Under IFRS9 accounting principles, impairment must be recognised in stages.
stage_1 assets are financial instruments that either have not deteriorated significantly in credit quality since initial recognition or have low credit risk. In this stage, financial institutions must recognise the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.
stage_2 assets are those which have experienced a significant change in the estimated default risk over the remaining expected life of the financial instrument. In this stage, financial institutions must recognise the expected credit losses that result from default events over the full lifetime of the financial instrument. For stage 2 assets, interest revenue is also accrued on the gross carrying amount.
From the Open Risk Manual:
Determination of Significant Increase in Credit Risk: Determination of whether SICR has occurred or not is required at each reporting date The assessment must use the change in the Default Risk over the expected life of the financial instrument, hence specifically not the change in the amount of expected credit losses The comparison is between the Default Risk as estimated at the reporting date and the Default Risk at initial recognition (it is a relative assessment) The assessment must use Reasonable and Supportable Information (see below for examples) If an instrument initially deemed to be Low Credit Risk continues being assessed as such, it is deemed that there has been no significant increase
Risk Increase Indicators Risk Indicators the can establish whether there has been a significant increase in risk vary considerably depending on the nature of the borrower, the product type, internal management methods and external market resources.
Elements to Consider Quantitative Elements: Scorecards or Risk Rating Systems after setting thresholds for determining what constitutes SICR in terms of the score or rating Qualitative Elements Backstop Indicators Low Credit Risk exception
The following lists provide some examples:
Internal (Management) Indicators Significant changes in internal price indicators of credit risk (the credit spread / premium that would be charged currently for similar risk) Other changes in the rates of terms of an existing financial instrument that would be significantly different if the instrument was newly originated Significant changes in external market indicators of credit risk for a particular financial instrument or similar financial instruments with the same expected life Changes in the entity’s credit management approach in relation to the financial instrument; ie based on emerging indicators of changes in the credit risk of the financial instrument, the entity’s credit risk management practice is expected to become more active or to be focused on managing the instrument, including the instrument becoming more closely monitored or controlled, or the entity specifically intervening with the borrower Expected changes in the loan documentation including an expected breach of contract that may lead to covenant waivers or amendments, interest payment holidays, interest rate step-ups, requiring additional collateral or guarantees, or other changes to the contractual framework of the instrument Past due information Significant increases in credit risk on other financial instruments of the same borrower. Significant changes in the expected performance and behaviour of the borrower, including changes in the payment status of borrowers in the group (for example, an increase in the expected number or extent of delayed contractual payments or significant increases in the expected number of credit card borrowers who are expected to approach or exceed their credit limit or who are expected to be paying the minimum monthly amount) A significant change in the quality of the guarantee provided by a shareholder (or an individual’s parents) if the shareholder (or parents) have an incentive and financial ability to prevent default by capital or cash infusion. Significant changes, such as reductions in financial support from a parent entity or other affiliate or an actual or expected significant change in the quality of credit enhancement, that are expected to reduce the borrower’s economic incentive to make scheduled contractual payments. Credit quality enhancements or support include the consideration of the financial condition of the guarantor and/or, for interests issued in securitisations, whether subordinated interests are expected to be capable of absorbing expected credit losses (for example, on the loans underlying the security).
External (Market) Indicators Credit spreads Credit default swap prices for the borrower Length of time (duration) or the extent (degree) to which the fair value of a financial asset is less then the amortized cost Other market information related to the borrower Significant change in the value of the collateral supporting the obligation or in the quality of third-party guarantees or credit enhancements, which are expected to reduce the borrower’s economic incentive to make scheduled contractual payments or to otherwise have an effect on the probability of a default occurring. For example, if the value of collateral declines because house prices decline, borrowers in some jurisdictions have a greater incentive to default on their mortgages. Actual or expected significant downgrade in an external credit rating Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or an actual or expected significant increase in unemployment rates An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations, such as a decline in the demand for the borrower’s sales product because of a shift in technology. Actual or expected significant internal credit rating downgrade or decrease (worsening) in behavioural scoring used to assess credit risk internally Actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased balance sheet leverage, liquidity, management problems or changes in the scope of business or organisational structure (such as the discontinuance of a segment of the business) that results in a significant change in the borrower’s ability to meet its debt obligations.
Example For the purpose of the EBA 2018 EU-Wide Stress Test projections banks shall, as a backstop, assume that Stage 1 assets which experience a threefold increase of annual point-in-time PD compared to the corresponding value at initial recognition (i.e. a 200% relative increase) undergo a significant increase in credit risk (SICR) and hence become Stage 2. Notably the backstop is defined with reference to the annual PD, not the lifetime PD.
stage_3 assets are those which whose credit quality has detiorated to the extent that they show objective evidence of a credit loss event. Practically, these would have been those assets which, under the previous IAS 39 accounting standards would have been considered impairment allowances. In this stage, financial institutions must also recognise the expected credit losses that result from default events over the full lifetime of the financial instrument. Furthermore, interest revenue should also be accrued on the net carrying amount.