Palestine Monetary Authority

PALESTINE MONETARY AUTHORITY

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Instructions No. (03) of 2018

Regarding the Requirements and Guidelines for Implementing International Financial Reporting Standard No. "9"

Based on the provisions of Decision No. (132) of 2011 regarding the licensing and supervision system for specialized lending institutions, particularly Articles (3, 11, 21) thereof, and in accordance with the powers delegated to us, and in the public interest, we have issued the following instructions:

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Article (1)

Scope of Application

The provisions of these instructions shall apply to all specialized lending institutions under the Palestine Monetary Authority.

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Article (2)

Requirements of International Financial Reporting Standard No. "9" Related to the Expected Credit Losses Model

1. The classification and measurement rules under International Financial Reporting Standard (IFRS) 9 differ from International Accounting Standard (IAS) 39, as the new rules are crucial for the proper application of the new impairment model based on the Expected Credit Losses (ECL) model.

IAS 39 requires financial assets to be classified into the following four categories:

a. Financial assets at fair value through profit or loss (which includes financial assets held for trading, plus financial assets designated by management under the fair value option), where changes in fair value are recorded in the income statement.

b. Available-for-sale financial assets (AFS), where changes in fair value are recorded in other comprehensive income ("equity"), but impairment/credit losses are reversed to the income statement.

c. Loans/Financing and receivables, which are recorded at amortized cost.

d. Held-to-maturity financial assets (HTM), which are recorded at amortized cost but are subject to "tainting rules" that may require reclassification to fair value through profit or loss for the entire relevant portfolio when sales from the portfolio are more than "insignificant" upon meeting certain other criteria.

It should be noted that reclassification is permitted only in rare cases. The last three categories (AFS, Loans/Financing and receivables, and HTM) are subject to the IAS 39 impairment recognition methods within the income statement.

IFRS 9 replaces the above classifications, classifying financial assets into the following three categories:

1. Amortized cost.
2. Financial assets at fair value through profit or loss.
3. Financial assets at fair value through other comprehensive income.

IFRS 9 uses a principles-based classification approach that considers the business models for managing financial assets and how cash flows are realized and managed. Additionally, IFRS 9 requires reclassification of financial assets if the business model changes. A single impairment measurement method, the "Expected Credit Losses (ECL) model", is used for amortized cost financial assets and financial assets at fair value through other comprehensive income (debt instruments only), with impairment recognized in the profit or loss statement.

2. According to the International Accounting Standards Board (IASB) requirements, the IAS 39 model for recognizing credit losses is referred to as the "incurred loss model" because it requires recognizing incurred credit losses at the financial reporting date rather than potential future losses. Loss determination is based on the occurrence of "triggering" events supported by objective evidence (such as borrower bankruptcy, loss of employment, decline in collateral value, and overdue installments), in addition to expert judgment. The application of the incurred loss approach does not allow specialized lending institutions to adequately provide for expected credit losses arising from emerging risks. This methodology has been widely considered as "too little, too late." Furthermore, the global financial crisis highlighted the systemic costs of banks and other borrowers, including specialized lending institutions, delaying credit loss recognition.

3. The impairment rules in IFRS 9 require specialized lending institutions and other companies to recognize expected credit losses (ECL) and update the recognized amount to reflect changes in the credit risk of financial assets. The IASB's approach is forward-looking and eliminates the requirement for an actual event (i.e., a specific starting point or event – Threshold) for recognizing credit losses. IFRS 9 requires that the ECL measurement process be based on reasonable, supportable, and available information without undue cost or effort, incorporating historical, current, and forward-looking/expected information. Consequently, the potential impact of future events on expected credit losses must be considered. All specialized lending institutions and other companies holding financial assets or liabilities other than those measured at fair value through profit or loss (such as trading portfolios) will be affected by the IFRS 9 impairment rules. Eligible instruments include: Loans/Financing, debt securities, and other financial assets classified and settled as (a) amortized cost or (b) fair value through other comprehensive income (debt instruments), as well as trade payables, trade receivables, lease receivables, loan/financing commitments, and financial guarantee contracts.

