IFRS 9 is introduced, down from an estimate of as much as 30% last November. And, of the 50 banks that were surveyed, 72% anticipate that the standard will increase volatility in profit or loss.

With less than four months to go, Malaysian banks are scrambling to get ready for the accounting overhaul. According to Ng, banks are at different stages of readiness for MFRS 9, with some of the bigger ones having started preparing for it since late 2015.

“One or two are already doing parallel runs, which is important because that’s when you really churn out the numbers and you can see the potential implications, and from there you can fine-tune your model. For example, you can see which segments in your portfolio carry higher expected credit losses (ECL), and which will be affected most by macroeconomic variables and so on. Banks may want to reconsider the strategy for those segments that are more sensitive or volatile,” Ng explains.

Malayan Banking Bhd (Maybank) says it is currently on a parallel run and refining its MFRS 9 methodology.

Banks will be required to switch to an expected loss model, as opposed to the incurred loss model they now use under MFRS 139.

For a performing loan, lenders will have to make provisions on the basis of projected losses over 12 months. However, if there are signs that the credit quality of that loan is deteriorating, then losses will have to be booked over the loan’s entire lifetime.

“One would expect that provisions will go up significantly upon MFRS 9 adoption. However, on transition, such provision will be adjusted through the opening balance sheet,that is, retained earnings and loss allowance as at Dec 31, 2017, figures (for December year-end entities),” says Malaysian Institute of Accountants (MIA) CEO Dr Nurmazilah Mahzan.

There will be no impact on a bank’s profit and loss (P&L) on Day One. Any movements in impairment allowances after that, however, will be recorded in and affect the bank’s P&L.

What the banks say

Of the six banking groups that responded to questions sent by The Edge, most acknowledge that annual provisions will go up but say the impact on their CET-1 capital on Day One will be manageable, especially if Bank Negara Malaysia allows them to offset the higher provisions against regulatory reserves (RR).

Bank Negara, in response to questions sent by The Edge (see next page), stated that any increase in provisioning under MFRS 9 will be significantly offset by existing RR that banks have been required to set aside since 2015.

All six banks — Maybank, CIMB Group Holdings Bhd, Hong Leong Bank Bhd, RHB Bank Bhd, AMMB Holdings Bhd and Affin Holdings Bhd — say they are on track with their respective plans for MFRS 9 adoption.

However, they do not indicate to what extent their annual earnings would be impacted.

Maybank chief financial officer Datuk Amirul Feisal Wan Zahir says based on its initial impact assessment, the potential reduction in the group’s capital ratios could range between 60 and 90 basis points for Day One adjustment to retained earnings on Jan 1, 2018.

The group’s capital ratios will nevertheless remain resilient post-MFRS 9 as they are among the strongest in the region, he says. As at June 30, its total capital ratio stood at 19.98% while its CET-1 ratio was at 13.56% (after a proposed dividend, assuming 85% reinvestment.)

“Furthermore, the potential reduction in Maybank group’s capital ratios arising from Day One impact can be mitigated if banks are allowed to offset the higher allowances for impairment losses against RR buffers,” he says.

On whether loans may become more expensive for the borrower post-MFRS 9, he says, “Any impact on risk-based pricing would vary depending on the duration of the financing facility. However, this would not necessarily translate into higher cost to borrowers across the board.”

AMMB group CEO Datuk Sulaiman Mohd Tahir, however, reckons that banks may offer shorter tenure loans, post MFRS 9, as a measure to manage and reduce lifetime ECL.

“The limits of loan commitments extended to customers may also be impacted due to the requirement to recognise ECL on loan commitments provided to customers,” he remarks.

Indeed, PwC’s Ng points out that in the past, banks may have liked to stretch loans because it would give them recurring income. “Now, they have to think it through for borrowers with not very good credit rating,” she explains.

Industry observers say unsecured loans such as personal financing and credit cards, which are high-risk, high-margin products, may also be a grey area for banks. Banks will also have to carry provisions for credit card limits, and thus may consider reducing the limit for some customers.

Maybank’s Amirul, however, does not expect the group to slow down certain loans as a result of MFRS 9. “We do not expect this to be so as we will continue to maintain the same prudence in our underwriting practices.”

AMMB, which has a March 31 financial year end, will transition to MFRS 9 only on April 1 next year. “Transitioning to (the new standard) will result in movements in the allowance for impairment losses. Offsetting this additional impairment allowance, there will be fair value gains arising from certain financial assets that are currently not measured at fair value under MFRS 139. Consequently, the impact on CET-1 is expected to be neutral,” Sulaiman says.

He adds, however, that it is currently too early to predict reliably the impairment allowance upon MFRS 9 adoption. “Our capitalisation is more than adequate,” he says, adding that AMMB would strive to maintain a consistent annual dividend payout.

Meanwhile, CIMB Group indicates that it does not expect MFRS 9 to throw it off its key targets for end-2018 under its T18 plan.

