- Type of Publication: Guideline Impact Analysis Statement
- Date: June 2016
- GIAS: Banks/FBBs/BHC/T&L/CRA/Life/P&C/IHC
The International Accounting Standards Board (IASB) issued the final version of International Financial Reporting Standard 9 Financial Instruments (IFRS 9) in July 2014. IFRS 9 will be effective for annual periods beginning on or after January 1, 2018.
As federally regulated entities (FREs) adopt IFRS 9, OSFI reviewed our existing Accounting and Disclosure Guidelines to determine whether they would continue to apply under IFRS 9. For the purposes of this Guideline, FREs include:
- a bank to which the Bank Act applies;
- a bank holding company incorporated or formed under Part XV of the Bank Act;
- the Canadian branch of a foreign bank in respect of which an order under subsection 524(1) of the Bank Act has been made;
- a body corporate to which the Trust and Loan Companies Act applies;
- an association to which the Cooperative Credit Associations Act applies;
- an insurance company or a fraternal benefit society incorporated, formed or continued under the Insurance Companies Act;
- an insurance holding company incorporated or formed under Part XVII of the Insurance Companies Act; and
- the Canadian branch of a foreign company in respect of which an order under Section 574 of the Insurance Companies Act has been made.
2. Summary of OSFI's proposed changes as a result of IFRS 9
OSFI undertook a review of its existing Accounting and Disclosure Guidelines, including:
- C-1 Impairment – Sound Credit Risk Assessment and Valuation of Financial Instruments at Amortized Cost;
- C-5 Collective Allowance – Sound Credit Risk Assessment and Valuation Practices for Financial Instruments at Amortized Cost;
- D-1, D-1A, D-1B Annual Disclosures;
- D-6 Derivatives Disclosures;
- D-10 Accounting for Financial Instruments Designated as Fair Value Option.
Following this review, OSFI has determined that when FREs adopt IFRS 9:
- Guideline D-1 (Deposit-Taking Institutions) will be rescinded;
- Impairment guidance will not apply to insurance companies, foreign bank branches or to deposit taking institutions (DTIs) that are not in the business of lending.
The content of the following Guidelines will be revised or replaced and consolidated into a single IFRS 9 Financial Instruments and Disclosures Guideline.
For Deposit-Taking Institutions:
- Guidelines C-1 and C-5 will be rescinded and replaced with new impairment guidance;
- Guideline D-6 will be retained;
- Guideline D-10 will be retained and revised.
- Guidelines D-1A, D-1B and D-6 will be retained;and
- Guideline D-10 will be retained and revised.
Rescinding Guideline D-1 for Deposit-Taking Institutions (DTIs)
OSFI reviewed the Annual Disclosures Guideline D-1 for federally regulated DTIs and determined that IFRS and revised Pillar 3 provide an extensive high quality set of disclosure requirements. As a result, OSFI proposes to rescind the DTI version of Guideline D-1 because IFRS and revised Pillar 3 requirements provide suitable and adequate disclosure guidance.
Retaining Guideline D-1A for Life Insurance Enterprises and Guideline D-1B for Property & Casualty Insurance Enterprises
OSFI's Guideline D-1A and Guideline D-1B expects federally regulated life and property & casualty insurers to provide financial disclosures with their annual financial statements or annual reports in addition to, or in conjunction with, all the disclosures required by IFRS. IASB's Insurance Contracts project is expected to have extensive disclosure requirements and OSFI will complete a comprehensive review of its disclosure guidelines for insurers once the new Insurance Contracts Standard is finalized. Therefore, OSFI proposes to retain Guidelines D-1A and D-1B and conduct a comprehensive review when the IASB finalizes their Insurance Contracts Standard.
Retaining Guideline D-6 for all industries
OSFI's Derivatives Disclosure Guideline D-6 provides FREs with guidance that is consistent with IFRS 7 including further disclosure requirements for derivative financial instruments and derivative non-financial instruments. OSFI proposes that no changes be made to the Derivatives Disclosure Guideline. The Guideline requires disclosure of complex derivative instruments that are not currently addressed by IFRS or Pillar 3. Many of the disclosures are unique and specific to OSFI, as they are necessary to reflect OSFI's capital requirements. OSFI will consider whether developments in the IASB disclosure initiatives will impact Guideline D-6 once they are finalized.
No impairment guidance for insurance companies, foreign bank branches, and DTIs not in the business of lending under IFRS 9
OSFI is proposing that no further supervisory impairment guidance would be provided to insurance companies, foreign bank branches, or to DTIs that are not in the business of lending.