4. As illustrated below, IFRS 9 requires specialized lending institutions and other companies to report/disclose expected credit losses in loss allowances through the income statement across three stages, where deterioration in credit quality is recognized after the initial recognition of loans/financing. Generally, for Stage 1, expected credit losses for 12 months are recognized, while for Stages 2 and 3, lifetime expected credit losses are recognized. All eligible exposures must be subject to this.

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Figure 1. IFRS 9 Impairment Stages

	Stage 1	Stage 2	Stage 3
Impairment recognition	12-month expected credit losses	Lifetime expected credit losses	Lifetime expected credit losses
Interest revenue	Effective interest on gross carrying amount	Effective interest on gross carrying amount	Effective interest on amortised cost
			Credit Impaired assets, such as those with IAS 39 incurred losses

Source: Adapted from IASB Project Summary: IFRS 9 Financial Instruments, July 2014.

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5. Stage 1: Upon creation or purchase of the financial instrument, a 12-month expected credit loss is recognized as an expense and a loss allowance is established, serving as a proxy for initial credit loss expectations. For financial assets, interest revenue is calculated on the gross carrying amount (i.e., without deducting the loss allowance). The specialized lending institution calculates 12-month expected credit losses as part of the lifetime expected credit losses of the financial instrument, representing expected credit losses resulting from events that affect the financial instrument's performance over the 12 months following the reporting date. If it is determined that the financial instrument has "low credit risk" at the reporting date, the specialized lending institution may assume that the credit risk of the financial instrument has not increased significantly since initial recognition. Credit risk is considered low if the financial instrument has a low risk of default, the borrower has a strong capacity to meet its contractual cash flow obligations in the near term, and adverse changes in long-term conditions may (but do not necessarily) reduce the borrower's ability to fulfill its obligations.

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6. Stage 2: When there is a significant increase in credit risk compared to credit quality at initial recognition or purchase, and the resulting credit quality no longer permits low credit risk, lifetime expected credit losses are recognized for the loan/financing. The transition from the 12-month ECL model to the lifetime ECL model results in a relatively large increase in loan/financing loss allowances. Interest revenue calculation on financial assets remains unchanged from the approach used in Stage 1.

7. According to IFRS 9, lifetime expected credit loss is a measurement of the present value of expected losses that will arise if borrowers default on their obligations throughout the life of the financial assets (loans/financing). It represents the probability-weighted average of credit losses, considering the probability of default (PD). Since expected credit losses consider the amount and timing of contractual payments, credit allocation (e.g., cash shortfall) anticipates full collection but at a time later than the scheduled payment date. An assessment of significant increases in credit risk can be performed on a collective basis, for example, for a portfolio or a subgroup of financial instruments, ensuring that lifetime expected credit losses are recognized. This applies when there is a significant increase in credit risk, even if evidence of this increase is not available at the individual level.

8. Stage 3: In this stage, there is a deterioration in credit quality that has become credit-impaired (such as incurred credit losses under IAS 39). According to IFRS 9, the disclosure and recognition of lifetime expected credit losses for loans/financing continue at this stage. Furthermore, interest should not be recognized on financial assets that fall under the definition of non-accrual interest according to PMA instructions regarding provisioning and specific allocation at this stage. Loans/financing may transition from Stage 1 to Stage 3 if credit risk deterioration is also considered, for example,

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9. Generally, IFRS 9 provides principles-based guidelines that do not mandate a specific method for calculating expected credit losses. For example, given that the objectives of expected credit losses stipulated in the standard have not been met, it is not necessarily mandatory to use a methodology based on calculating probability of default, loss given default, and exposure at default (PD/LGD/EAD ECL calculation). Other methods may be used (such as a loss rate method that compounds expected credit losses for various credit assets based on historical loss ratios adjusted for forward-looking expectations). Broad use of judgment is permitted in key controls, which is available when an institution applies specific rules in the standard, such as those involving practical expedients in credit risk when measuring expected credit losses and whether forecasts are reasonable and supportable as a basis for the expectation range.

