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August 24, 2021 03:54 PM

Has IFRS 9 improved the relevance of accounting loan loss provisions for CDS pricing?

Posted by obersonro

Yes, but…

 

In 2018, banks have implemented the expected credit loss (ECL) model under International Financial Reporting Standard (IFRS) 9 to estimate loan losses, which replaces the incurred loss model under International Accounting Standard (IAS) 39. The key novelty of the ECL model is the incorporation of forward-looking information for recognizing accounting loan loss provisions (LLPs), which provides ample room for managerial discretion.

The literature recognizes accounting discretion as a double-edged sword. On the one hand, it allows managers to convey private information. On the other hand, opportunistic accounting choices might degrade bank transparency. Consequently, the usefulness of accounting information for credit default swap (CDS) pricing will likely depends on managers’ intentional use of the discretion provided under IFRS 9 and/or ability to estimate credibly future expected loan losses.

In a recent study, forthcoming in the European Accounting Review, I first show that the shift to the ECL model improves the timeliness of loan loss recognition. However, under the IFRS 9 regime managers also use their accounting discretion more aggressively over LLP estimates to smooth earnings. These primary results call into question a potential informational benefit of IFRS 9 adoption as discretionary smoothing via LLP is known to obscure the underlying risk attributes of a bank’s loan portfolio. I then report that, on average, LLPs became more informative for CDS pricing after banks adopted IFRS 9 (but mostly concentrated amongst banks with weaker pre-IFRS 9 information environments). Results from an additional set of tests show that LLPs are more credit-risk relevant for longer CDS maturities than for shorter CDS maturities under IFRS 9, which was not the case under IAS 39. Importantly, these results also indicate that LLPs contain more forward-looking information under IFRS 9 than IAS 39.

I further provide several additional analyses motivated by managers’ intent of the greater discretion provided under IFRS 9. I first find that the higher the level of abnormal LLPs, the lower the enhancement of the credit-risk relevance of LLPs because of IFRS 9 adoption. I also report that under the IFRS 9 regime, LLPs are generally not reflected in CDS spreads for banks operating in countries where LLP reflects mainly discretionary smoothing via LLP while it does in countries where LLP reflects a more forward-looking orientation. I also show that large impairments for performing loans that have experienced a significant increase in credit risk (SICR), are consistently reflected in CDS spreads. Consequently, the determination of a SICR by managers, which is at the discretion of managers, can be considered the main source of credit-risk relevant information. Finally, I report that strong governance plays a key role for the enhanced credit-risk relevance of LLPs in a setting characterized by a high level of discretion afforded to managers.

This article complements the literature on the role of accounting in CDS pricing. It also responds to recent calls by academics for further research to examine the effects of banks’ financial reporting on credit markets. Finally, the evidence in this article contributes to the debate regarding the economic outcome of the IFRS 9 ECL model and suggests interesting avenues for further research.

Discover more about this study: https://doi.org/10.1080/09638180.2021.1956985

To cite this article: Romain Oberson (2021) The Credit-Risk Relevance of Loan Impairments Under IFRS 9 for CDS Pricing: Early Evidence, European Accounting Review, DOI: 10.1080/09638180.2021.1956985

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