IFRS 9: Why loan loss provisions will spike

Financial institutions, Saccos included, started announcing their financial results for the year ended 31 December 2020. Some issued profit warnings to their shareholders. Generally, it is expected that loan loss provisions will spike across the majority of financial institutions due to various lessons.

High probability of default (PD) rates as a result of the loss of income. For the better part of 2020, many businesses came to a standstill. Though the pandemic negatively impacted many, some were affected in greater magnitudes than others, for instance, hotels, logistics, entertainment spots, and schools. This translated to massive layoffs and liquidity constraints, which in turn impacted the ability to repay loans. 

The Ministry of Health protocols requiring minimal movement and social distance also meant that the groups could not meet physically. 

Loan restructuring and awarding of moratoriums, including loan holidays, signified liquidity challenges for the borrowers. This translates to lower interest income being earned by the lenders. Therefore, it is expected that the top line will shrink compared to previous years and against the budget, which could trickle down to lower profits.

High exposures in mobile-based loans. The majority, if not all financial institutions, now have mobile loans. Where these have been issued without any collateral, the lenders’ exposure is equally high. Considering this from an IFRS 9 perspective, any uncollateralized facility is expected to have a high loss given default (LGD). When this is now coupled with a high probability of default (PD) due to reduced income and competing needs, it is expected that the loan loss provision will also increase.

Fall in value of collaterals. People shy away from capital investments such as land and motor vehicles, which form most of the collaterals held by financial institutions during the pandemic. This reduces collaterals’ value due to high supply with low demand, longer durations taken to dispose of the collateral, and the high cost of disposing of it. When we factor the time value of money, then it is expected that the discounted collateral amount will be lower and so will the LGD, therefore translating to a high expected credit loss provision (ECL).

Fall in value of Kenya’s sovereign credit rating. Recently, S&P Global Ratings lowered its long–term foreign and local currency sovereign credit ratings on Kenya to ‘B’ from ‘B+.’ A fall in the country’s sovereign credit rating requires higher loan loss provisions to be held.

Businesses need to relook into their business models and adopt any corrective and preventative measures that could salvage the loan loss provisions held. This may include reassessing the tenures of facilities issued, forward-looking information parameters to consider when assessing for default, nature of collaterals held, valuation approaches applied when valuing the collaterals, and managing exposures with other financial institutions.

The COVID pandemic had clearly brought out what the new standard IFRS 9 intended to resolve when it became effective in January 2018. Unlike the earlier standard, IAS 39, which required that a loan loss provision is only recognized when the default has occurred, IFRS 9 requires that a loan loss provision is recognized way before the default occurrence. This means that a 12 month and a lifetime provision is always held to cushion the lender should default eventually occur.

About the author. Josphat Irura is an IFRS Technical Consultant at Comperio Financial Management Services and has worked with Big 4 audit firms and consulted with multiple financial institutions in Kenya and across the East Africa region.