Recommendations on the Application of IFRS 9

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Date of creation: 2024-10-31

APPROVED

by the Resolution of the Supervisory Committee of the NBKR No. 51/2 dated 28.12.2017

RECOMMENDATIONS

on the application of International Financial Reporting Standard (IFRS) 9 (amendments and additions approved by the Resolutions of the Supervisory Committee No. 39/1 dated 10.09.2024)

1. General Provisions

2. These Recommendations on the application of International Financial Reporting Standard 9 (hereinafter referred to as the "Recommendations") were developed in accordance with the legislation of the Kyrgyz Republic, international standards of the Basel Committee on Banking Supervision (hereinafter referred to as "BCBS"), International Financial Reporting Standards (hereinafter referred to as "IFRS"), and regulatory legal acts of the National Bank of the Kyrgyz Republic (hereinafter referred to as the "National Bank").

The Recommendations primarily concern necessary adjustments to the financial reporting of commercial banks and other financial and credit organizations of the Kyrgyz Republic (hereinafter referred to as the "Bank" with respect to all the above-mentioned organizations), regulated by the National Bank.

(In the edition of the Resolution of the Supervisory Committee No. 39/1 dated 10.09.2024)

2. 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 the assessment of reserves. These minimum requirements are recommended for use by the Bank in its activities for the effective and proper management and assessment of credit risk, in accordance with IFRS.

3. More specifically, the Bank must ensure the existence of 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 methods for assessing credit risk.

4. For the avoidance of doubt, this credit risk assessment process may be quantitative or qualitative, or combine both approaches, but it 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 the assessment of credit risk. Regardless of whether the system is quantitative or qualitative, the credit risk assessment must allow for the determination of the credit risk of financial instruments at the date of initial recognition, as well as at the date of preparation of the Bank's financial statements.

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

6. The Bank must establish effective internal control procedures regarding the approval of loans, credit risk management, and the measurement system (hierarchy) of credit risk. These procedures must be reviewed and assessed by the National Bank on a regular basis (see assessment points). For effectiveness, internal control procedures must be officially established within the organization and reflected in relevant documentation (see documentation points).

7. The following terms are used for the purposes of the Recommendations:

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 of money"), discounted at the initial effective interest rate.

ECL (Expected Credit Losses)

– the weighted average of credit losses determined using appropriate default probabilities or probability of default as weighting coefficients.

The Bank must assess expected credit losses for a financial instrument in a way 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)

– estimates the probability of a potential borrower defaulting in a future time horizon. The probability of default must include historical information, as well as current and forecast external and internal indicators.

Probability of default may be assessed using a model with appropriate explanatory variables, some of which may be macroeconomic indicators.

LGD (Loss Given Default)

– is the share of losses from the exposure at risk (EAD), arising as a result of default, minus the fair value of collateral assets and other coverage for possible defaults (insurance payouts, etc.).

EAD (Exposure at Default)

– is the present value of future contractual cash flows of the issued loan. Exposure at default (EAD) for issued loans is the volume of cash flows for the repayment of principal and interest provided 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 the Bank's management, are obliged 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 volume of reserves in accordance with the Bank's declared policy and procedures, applicable accounting system, and relevant supervisory norms.

4. The Bank's Board of Directors is responsible for approving and regularly reviewing the Bank's strategy for managing credit risks, as well as significant policies and procedures for determining, measuring, assessing, monitoring, reporting, and mitigating credit risks in accordance with the risk appetite defined by the Board of Directors. In addition, the Board of Directors is responsible for other aspects of control, such as model validation and an effective system for building credit risk ratings.

5. To fulfill these duties, the Board of Directors may issue instructions to the Bank's management regarding the development and maintenance of proper procedures that must be applied systematically and consistently. Nevertheless, the Board of Directors must also require the Bank's management to report regularly on the results of credit risk assessments and measurement procedures, including the assessment of the ECL reserve, 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 different categories depends on satisfying two tests:

• (a) the "contractual cash flows" test (or 'SPPI').

The contractual cash flows test or SPPI is designed to determine whether the financial asset is held solely to collect contractual cash flows consisting of payments of principal and interest on the principal amount (SPPI).

For the main loan or lending conditions, the principal (amount) is the main part of the financial asset. Then interest is mainly compensation for the time value of money and the credit risk associated with the principal amount, as well as other ordinary risks and costs related to lending, and a profit margin. The SPPI test is conducted at the level of an individual financial instrument, but may be conducted at the level of a group or products if the products have a similar cash flow structure.

