Aptivaa has been a key representative speaker across panels of various risk events held recently such as the PRMIA Qatar chapter event, a Workshop on IFRS 9 organized by FIS for banks at Kuwait City, 3rd Banks Risk Management conference 2016 at Amman and the IFRS 9 workshop at GARP Istanbul chapter. During these interactions a number of participants have reached out to us for views on the approach for estimation of Effective Interest Rate (EIR). Also, as a part of our current engagements on IFRS 9 with several Banks, this is a question that is posed to us oftentimes.
Given the uncertainty around the subject, we thought of sharing some key insights on the subject as to how to compute EIR for fixed or floating rate instruments, how to compute EIR for products which involves both interest income and fee income, what are the challenges which banks might face while computing EIR, what are the operational simplifications which banks might consider while computing EIR.
Before diving into the complexities of Effective interest rate, let us discuss the role of EIR and why it is required to be computed under IFRS 9.
The expected credit loss (ECL) model under IFRS 9, uses a dual measurement approach where the loss allowance is measured at an amount equal to either the 12-month expected credit losses (Stage 1) or the lifetime expected credit losses (Stages 2 and 3). The credit loss estimates based on LGD, PD and EAD should then be discounted using original EIR or credit-adjusted (for purchased or originated credit impaired asset) EIR. Here the original EIR is used to discount the cash shortfalls for arriving at the final estimate of ECL.
Further guidance from IFRS 9 section B5.5.44, states that ECL shall be discounted to the reporting date, not to the expected default or some other date, using the effective interest rate determined at initial recognition or an approximation thereof. If a financial instrument has a variable interest rate, expected credit losses shall be discounted using the current effective interest rate.
For Stages 1 and 2, interest revenue is calculated on the gross carrying amount. Under Stage 3, interest revenue is calculated based on the amortized cost of the financial asset (i.e., the gross carrying amount adjusted for the loss allowance). IFRS 9 states that the interest revenue recognition for a financial instrument measured at amortized cost shall be calculated using the Effective Interest Rate.
Transaction costs that are directly attributable to the acquisition or issue of the financial asset shall include fees and commission paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and security exchanges, transfer taxes and duties. Expenses such as employee bonuses related to the origination of an asset, or legal costs for review of collaterals, etc. are some of the integral parts of transaction costs which banks need to consider as a part of EIR estimations Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.
However, sourcing this level of granular details at a contract level for EIR estimation will be an operational challenge for Banks as these details are usually maintained at a portfolio or a product level (in ledger management systems) and hence allocation at a contract level is proving to be a challenge for several banks.
There is a lot of subjectivity around what type of fee needs to be included when computing EIR. IFRS 9, standard has provided some insights on this subject under section B5.4.1; however, the description of feesfor financial services may not be indicative of the nature and substance of the services provided.
IFRS 9 has also provided some clarifications on those fees which are not considered as an integral part of EIR related to a financial instrument. Such fees are ?
The requirements in IFRS 15 shall be applied to the facts and circumstances of each arrangement in determining when to recognise a fee as income that an Entity might receive. Factors such as whether there is continuing involvement in the form of significant future performance obligations necessary to earn the fee, whether there are retained risks, the terms of any guarantee arrangements, and the risk of repayment of the fee, shall be considered.
Banks thus face challenges that are two fold - firstly making changes in ledger management to identify the fees at a contract level, and secondly to create a framework wherein the nature or purpose of the fees are mapped to IFRS9 criterion.
Time value of money needs to be considered using the effective interest rate (EIR) when measuring Expected credit losses (ECL). Discounting is necessary because the original cost of the asset would have been based on the discounted contractual cash flows, and so not discounting cash flows that are now not expected to be received would overstate the loss. All Banks/FIs usually have both fixed and floating rate products for which EIR needs to be computed.
Interest: 1.25% fixed Frequency: Monthly Upfront fee: CU 360 Monthly Fixed EMI: CU 1083.10 The loan repayments are interest and principal payments each month.
The fee is an incremental cost that are directly attributable to the acquisition of a financial asset and hence becomes a part of EIR (deducted from the cash flow received from the lender on transaction day) and then EIR is calculated for the above illustration by solving for ?x? in the following equation.
11,640 = (150+933.10) / (1+x)30/365 + (138.34+944.76) / (1+x)60/365 + (1083.10) / (1+x)90/365 +............................. + (13.37+1069.73) / (1+x)365/365
Therefore, we proceed to check, if 31/Jan/2016 is greater than 3/Jan/2016. And, since it is greater the value of ?n? will be 28. Similarly, we need to do this for all the cash flow instances in order to amortize the fees of the loan over the life of the asset. Therefore as per the above formula ? Total Cash inflow / (1+EIR) n/365
Approach 1 - Based on actual benchmark interest rate that is set for the current reporting period. For instance, the LIBOR rate as of the reporting date
Approach 2 - An alternative approach is to project estimated cash flows (including current expectations about future interest rates) in calculating the EIR. This would result in the EIR and the spot interest rate for the current period being different if the yield curve for the maturity of the instrument is not flat.
The standard allows for the period over which the rate is calculated to be shorter than the expected life of the instrument, when appropriate. That means an instrument may have different EIRs over its life because the instrument may have multiple reset periods and an EIR is calculated for each period.
However, if the instrument is recognised at an amount equal to the principal receivable or payable on maturity, then this periodic re-estimation does not have a significant effect on its carrying amount. Therefore, for practical reasons, in such cases, the carrying amount is usually not adjusted at each repricing date, because the impact is generally insignificant.
Under IFRS 9, for financial assets which are purchased or originated credit-impaired, the EIR which is used to discount the future cash payments or receipts to amortized cost is needs to be Credit-adjusted. The difference between Credit Adjusted EIR and normal EIR is that, when calculating the former, an entity shall estimate the expected cash flows by considering all contractual terms of the financial asset (for example, prepayment, extension, call and similar options) expected credit losses..
To summarize, in order to meet IFRS 9 requirements to estimate EIR, a bank that has cash flow engines to estimate future cash flows may choose any of the approaches for the floating rate instruments. For fixed rate instruments the estimation of EIR is much simpler, however, identification of fees which is an integral part of EIR would still remain a challenge for banks. It should also be noted that there should be consistency between interest rate used to book interest income (which is also the basis of cash flows projections) and interest rates used to discount the expected cash losses.
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