- Lending is not a core business activity for insurers or for DTIs that are not in the business of lending, as loans represent a small portion of their overall business. Therefore, additional guidance such as that developed by the Basel Committee for internationally active banks would be less relevant to these entities. If a DTI concludes that it is not in the business of lending, this should be communicated to OSFI in a timely manner and may be subject to supervisory review.
- Foreign bank branches are operating units (rather than separate legal entities) of authorized foreign banks. OSFI does not require authorized foreign banks to maintain allowances for credit risk on the books of their Canadian branch.
OSFI issued the draft IFRS 9 Financial Instruments and Disclosures guideline for public consultation in March 2016 and received comments from six stakeholders. A summary of material comments received and an explanation of how they have been addressed has been provided along with the final Guideline.
The IFRS 9 guideline is effective when IFRS 9 is applicable to FREs.
5. Accounting for Financial Instruments Designated as Fair Value Option (applicable to all FREs)
OSFI's guideline Accounting for Financial Instruments Designated as Fair Value Option (Guideline D-10) was developed in 2006 when Canadian GAAP adopted the Financial Instruments standard that permitted entities to fair value any financial asset or financial liability at initial recognition to profit and loss (also known as the Fair Value Option or FVO). OSFI focused on the reliability of fair values for prudential purposes when observable market prices are not available. In order to ensure financial institutions maintain the quality of regulatory capital and reliability of regulatory reporting, Guideline D-10 expects FREs to use the FVO only if fair values are reliable. In addition, Guideline D-10 limits the accounting option to designate loans as fair valued to profit and loss and instead requires loans to remain measured at amortized cost. The amortized cost value then flows through to regulatory capital. No further adjustments or filters are required in regulatory capital, conforming to OSFI's preference for using one set of general purpose financial statements for both financial reporting and capital determination. Guideline D-10 applies to all industries.
II. Problem Identification
The new accounting standard for Financial Instruments, IFRS 9 also permits entities to use the Fair Value Option (FVO) to change the classification from amortized cost or fair valued through other comprehensive income (FVOCI) to fair value through profit and loss to eliminate accounting mismatches. As FREs adopt IFRS 9, OSFI needs to determine if Guideline D-10 continues to address OSFI's concerns.
Life insurers' business model will likely require them to classify their invested assets (including loans) backing insurance liabilities as FVOCI. The FVOCI classification for the invested assets would create an accounting mismatch because fair value changes in the assets will be recorded in OCI while changes in insurance liabilities are recorded in profit and loss (P&L), both under the Canadian Asset Liability Method (CALM) and under the future insurance contract standard IFRS 4 Phase II. Life insurers would like to use the FVO for the invested assets, including loans, to eliminate the accounting mismatch. Using the FVO ensures that changes in value of the assets that support insurance liabilities would be reported in P&L to offset the changes in insurance liabilities that would also be reported in P&L.
Guideline D-10 should continue to address the reliability of fair values of assets with unobservable market inputs under IFRS 9 and ensure the changes in fair values are not included as part of regulatory capital. As part of this assessment, OSFI will review the impact of the life insurance business model under IFRS 9 and the effectiveness of Guideline D-10 on such a model.
IV. Options and Assessment
OSFI has identified three options for addressing the Fair Value Option, which are outlined below:
Option 1: Rescind Guideline D-10 and set prudential valuation adjustments.
This option would rescind Guideline D-10 and, in its place, OSFI would establish prudential valuation adjustments to remove any unrealized gains or losses from loans accounted for using the FVO in regulatory capital. Essentially, loans would be reflected as though they are accounted for using amortized cost for regulatory capital purposes.
This option addresses life insurers concerns by allowing them to minimize accounting mismatch while also allowing FREs to recognize all economic relationships on the financial statements. FREs are to manage their own risks, including risks of accounting volatility. In order to ensure appropriate regulatory capital for the protection of depositors and policyholders, prudential valuation adjustments would be required to address any issues with fair value measurements for regulatory capital, possibly leading to two sets of books.
However, this option does not address the robustness of valuation techniques used for fair valuing loans, which may vary from institution to institution for financial reporting. This option may also increase accounting volatility because loans are fair valued through profit and loss rather than carried at amortized cost.
Option 2: Retain Guideline D-10 and update with IFRS 9 references only.
This option would retain Guideline D-10 and, where required, incorporate references to IFRS 9. As such, the content of the guideline would remain unchanged.
This option encourages the maintenance of strong regulatory capital by addressing the reliability of valuing loans on a fair value basis given that most FREs use significant management judgement to fair value their loans due to the lack of observable inputs. The continuation of an existing Guideline with which the industry is familiar provides consistent treatment across the three industries and aligns the treatment for both capital and accounting purposes (only one set of books).