“At this stage, we expect the impact on capital to be manageable within our capital plans to achieve our targeted CET-1 ratio of 12% for the group by end-2018,” group CEO Tengku Datuk Seri Zafrul Aziz says.

Hong Leong Bank group CEO Domenic Fuda says from a business perspective, there will be various elements the group will need to consider upon adoption of MFRS 9.

“For instance, loan tenure and credit limit offered to customers are some of the key items to be considered by the bank in determining its business strategies going forward. The ability to proactively manage collection efforts and having access to dynamic data analytics are also important,” he says.

It is premature to assess the potential impact on dividend payment to shareholders, he adds.

Affin Holdings, the country’s second smallest bank, says based on its preliminary assessment, there will be an increase of about 50% in its total provisions upon the adoption of MFRS 9.

The group’s balance sheet is strong enough to weather the impact of MFRS 9, its group CEO Kamarul Ariffin Mohd Jamil says. “Based on impact assessment, the impact on the capital adequacy ratio is less than 1% to the group, which is well within the capital requirements level under Basel III.”

He reveals that the group’s estimated cost for MFRS 9 implementation is about RM5 million this year.

Teething problems

Meanwhile, banking stocks, which investors have chased up this year, may lose some of their shine because of the uncertaintities surrounding MFRS 9.

“The adoption of MFRS 9 in 2018 will create uncertainties for banks’ earnings, which, in turn, would affect the sentiment on banking stocks,” says CIMB Research. In a report entitled Beware the opening of MFRS 9 Pandora’s Box in 2018 two months ago, it downgraded its investment call on the banking sector to “neutral” from “overweight”. Most research houses have a neutral stance on the sector.

CIMB Research estimates that a 10% to 50% increase in banks’ credit cost arising from the adoption of MFRS 9 will lower their FY2018-FY2019 net profit by between 1.3% and 8.3%.

“We expect the negative impact from adoption of MFRS 9 on net profit will be the largest for Maybank at 2.3% for every 10% increase in loan loss provisioning. We believe the net impact will be the smallest at only 0.4% and 0.6%, respectively, for Hong Leong Bank and Public Bank (for every 10% rise in loan loss provisioning),” it says, based on its simulation.

While Public Bank has remained largely silent on its MFRS 9 preparation, analysts note that it is likely to weather the impact the best. The fact that it has the highest loan loss reserves buffer among the banks at 249%, inclusive of RR, is “a major positive”, says UOB Kay Hian Research.

In Malaysia, the banking system had gross non-performing loans of RM26.1 billion as at end-July while the gross impaired loan ratio stood at 1.68%.

Investors will be able to see the impact on the banks from their first-quarter results next year, at least for those with a Dec 31 financial year end.

It becomes even more important now that investors read the banks’ disclosures.

“When they (banks) prepare their financial statements, the disclosures they make will be the story, where they have to explain how they assess the loans and the considerations that went into it. Because the standard is principle based, there is a lot of judgement involved, for example, judgement on how you move from Stage 1 to Stage 2,” notes MIA’s Dr Nurmazilah.

Disclosures are expected to get more complicated and it will be increasingly tough to compare one bank’s performance with another given that each bank’s ECL model will be different.

“It can be very different, especially because of the forward-looking element. In the model, there’s Stage 1,2,3, and on top of all this, you need to include macroeconomic variables. So you plot the GDP, unemployment, inflation … it will be different for every bank. The one that has more optimistic views will likely have lower provisions,” says PwC’s Ng.

“There are some elements where management judgement will come into play. And so, it’s very important that there is a strong governance framework around all this,” she adds.

What is certain is that banks are in for a challenging time as they adjust to MFRS 9.

“As with any new regulation, first time implementation is always difficult but encourages discussion and debate. It will be challenging … a teething process,” Nurmazilah remarks.

In Asean, Thailand and Indonesia are the only two major countries postponing the adoption of IFRS 9 to 2019.

What is MFRS 9?

IFRS 9, or MFRS 9 as the Malaysian equivalent is known, is a complex accounting standard governing financial instruments that will replace IAS 39 (MFRS 139) next year. It will require banks to make provisions for expected losses in the future. Issued by the London-based International Accounting Standards Board, IFRS 9 was designed to address the “too little too late” criticism following the 2008/09 global financial crisis that banks were not able to account for losses until they were incurred even when it was apparent that they were coming.

For banks, the most significant change effected by the new standard will be their approach to impairment, although asset classification/measurement and hedge accounting will also be affected.

Loans can be in one of any three stages, as the general MFRS 9 model (below) shows. Loans that are performing and just originated fall under Stage 1 — where banks have to make provisions on the basis of projected losses over 12 months.

Loans are constantly assessed and fall into Stage 2 if there is a deterioration in credit quality. Banks will then have to provide over the expected life of the loan, like they do for Stage 3, under which non-performing loans fall.

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