SLFRS 9, the new standard on Financial Instruments replaces the erstwhile standard LKAS 39 effective January 1, 2018. Transition to SLFRS 9 is expected to have a profound impact on the business of banks as it has a pervasive impact not only on accounting but also on the structuring of products, risk assessment of borrowers, capturing of newer and larger data sets, regulatory capital etc. This is primarily accountable to revised requirements with respect to classification and measurement of financial assets and moving from an incurred loss model to an expected credit loss model.

SLFRS should be as much part of the CEO agenda as it is of the CFO/ Controller’s agenda as it is expected to significantly alter the KPIs and business ratios (cost to income ratio, NII, NIM, NPL ratios and provision coverage ratios) based on the choices made. Banks are advised to proactively reach out to internal and external stake holders to highlight impacts of these changes.

Some of the significant potential changes in practices that are expected due to SLFRS 9 are as follows:

•       SLFRS 9 brings in the concept of classification of financial assets depending on the business model test and cash flow characteristics, whereby the existing LKAS 39 categories of held-to-maturity (HTM), held-for-trading (HFT), available-for-sale (AFS) and loans and receivables (L&R) have been replaced with three principal classification categories: measured at amortised cost, fair value through other comprehensive income (FVOCI) and fair value through profit or loss (FVTPL).

•       Equity investments are required to be measured at fair value, with an option to irrevocably elect to measure fair value changes through OCI (without the ability to recycle). LKAS 39 had an exception to the measurement requirements for investments in unquoted equity instruments that do not have a quoted market price in an active market and for which fair value therefore cannot be measured reliably. Such financial instruments are measured at cost. IFRS 9 removes this exception, requiring all equity investments to be measured at fair value.

Thus, SLFRS 9 may have a significant impact on the way financial assets are classified and measured, resulting in changes in volatility within profit or loss and equity, which in turn are likely to impact the Key Performance Indicators (KPIs).

The new provisioning computation (forward looking credit losses) is likely to have a significant impact on the systems and processes of banks, due to its extensive requirements for data and calculations.

•       SLFRS 9 replaces the 'incurred loss' model in LKAS 39 with an 'expected credit loss' model. The new model applies to financial assets that are not measured at FVTPL, including loans, lease and trade receivables, debt securities and off balance sheet exposures such as loan commitments (revocable and irrevocable), contingencies and financial guarantees. It does not apply to equity investments as they are accounted for either at FVTPL or FVOCI.

•       For assets where there had been significant increase in credit risk since origination (Stage 2), i.e. when the facility is more than 30 days overdue, SLFRS requires recognition of lifetime ECL as against 12 months ECL (Stage1). This will create a cliff effect and will tantamount to a high impairment charge being recognized upfront. Hence, banks may now need to spend greater effort on early collections so as to avoid recognition of life time provisions.

•       Further, for loans classified as Stage 3, interest income is recognised on accrual basis using the EIR method on loan balance, net of ECL loss provision, unlike under LKAS 39 where no such interest was being accrued.

The current environment where SLFRS transition is being conducted has considerable ambiguity due to the lack of certain key regulatory clarifications and guidance. The treatment of SLFRS transition adjustments on capital adequacy is also unclear, since there could be instances wherein the transition adjustments have a significant impact on the net worth of banks on transition. Making business decisions in such an environment may prove to be challenging. The banking industry will look forward to receiving inputs from the regulators like the CBSL to help companies achieve a smoother transition for both financial and regulatory reporting.