10. According to IFRS 9, interest revenue is calculated differently depending on the asset's (financing/loan) status regarding credit impairment. For example, for financial assets (credit-impaired) purchased or originated where there is no objective evidence of impairment at the reporting date, interest revenue is calculated by applying the effective interest rate (EIR) to the gross carrying amount. For financial assets that are not purchased or originated credit-impaired, but later become impaired, interest revenue is calculated by applying the EIR to the amortized cost, which ensures the gross carrying amount adjusted for the ECL loss allowance. For purchased or originated credit-impaired financial assets, interest revenue is recognized by applying the effective interest rate to the credit-adjusted amortized cost. The credit-adjusted rate is the effective rate that

discounts the expected cash flows at initial recognition (explicitly considering the ECL model as well as the contractual performance conditions), referring to the amortized cost at initial recognition. Specialized lending institutions must follow the PMA's requirements and instructions regarding the recognition of non-accrual interest as outlined in paragraph 8 above.

11. Under IFRS 9, interest revenue on loans/financing in Stage 2 is calculated based on the gross financing/loan amount, and in Stage 3 on a net amount after deducting loan/financing loss allowances. It also includes new guidance on derecognition not included in IAS 39. Continuing to recognize interest revenue on loans/financing that have not been received in cash raises supervisory interest. It discourages specialized lending institutions from taking effective measures to reduce levels of non-performing/overdue loans/financing.

12. IFRS 9 and IFRS 7 regarding disclosure of financial instruments require specialized lending institutions to provide new qualitative and quantitative disclosures. These new disclosures cover credit risk management policies, characteristics of expected credit losses, derecognition, and changes in credit risk for loan/financing plans and other financial instruments subject to the impairment methodology. Specialized lending institutions should engage external auditors to ensure that disclosure requirements are met in accordance with International Financial Reporting Standards and appropriately detailed in their interim and annual reports.

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Article (3)

Credit Risk and Expected Credit Loss Allowances

1. Specialized lending institutions are directed to proceed during the year 2018, which is the first year of implementing IFRS 9, in order to allow more time for specialized lending institutions to develop risk management policies, IT systems, and processes for implementing IFRS 9 during 2018. Despite IFRS 9 being mandatory in 2018, however,

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will allow specialized lending institutions to make "reasonable approximations" to the new ECL model allowances for the first nine months of the year (three quarters) in financial reports and supervisory data for 2018, and in the fourth quarter (remaining) of 2018, specialized lending institutions must fully and properly apply all IFRS 9 requirements. Furthermore, IFRS 9 applies to all specialized lending institutions providing Islamic financing services under these guidelines regarding IFRS. Each lending institution must submit a report to the PMA during each quarter of 2018 on progress regarding the implementation of the said standard, along with a letter from the external auditor (semi-annually) stating the extent of its agreement with what is included in the specialized lending institution's report and adding any clarifications regarding the progress report. Based on the submitted reports, the PMA will hold meetings during 2018 with the lending institution and its external auditor to discuss these reports and the progress made regarding standard implementation and address controls raised by all parties.

2. Treatment of Specific Provisions (SP) and General Provisions (GP) and related transition arrangements. Although the quantitative impact study of implementing the standard was useful in directing the attention of specialized lending institutions and external auditors to important aspects of implementing IFRS 9, the PMA seeks further information before changing its rules regarding specific and general provision instructions. Since full external audits of specialized lending institutions, along with submitted reports and coordination, will form a better basis for conducting comprehensive and reliable assessments of IFRS 9 implementation, and based on that, retaining its current rules and general regulatory rules with some modifications during the years (2018 and 2019) for the annual financial statements to be published. Before the end of 2020, the PMA requests if additional modifications to existing rules are required. Below is a summary of what these rules include:

• For the purposes of these instructions, expected credit loss (ECL) allowances under IFRS 9 are distributed (meaning credit loss allowances "contra asset account" and assets)