• (b) the "business model" test ("BM").

The business model test or BM involves determining the business approach used to manage the type of financial asset from the perspective of generating cash flows. That is, the BM approach used in the business environment involves an assessment of whether the contractual conditions are practically fulfilled: for example, whether assets are held to generate or collect cash flows, or to sell financial assets, or both. The business model is assessed with respect to financial instruments at the business level, which implies the use of groups of individual financial instruments at the product or portfolio level.

13. The business model is developed by the Bank's Board of Management in interaction with responsible structural subdivisions and approved by the Bank's Board of Directors. Depending on changes in the business environment, the BM may be revised, which must be justified and documented, in accordance with the Bank's procedures. At the same time, the duties of the Board of Directors include an effective internal control system, which is of fundamental importance for the assessment and measurement of credit risk.

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

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

16. It is required to assess assets at amortized cost (AC) and fair value through other comprehensive income (FVOCI) for the purpose of calculating the reserve for expected credit losses.

17. Financial instruments that were not included in either of the above two categories are classified as measured at fair value through profit and loss (FVPL).

Financial instruments classified at amortized cost (AC) or at fair value through other comprehensive income (FVOCI) can be chosen or designated for classification at FVPL. Such a choice may occur provided that the use of FVPL eliminates or significantly reduces an 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, accounting for financial liabilities at fair value through profit or loss (FVPL) is required, which occurs when:

• the liability is managed on a fair value basis;
• the application of the fair value accounting method would eliminate or reduce inconsistencies in recognition (accounting mismatch); or
• the instrument is a hybrid contract (i.e., contains a main contract and a related derivative instrument), for which it is necessary to separate the related derivative instrument.

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 criteria of the SPPI or BM test 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 derivative instruments from the main contract and assess them at FVPL.

21. Investments in equity instruments do not have characteristics of contractual cash flows 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 if the objective for which they are held within the relevant business model changes significantly after the initial recognition of these assets.

24. Documentation Requirements

25. The Bank must initiate appropriate documentation and ensure documentation as part of effective internal control. Documentation must cover:

(a) relevant provisions of accounting and credit risk policies 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 subdivisions or departments.

The absence of documentation on loan 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 presumptive evidence of weak internal control.

24. In connection with the application of IFRS 9, the Bank also needs to review existing internal documents:

(a) the Bank's accounting policy;
(b) credit policy;
(c) other internal documents involved.

25. In the future, the Bank must adhere to the procedure for classifying financial assets required within the new accounting system. All types of products must be properly defined as belonging to one of the classification categories. In addition, it is necessary to indicate the reasons for attribution to a particular category in the classification system.

26. Within the framework of this process of developing and approving the classification of financial assets and their subsequent accounting, the Bank should consider the possibility of carrying out the following activities:

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

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

• criteria for full and partial write-off of assets, as well as specifying 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 appropriate changes to existing policies and procedures in the following areas:

29. Definition of clear criteria for conducting the business model (BM) test, which may include:

a) the objective of managing financial assets; b) the process for approving new financial instruments; c) the business development strategy for financial instruments; d) the sales monitoring process; e) analysis of sales taking into account expectations regarding future sales and other deviations from the objectives of each of the selected models; f) a procedure for changing the BM and reclassifying financial instruments.

2. Development and implementation of a procedure designed to determine whether each financial asset passes the SPPI test and meets the criteria, including:

a) preparation of a standard list of criteria (i.e., a "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 the application of a more judgment-based approach in the case of non-standard financial instruments compared to standard ones.

6. Increase in Credit Risk

7. An increase in credit risk and deterioration of loan quality are determined by objective events that allow classifying the asset in accordance with various stages.

These stages are as follows:

• Stage 1 – initial recognition of the financial instrument, when the instrument does not demonstrate a significant increase in credit risk;
• Stage 2 – a significant increase in the credit risk of the financial instrument is observed since its initial recognition;
• Stage 3 – the financial instrument is fully impaired: there is objective evidence of default on the financial instrument.

30. The Bank must determine (and specify which criteria it will use for this purpose) what constitutes a significant increase in credit risk and in which cases a financial asset can be recognized as fully impaired.

