Recommendations on the Application of International Financial Reporting Standard (IFRS) 9

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Back Print Version Date of creation: 2018-08-23

APPROVED by Resolution No. 51/2 of the National Banking Supervision Committee dated 28 Dec 2017 No. 51/2 of 28.12.2017

RECOMMENDATIONS on the Application of International Financial Reporting Standard (IFRS) 9

1. General Provisions

2. These Recommendations on the application of IFRS 9 (hereinafter, the Recommendations) were developed in accordance with the legislation of the Kyrgyz Republic, international standards of the Basel Committee on Banking Supervision (hereinafter, BCBS), International Financial Reporting Standards (hereinafter, IFRS), and regulatory acts of the National Bank of the Kyrgyz Republic (hereinafter, the National Bank). The Recommendations primarily concern necessary adjustments to the financial statements of commercial banks, the State Development Bank of the Kyrgyz Republic, and other financial-credit organizations of the Kyrgyz Republic (hereinafter, collectively, the Bank) regulated by the National Bank.

3. The Recommendations define minimum standards regarding the formation of accounting information on estimated reserves for expected credit losses, but do not contain an exhaustive methodology for reserve assessment. These minimum requirements are recommended for use by the Bank in its operations to ensure effective and proper management and assessment of credit risk, in accordance with IFRS.

4. Specifically, the Bank must ensure an adequate process for assessing and measuring credit risk, which is periodically analyzed and updated. In turn, the measurement of expected credit losses (ECL) must rely on due and effective procedures and reliable credit risk assessment methods.

5. To avoid doubt, this credit risk assessment process may be quantitative or qualitative, or a combination of both, but must reflect the expected probability of default obtained by measuring credit risk. In accordance with IFRS 9, the assessment process may be either a "scoring" system or a "hierarchical" system reflecting credit risk assessment. Regardless of whether the system is quantitative or qualitative, the credit risk assessment must enable the determination of credit risk for financial instruments at initial recognition and at the Bank's reporting date.

6. The Bank must have appropriate definitions of "significant increase in credit risk" and "default risk".

7. The Bank must establish effective internal control procedures regarding credit approval, credit risk management, and the measurement (hierarchy) system for credit risk. These procedures are subject to regular review and assessment by the National Bank (see assessment points). For effectiveness, internal control procedures must be officially established within the organization and reflected in corresponding documentation (see documentation points).

8. For the purposes of these Recommendations, the following terms are used: Credit Loss – the difference between all contractual cash flows due in accordance with the contract and all cash flows that the Bank expects to receive (or "shortfall"), discounted at the initial effective interest rate. ECL (Expected Credit Losses) – the probability-weighted value of credit losses, determined using corresponding default risks or probabilities of default as weighting factors. The Bank must assess expected credit losses for a financial instrument in a manner that reflects:

• an unbiased and probability-weighted amount determined by evaluating a range of possible outcomes;
• the time value of money; and
• reasonable and supportable information about past events, current conditions, and forecasts of future economic conditions available at the reporting date without undue cost or effort. PD (Probability of Default) – assesses the probability of a borrower's potential default over a future time horizon. The probability of default must include historical information, as well as current and forecasted external and internal indicators. The probability of default may be assessed using a model with corresponding explanatory variables, some of which may be macroeconomic indicators. LGD (Loss Given Default) – is the proportion of loss from the exposure at default (EAD), arising as a result of default, net of the fair value of collateral and other coverages for potential defaults (insurance recoveries, etc.). EAD (Exposure at Default) – is the present value of future contractual cash flows for a granted loan. Exposure at default (EAD) for granted loans is the volume of cash flows for principal and interest repayments stipulated by the agreement (contract).

2. Duties of the Board of Directors and Bank Management

3. The Bank's Board of Directors (or another body performing equivalent functions), as well as bank management, are obligated to maintain proper credit risk management practices in the Bank, including an effective internal control system. The National Bank considers the presence of credit risk management practices and an effective internal control system as a key factor in determining the appropriate level of reserves in accordance with the Bank's stated policies and procedures, applicable accounting system, and relevant supervisory standards.

