Expected Credit Loss: A CVA for non-Defaulted Financial Instruments

The recent requirements by banking regulators and the adoption of IFRS 9 by financial institutions draws some startling parallels to Credit Value Adjustments (CVA) for derivative exposures. On trading books, the price of counterparty risk is called CVA. In essence CVA is the difference between the price of a derivative negotiated with a riskless counterparty and the price of a derivative negotiated with a credit risky counterparty. IFRS 9, which is a new requirement on performing loan books is to recognize loan loss allowances or provisions before a default event occurs, based on the measurement of an Expected Credit Loss (ECL). 

IFRS 9 provisioning as measured through ECL measures similar effects as CVA but involves different modelling challenges. Thus ECL and CVA are similar concepts, one quantifying levels of provisions for a banking book and the other for a trading book. Trading desks have lately expanded provisioning measures for different aspects of market risk under a class of measures known as xVA.

The concept of provisioning is well established on the banking book and there are stringent requirements for such from regulators and accountants.  Capital markets participants on the trading book, however, have extensive experience with financial modelling which is not the case with their counterparts on the banking book.

CVA in essence measures ECL as seen by the market on a derivative instrument. The main attributes of for the expected loss is the exposure (amount) to a counterparty and credit spread of the counterparty which is market observable. This contrasts with IFRS 9 provisions which are not market observable but are fundamentals driven aiming to measure forthcoming credit losses and how they are influenced by macroeconomic factors. The significant challenge for measure ECL for IFRS 9 therefore lies in the ability to accurately measure the significant risk deterioration (such as Loss Given Default (LGD)) and default probability term structure for any tenor.

Participant on the banking loan book can learn a lot on the financial modelling techniques required for IFRS 9 from their trading book counterparts.

IFRS 9 on Banks in Africa

The IASB issued a new accounting standard on July 24 2014 called IFRS 9 which is targeted at financial instruments' valuation and risk assessment. IFRS 9 is to replace the existing standard known as International Accounting Standard (IAS) 39. IFRS 9, in essence specifies how an institution should classify and measure financial assets and liabilities. This new standard has a mandatory effective date of January 1 2018.

One key change that IFRS 9 introduces is the concept of Expected Credit Loss (ECL)  provisioning which is to replace the incurred loss approach. The devil here certainly lies in the details as far as the quantification and measurement of Expected Credit Loss rates in the face of a lack of reliable loss data in most developing countries, particularly in the African markets.

Like many of the new regulations recently proposed, such as liquidity ratios in Basel III, the motivation for IFRS 9, in part, traces its roots to the recent global financial crisis of 2007-2009. Authorities observed delayed recognition of credit losses in banks and other lenders, where accounting standards at the time prevented banks and lenders from appropriate provisioning for credit losses causing excessive lending not aligned to emerging risks and thereby exacerbating the financial crisis.

While it is still somewhat challenging  to forecast an emerging credit environment, it is both theoretically appealing and practically plausible to aligned credit risk management to market risk management techniques widely used in capital markets and is akin to moving from book value accounting to fair value accounting and thereby synchronising valuation philosophies on both sides of the balance sheet.

-Dr Blessing Mudavanhu
Dura Capital