31. For the purposes of determining a significant increase in credit risk and recognizing reserves (ECL) on a collective basis, the Bank, if there is sufficient justification, may group financial instruments by similar characteristics:

As an example of such credit risk characteristics, the following incomplete list can be cited:

• types of models used to measure credit risk;
• credit risk ratings;
• types of collateral;
• dates of initial recognition;
• remaining maturities;
• industries;
• geographical location of borrowers; and
• cost of collateral relative to the financial asset, if this indicator affects the probability of default.

32. Information must be suitable for assessing and measuring credit risk and have characteristics of weighting and justification. The Bank must be able to demonstrate how it considered such information in the process of assessing and measuring ECL. For this, the Bank may use the following indicators:

• internal historical experience of credit losses;
• yield rates and prices (of similar) instruments;
• internal and external ratings;
• credit loss experience of other institutions;
• external reports and statistics.

7. Calculation of Expected Credit Losses (ECL)

8. For the purposes of this chapter, expected credit losses (ECL) refer to a probability-weighted assessment of credit losses (i.e., the present value of all expected cash flows that may not be received) over the expected life of the financial instrument. Since expected credit losses take into account the amount and timing of payments, a credit loss arises even if the Bank expects to receive the full amount, but later than provided by the contract.

9. The calculation of expected credit losses is performed for financial instruments accounted for at amortized cost or at fair value through other comprehensive income.

10. The calculation of expected credit losses is not performed for financial instruments accounted for at fair value through profit and loss.

11. Upon initial acceptance of the asset onto the balance sheet, it is determined as not having a significant increase in credit risk. In Stage 1, reserves for losses (ECL) for the existing asset are calculated as ECL for a 12-month period, or expected losses over the life of the asset (LECL) are assessed for the entire life of the asset if its life is less than 12 months.

For Stage 2, i.e., when a significant increase in credit risk is noted, the financial asset has significant additional credit risk. Then the reserves for expected credit losses (ECL) required for the financial asset are equivalent to reserves for expected credit losses over the entire life (LECL) based on the life of the asset.

For Stage 3, i.e., when actual impairment exists, it is required that expected credit losses over the entire life of the asset (LECL) be recalculated for the financial asset.

Accrual of interest income is produced on the gross amount of the asset if the asset is classified in Stage 1 and Stage 2, and on the net amount, i.e., the balance sheet value minus the reserve for losses (net), if the asset has moved to Stage 3.

37. The following formula may be used to calculate expected credit losses (ECL):

ECL = EAD * LGD * PD

38. Consideration of forward-looking information, including macroeconomic factors, is a distinctive feature of the ECL accounting basis, and this is of fundamental importance for the timely reflection of ECL in accounting. Banks may use reasoned judgments consistent with accepted methods of economic analysis and forecasting.

39. The procedure for measuring and calculating ECL (from the definition of credit risk assessment and changes in credit risk) must include:

• time value of money. Discounting to the reporting date using the effective interest rate at the time of initial recognition or using an approximation;
• expected value. The assessment must necessarily include the probability of occurrence of a credit loss and the probability of non-occurrence of a credit loss;
• incomplete and/or late receipts. Deficit in principal and interest payments, as well as payments made late and without compensation;
• collective and individual assessment;
• assessment period. The maximum possible term of the instrument, including possible extension provisions;
• additional information. Any reasonable and verifiable information that can be obtained by the Bank without incurring unreasonable expenses and without excessive effort, including both information about past events and the current situation, as well as economic forecasts.

40. The Bank must justify the judgment in which a selected economic scenario is used to assess ECL.

41. The Bank must consider whether and to what extent forecast information will be useful for the Bank in assessing both credit risk and the probability of default. The key element is that the Bank must: "appropriately take into account the impact of forecast information, including macroeconomic factors." Banks must have the necessary tools to ensure a reasoned assessment and timely recognition of ECL. Information regarding historical loss experience CANNOT (emphasized especially) fully reflect credit risk in lending. However, in many cases, it is important to consider historical loss experience, and this is the first practical step.

42. The Bank must consider which and to what extent macroeconomic variables are suitable for forecasting ECL. First, the National Bank recognizes that there are many factors that affect credit risk and ECL, for example, GDP growth rates, interest rates, (inflation), foreign exchange rates, volumes of money transfers, and the borrower's industry/sector. Second, which factors are applicable, acceptable, and appropriate – this must be decided by the Bank on an individual basis. Third, lending to different groups carries different credit risks, so factors must change to account for different circumstances, such as different financial products, segments, industries, currencies, etc. The acceptability and effectiveness of the macroeconomic model and its constituent variables are