4. The Bank's Board of Directors is responsible for approving and regularly reviewing the Bank's credit risk management strategy, as well as significant policies and procedures for determining, measuring, assessing, monitoring, reporting, and mitigating credit risks in accordance with the Board's approved risk position. Furthermore, the Board of Directors is responsible for other control aspects, such as model validation and an effective credit risk rating system.

5. To fulfill these duties, the Board of Directors may issue directives to bank management regarding the development and maintenance of proper procedures that must be applied systematically and consistently. Nevertheless, the Board of Directors must also require bank management to provide regular reports on credit risk assessment and measurement procedures, including the ECL reserve assessment, as the Board of Directors is responsible for building the risk structure and internal control system, as well as monitoring within them.

6. Classification and Assessment of Financial Assets and Liabilities

7. Financial assets are classified into three categories:

• measured at amortized cost (AC);
• measured at fair value through other comprehensive income (FVOCI);
• measured at fair value through profit or loss (FVPL).

12. Classification into various categories depends on satisfying two tests:

• (a) the "contractual cash flow characteristics" test (or 'SPPI'). The contractual cash flow or SPPI test aims to determine whether a financial asset is held solely for the payment of principal and interest on the principal amount (SPPI). For the principal loan or lending terms, the principal amount (sum) is the core part of the financial asset. Then interest is primarily compensation for the time value of money and credit risk related to the principal amount, as well as other ordinary risks and costs associated with lending, plus a profit margin. The SPPI test is conducted at the level of an individual financial instrument but may be conducted at the group or product level if products have similar cash flow structures.
• (b) the "business model" test ("BM"). The business model or BM test involves determining the business approach used to manage financial assets in terms of cash flow generation. That is, the BM approach used in an entrepreneurial environment involves assessing whether assets are held for generating or collecting cash flows, or for selling financial assets, or both. The business model is evaluated with respect to financial instruments at the business level, which involves using groups of individual financial instruments at the product or portfolio level.

13. The business model is developed by the Bank's Management Board in coordination with responsible structural units and approved by the Bank's Board of Directors. Depending on changes in the entrepreneurial environment, the BM may be revised, which must be justified and documented according to Bank procedures. In this regard, the Board of Directors' duties include an effective internal control system that is fundamental to assessing and measuring credit risk.

14. A financial asset is classified into the measured at amortized cost (AC) category if the financial instrument, first, (a) satisfies the SPPI test, namely: under contract terms for these financial assets, these flows represent repayment of principal and interest on the principal amount; and second, (b) under the BM test, it is established that the main objective for holding the financial asset is to collect contractual cash flows. It is noted that within the BM test, it can be concluded that the main objective remains to collect contractual cash flows, even despite some volumes of sales of financial assets. However, such a situation arises only if sales are not frequent, and the reason for sales does not correspond to the Bank's ordinary business practice.

15. A financial asset is classified into the measured at fair value through other comprehensive income (FVOCI) category if the financial instrument, first, (a) satisfies the SPPI test, and (b) under the BM test, it is established that during ordinary business operations, the objective is to hold financial assets for contractual cash flows and sell them.

16. Assets must be assessed at amortized cost (AC) and fair value through other comprehensive income (FVOCI) for the purpose of calculating the expected credit loss reserve.

17. Financial instruments not included in either of the above two categories are classified as measured at fair value through profit or loss (FVPL). Financial instruments classified at amortized cost (AC) or fair value through other comprehensive income (FVOCI) may be designated for classification at FVPL. Such designation may occur provided that the use of FVPL eliminates or significantly reduces accounting inconsistency ("accounting mismatch").

