A paradigm shift in banking

The global banking sector is undergoing a significant transformation with the introduction of the International Financial Reporting Standard 9 (IFRS 9), which mandates using the Expected Credit Loss (ECL) framework for credit loss provisioning. This shift from the traditional incurred-loss model to a forward-looking ECL approach represents a fundamental change in how banks recognise and account for credit losses. For Bangladesh's banking sector, this transition, as outlined in Bangladesh Bank's BRPD Circular No. 03, dated January 23, 2025, marks a critical step toward aligning with international best practices and enhancing financial transparency. This article delves .into the key aspects of IFRS 9, the ECL framework, and its implications for the banking sector, particularly in Bangladesh.

THE EVOLUTION FROM INCURRED LOSS TO EXPECTED CREDIT LOSS: For decades, banks worldwide have relied on the incurred-loss model, which recognises credit losses only after they occur. While this approach is straightforward, it has been widely criticised for its reactive nature and inability to account for future risks. The incurred-loss model often results in delayed recognition of credit losses, which can exacerbate financial instability during economic downturns.

IFRS 9, issued by the International Accounting Standards Board (IASB) in July 2014, introduces a more proactive approach through the ECL framework. Under IFRS 9, banks are required to recognize credit losses based on expected future defaults rather than past events. This forward-looking approach considers past events, current conditions, and forecast information, ensuring that credit losses are recognized in a more timely and accurate manner. The ECL framework is designed to mitigate procyclicality and provide a more realistic assessment of credit risk, thereby enhancing the resilience of the banking sector.

THE ECL FRAMEWORK: SCOPE AND APPLICATION: Under IFRS 9, financial assets are classified based on the business model for managing them and their cash flow characteristics. Financial assets such as loans, lease receivables, loan commitments, and financial guarantee contracts are subject to the ECL framework if they meet specific criteria. For simplicity, this article focuses on the application of the ECL framework to loans.

THE ECL FRAMEWORK REQUIRES BANKS TO RECOGNIZE CREDIT LOSSES IN THREE STAGES: Stage 1: When a loan is originated or purchased, banks recognise 12-month ECLs, which represent the expected credit losses resulting from default events that are possible within the next 12 months. A loss allowance is established, and interest revenue is calculated on the loan's gross carrying amount.

Stage 2: If a loan's credit risk increases significantly since its initial recognition, banks recognise lifetime ECLs. The calculation of interest revenue remains the same as in Stage 1.

Stage 3: If a loan becomes credit-impaired, banks recognise lifetime ECLs and interest revenue is calculated based on the loan's amortised cost (gross carrying amount less the loss allowance).

TWELVE-MONTH VS. LIFETIME EXPECTED CREDIT LOSSES:

The ECL framework distinguishes between 12-month ECLs and lifetime ECLs. Twelve-month ECLs represent the portion of lifetime ECLs associated with the possibility of a loan defaulting within the next 12 months. It is not the expected cash shortfalls over the next 12 months but the effect of the entire credit loss on a loan over its lifetime, weighted by the probability that this loss will occur in the next 12 months.

Lifetime ECLs, on the other hand, represent the expected present value of losses that arise if a borrower defaults on its obligation throughout the life of the loan. These losses are calculated as a weighted average of credit losses, with the probability of default serving as the weight. Even if a bank expects to be paid in full but later than the contractual due date, a credit loss is recognized.

DISCLOSURE REQUIREMENTS: IFRS 9 mandates that banks disclose detailed information about their ECL calculations, including the basis for measuring ECLs and assessing changes in credit risk. Banks must also provide a reconciliation of the opening and closing ECL amounts and carrying values of the associated assets, categorized by asset class and type of ECL (12 months or lifetime). These disclosure requirements enhance transparency and enable stakeholders to better understand a bank's credit risk profile.

REGULATORY TREATMENT OF ACCOUNTING PROVISIONS: The timely recognition of credit losses is crucial for promoting safe and sound banking systems. The Basel Committee on Banking Supervision (BCBS) has long recognized the close relationship between capital and provisions. In October 2016, the BCBS released a consultative document and discussion paper on the regulatory treatment of accounting provisions under the Basel capital framework, in light of the shift to ECL by both the IASB and the US Financial Accounting Standards Board.

Given the diversity of accounting and supervisory policies across jurisdictions, the BCBS decided to retain the current regulatory treatment of provisions for an interim period. However, the BCBS has set out optional transitional arrangements for the impact of ECL accounting on regulatory capital and corresponding Pillar 3 disclosure requirements. These arrangements provide flexibility for individual jurisdictions as they transition to the ECL framework.

BANGLADESH'S JOURNEY TOWARD IFRS 9 IMPLEMENTATION: Bangladesh's banking sector is poised to embrace IFRS 9 and the ECL framework by 2027, as outlined in Bangladesh Bank's BRPD Circular No. 03 of this year. This transition represents a significant departure from the traditional rule-based loan classification system and underscores the central bank's commitment to enhancing risk management and financial transparency.

To facilitate a smooth transition, Bangladesh Bank has laid out a detailed roadmap with specific timelines and milestones. Key steps include the formation of IFRS 9 Implementation Teams, the development of comprehensive databases for ECL calculations, and extensive training programs for bank employees. By December 2027, the ECL-based loan classification and provisioning system is expected to be fully operational across the banking sector.

PREPARING FOR SUCCESS: Successful implementation of IFRS 9 requires significant institutional readiness. Banks must review and upgrade their internal systems, accounting standards, and IT infrastructure to meet the demands of the new framework. The IFRS 9 Implementation Team, comprising officials from Credit Risk Management, Financial Accounts, IT, and Internal Control and Compliance (ICC), will play a pivotal role in ensuring compliance and operational efficiency.

To maintain transparency and accountability, banks must submit quarterly progress reports to their Board of Directors (BODs), with summaries shared with the Banking Regulation and Policy Department (BRPD). These reports will provide a clear picture of the implementation status, highlight challenges, and outline corrective actions. Additionally, banks are encouraged to seek technical assistance from external experts to address complex implementation issues and ensure a smooth transition.

A BRIGHTER FUTURE FOR BANKING: The adoption of IFRS 9 and the ECL framework represents a transformative step for Bangladesh's banking sector. By following the structured roadmap and prioritizing capacity building, banks can ensure a seamless transition to the ECL-based provisioning system. This shift will not only strengthen the financial health of banks but also bolster investor confidence and contribute to the overall stability of the economy.

As Bangladesh's banking sector embarks on this journey, it stands poised to emerge as a more resilient, transparent, and globally competitive player in the financial landscape. The road ahead may be challenging, but the rewards-greater stability, transparency, and trust-are well worth the effort.

The introduction of IFRS 9 and the ECL framework marks a new era for the global banking sector, and Bangladesh is no exception. By adopting a forward-looking approach to credit loss provisioning, banks can better manage risks, enhance financial transparency, and build trust among stakeholders. Successful implementation of IFRS 9 will require careful planning, robust systems, and a commitment to capacity building. However, the long-term benefits of a more resilient and transparent banking sector make this transition a critical step toward a brighter financial future.

Dr. Md. Touhidul Alam Khan is an experienced banker and cost & management accountant from the Institute of Cost & Management Accountants of Bangladesh (ICMAB). touhid1969@gmail.com