Since the 31st of December 2019, the German Institute of Public Auditors (the Institut der Wirtschaftsprüfer [IDW]) governs a new national accounting standard: IDW ERS BFA 7It can be assumed that the establishment of this standard will increase the General Loan Loss Provisions (Pauschalwertberichtigungof financial institutions. This can mainly be attributed to the fact that some institutes still calculate General Loan Loss Provisions according to the tax requirements set by the German Ministry of Finance in 1994In the initial implementation of IDW ERS BFA 7 the effect of risk provisioning has to be recognized in the income statement, unlike IFRS 9 where it was possible to recognize risk provisioning into equity when initially applied. Besides the initial short-term shockafter initiation the overall volatility of the P&L’s of affiliated firms increases gradually and losses arising from non-performing loans are recognized earlier. 

Which entities are affected? 

On the 10th of December 2018, the IDW published the “Draft statement on accounting: risk provisioning for expected, but not yet individually specified, counterparty default risks in the (consolidated) financial statements of institutions”.  

With this draft the IDW determines the formation of General Loan Loss Provisions at credit institutes, which primarily consist of banksMore specifically, the draft is aimed at entities that classify the German Banking Act (KWG) or the German Payment Services Supervision Act (ZAG) such that financial services companies (e.g. credit unions) and payment providers (e.g. fintech’s) are obliged to comply as well. It should be emphasized that this standard only affects entities that report under national accounting standards and therefore no significant changes arise for entities reporting under IFRS 9Overall, IDW ERS BFA has widespread effect on financial and finance related entities in Germany. 

What are the consequences for affected entities? 

IDW ERS BFA 7 is based on the general principles of the Handelgesetzbuch (German law that governs the primary commercial code), which among other things oblige financial institutions to prudently assess and thus consider all expected risks and losses, in particular, the expected credit losses resulting from non-performing loans. The factual and quantitative assessment base for the General Loan Loss Provisions targets all claims on customers and banks as well as contingent liabilities and other obligations (including irrevocable loan commitments) [par. 7, section 2]In addition, from the perspective of the IDW, risk provisions should be formed for bonds and other fixed-income securities, even when a write-down of the market value in case of non-permanent impairment is projectedFor respective financial instruments, based on their lifetime duration, calculation methods should be used that determine the expected loss based on past observed credit losses, up-to-date market information and forward-looking economic and financial perspectives. 

How should affected entities change their policies regarding provisioning? 

In its core, the draft does not prescribe any specific procedure for the calculation of General Loan Loss Provisions. However, the procedure that needs to be used must comply to the proposed principles. Usually, recognized quantitative mathematical procedures are used within financial institutions to determine risks involving outstanding credit as part of internal risk management. In this case, entities are obliged to take consideration of these models when calculation procedures for General Loan Loss Provisions are adopted. Furthermore, if no internal risk modelling is administered, entities are expected to set up their own systems or look for third parties that can provide assistance.   

Irrespective of the method used, foreseeable losses should be determined while taking into account up-to-date information, assessment of risk classification methods (e.g. ratings) and the remaining term of the loan portfolio. When determining the General Loan Loss Provisions, comprehensible assumptions are to be made regarding the probability of default, the amount of the loan at the time of default, future cashflows from borrowers, proceeds from the realization of collateral or other credit risk mitigation agreements (excluding any fees). 

"For respective financial instruments, based on their lifetime duration, calculation methods should be used that determine the expected loss based on past observed credit losses, up-to-date market information and forward-looking economic and financial perspectives."

The IDW ERS BFA 7 draft closely ties the design of the aforementioned procedures to the principle of prudence under the Handelgesetzbuch and in order to appropriately consider the prudence principle – in line with the IDW RS HFA 4 – the calculation of the General Loan Loss Provision must take into account the risk of the timing and volume of revenue declines and realizations of consecutive losses. In order to consider these risks, the IDW proposes a minimum coverage for the General Loan Loss Provisions. That minimum coverage should be based on the amount of the expected loss, which is calculated over a 12-month observation period, excluding the present value of the credit premiums [par 24, section 4]. A fall below this minimum coverage is permitted in justified exceptional cases.  

In regard of credit premiums, the IDW proposes the application of a term structure where expected credit losses (after considering collateral and other credit risk mitigation techniques) are to be reduced by the credit premia contained in the contractually agreed interest income (fixed interest), as long as these compensate for the expected credit risk. If the repayment term is set on the basis of expectations due to a lack of contractual arrangements, then the update of the credit premiums must be considered by this expected date. Maturity expectations are to be determined in accordance with internal controls. The eligible credit premia are discounted to the balance sheet date. The figure below illustrates the credit premium mechanism given a linear payment structure. 

Credit premia are only considered in case of lifetime expected credit losses. The General Loan Loss Provision is the difference between the lifetime expected credit losses and the discounted credit premium

Credit premia are only considered in case of lifetime expected credit losses. The General Loan Loss Provision is the difference between the lifetime expected credit losses and the discounted credit premium

As an alternative method to the aforementioned mathematical-statistical methods, the IDW allows the use of simplified procedures. However, it should be argued why such procedures are a reliable estimate for the amount of expected credit losses [par. 26, section 5]. Additionally, the General Loan Loss Provisions should be based on the 12-month expected credit loss.Estimates below this minimum amount are permissible in justified exceptional cases. Particularly, when using simplified procedures, a greater risk of inaccurate estimates exists, such that a more cautious approach of the evaluation parameters is demanded. Significant changes in the structure and risk content of the loan portfolio must be taken into account through appropriate adjustments (e.g. adjustment of the average default rate). 

Outsourcing implementation of IDW ERS BFA 7 compliance 

For the financial institutions involved in this draft, the requirements that are outlined above raise various issues for the implementation of the provisions of IDW ERS BFA 7. These issues may differ significantly for the standard Handelgesetzbuch accounting officers and companies that prepare their consolidated financial statements in accordance with IFRS 9. In regard with a harmonization of risk provisioning in accordance with both IFRS 9 and HGB, assuming risk provisions according to IFRS 9 is a potential solution with comparatively low operational conversion costs. However, entities that were not reporting under IFRS 9 before, will need to develop fundamental new systems and will face complex requirements that need to be fulfilledThis is where the Credit Risk Suite can provide assistance. Through our solution any entity can comply to the mathematical-statistical procedures required by the IDW such that accounting disadvantages arising from adoption of the simplified procedures can be circumvented. Additionally, the solution implements numerous recognized quantitative estimation methods (e.g. econometric PD models, transition matrices) that can be fine-tuned for consistency with the internal risk management policy of a given entity and/or supplement general risk management analysis given dynamically adjustable economic scenarios.