18. For FVPL classification, no reserve for expected credit losses is required. The fair value itself also includes the quality of the financial asset and reflects all changes in credit risk and impairment (deterioration) of the loan. In turn, changes in fair value are reflected in the Statement of Profit or Loss.

19. Financial liabilities are generally accounted for at amortized cost (AC). In some cases, financial liabilities must be accounted for at fair value through profit or loss (FVPL), which occurs when:

• the liability is managed on a fair value basis;
• applying the fair value accounting method will eliminate or reduce inconsistencies in recognition (accounting mismatch); or
• the instrument is a hybrid contract (i.e., contains a main contract and an associated derivative instrument) for which the associated derivative instrument must be separated.

20. Hybrid instruments including main financial contracts are assessed using the same two tests for classification criteria. In many cases, hybrid contracts may not meet the SPPI or BM test criteria and therefore must be assessed at fair value through profit or loss (FVPL). Similarly, if a liability contains embedded derivative instruments, it may be necessary to separate these embedded derivatives from the main contract and assess them at FVPL.

21. Investments in equity instruments do not have contractual cash flow characteristics that satisfy the SPPI test, and therefore they are reflected and accounted for at FVPL.

22. Reclassification of Financial Assets

23. Reclassification of financial assets is required when the objective for which they are held within the relevant business model changes significantly after initial recognition of these assets.

24. Documentation Requirements

25. The Bank must initiate corresponding documentation and ensure documentation as part of effective internal control. Documentation must cover: (a) relevant accounting and credit risk policy provisions and procedures; (b) approval, assessment, and management of credit risk; (c) necessary definitions of "significant increase in credit risk" and "default risk"; (d) responsible structural units or departments. The absence of documentation for credit approval, credit risk management procedures, and credit risk assessment systems, as well as concepts of "significant increase in credit risk" and "default risk", or the approach to accounting classification, will be considered by the National Bank as prima facie evidence of weak internal control.

26. In connection with the application of IFRS 9, the Bank must also review existing internal documents: (a) the Bank's accounting policy; (b) credit policy; (c) other relevant internal Bank documents.

27. Thereafter, the Bank must adhere to the financial asset classification procedure required under the new accounting system. All types of products must be properly defined as belonging to one of the classification categories. In addition, reasons for assignment to a particular category in the classification system must be specified.

28. Within this process of developing and approving the classification of financial assets and their subsequent accounting, the Bank should consider performing the following activities:

• developing a procedure for determining the estimated category of financial assets (in the form of decision trees, checklists, or other tools);
• developing a procedure for identifying, classifying, and accounting for financial assets in accordance with paragraph 25 of these Recommendations;
• developing and implementing a procedure for reclassifying assets into the corresponding accounting category.

27. To develop and approve the process for derecognition and modification of financial assets, the Bank should consider:

• criteria for full and partial write-off of assets, as well as identifying cases where modification leads to derecognition of the instrument;
• criteria for determining significant modification of contracts for financial assets;
• criteria (whether quantitative or qualitative) for determining what constitutes a significant modification.

28. It is necessary for the Bank to develop new policy provisions and procedures or make corresponding changes to existing policies and procedures in the following areas:

29. Defining clear criteria for conducting the business model test (BM), which may include: a) the objective for managing financial assets; b) the approval process for new financial instruments; c) the business development strategy for financial instruments; d) the sales monitoring process; e) sales analysis taking into account expectations regarding future sales and other deviations from the objectives of each selected model; f) a procedure for changing the BM and reclassifying financial instruments.

30. Developing and implementing a procedure designed to determine whether each financial asset passes the SPPI test and meets the criteria, including: a) preparing a standard list of criteria (i.e., "checklist") as a practical method for applying the SPPI test; b) for standard financial instruments: a list of clear criteria regarding how to apply the SPPI test; c) for non-standard financial instruments: a list of clear criteria regarding how to apply the SPPI test. This may require greater application of a judgment-based approach for non-standard financial instruments compared to standard ones.

31. Increase in Credit Risk