This option does not address concerns expressed by life insurers regarding accounting mismatch in financial reporting. In addition, this option has limited efficacy for loans held to support life insurance liabilities because it would only restrict the accounting option to change the classification from FVOCI or amortized cost to fair valued through profit and loss. Guideline D-10 cannot limit the business model test that may require life insurers to use FVOCI.
Option 3: Modify Guideline D-10 to address limited efficacy of the Guideline for life insurers' business model under IFRS 9.
Similar to Option 2, this option would see Guideline D-10 retained and updated for references to IFRS 9, but life insurers' investments in loans that are classified as FVOCI under IFRS 9 would be exempted from the Guideline. To promote confidence in the fair valuation practices of life insurers, OSFI would review life insurers' fair value practices and develop regulatory capital adjustments to address fair value reliability and quality of regulatory capital issues for loans measured at fair value.
This option promotes confidence in fair valuation practices for regulatory capital while allowing life insurers to minimize accounting mismatch in financial reporting for loans that are classified as FVOCI under IFRS 9. It also ensures DTIs continue with existing risk management and financial statement discipline in hedge accounting to reflect their risk management practices.
OSFI will need to undertake new work to review life insurers' fair value practices and will work with life insurers to develop the capital treatment to remove the effects of fair valuation from regulatory capital.
Fair valuations of loans need to be reliable to be considered appropriate for regulatory capital purposes. Given that loans make up a large portion of DTI's assets, it is essential to have reliable valuations for prudential capital purposes. OSFI is of the view that loans should be measured at amortized cost and should be subject to the expected credit loss requirements in IFRS 9 to measure impairment. Guideline D-10 has been in place since 2006 and its continuation is not expected to cause material changes to FREs' processes.
With respect to life insurers, Guideline D-10 has limited efficacy under IFRS 9 because of the application of the business model test. Consequently, OSFI believes it appropriate to modify Guideline D-10 to exempt its applicability to loans on the financial statements of life insurers that are classified as fair valued through other comprehensive income. Instead, OSFI plans to promote greater confidence in the fair valuation practices of life insurers by reviewing their fair value practices and developing a capital solution to address any quality of capital issues for loans measured at fair value.
As part of OSFI’s ongoing monitoring of impacts of new or revised IFRSs to its guidelines and supervisory practices, when the IASB publishes the revised Insurance Contracts standard, OSFI will assess whether any amendments would be needed for the IFRS 9 Financial Instruments and Disclosures guideline.
6. Impairment Guidelines (applicable to DTIs in the Business of Lending)
OSFI currently has two guidelines that establish supervisory expectations on the application of the IAS 39 Financial Instruments incurred loss accounting requirements:
- Guideline C-1 - Impairment – Sound Credit Risk Assessment and Valuation of Financial Instruments at Amortized Cost Guideline; and
- Guideline C-5 - Collective Allowances - Sound Credit Risk Assessment and Valuation Practices for Financial Instruments at Amortized Cost.
These guidelines are intended to encourage sound credit risk assessment processes that are adequate and appropriate to the business. They also expect that DTIs will adopt an active and anticipatory approach to measuring and reporting the credit risk inherent in their loan portfolios. Supervisors promote the use of sound and prudent credit risk practices by DTIs, as experience demonstrates that delayed recognition and measurement of increases in credit risk affect the capital adequacy of DTIs and hamper the proper assessment and control of a DTI's credit risk exposure.
II. Problem Identification
In July 2014, the IASB issued IFRS 9, Financial Instruments, which replaces IAS 39. IFRS 9 requires an Expected Credit Loss Framework (IFRS 9 – ECL) for impairment, which replaces the IAS 39 incurred loss framework.
IFRS 9 – ECL removes the recognition threshold that objective evidence must exist before recognizing impairment. Instead, IFRS 9 – ECL requires DTIs to incorporate the impact of forward-looking information in their assessment and measurement of credit risk.
Due to this change in accounting, OSFI is assessing what, if any, supervisory impairment guidance is necessary for DTIs that are in the business of lending, and consequently, whether amendments are needed to guidelines C-1 and C-5.
In line with OSFI's mandate, the objective of guidelines C-1 and C-5 is to protect depositors by expecting that DTIs employ sound credit risk management and mitigation techniques, while recognising the importance of allowing DTIs to operate in a competitive environment and take reasonable risks.
IV. Options and Assessment
Issue A: Is there a need for OSFI impairment guidance applicable to DTIs to supplement the IFRS 9 – ECL requirements?
Option 1: No need for OSFI impairment guidance
Under this option, OSFI would not issue impairment guidance. This option would be the least complex since there would be no additional guidance beyond IFRS 9 – ECL.
However, this option could result in a low quality implementation of IFRS 9 – ECL because DTIs could use accounting simplifications to minimize their consideration of forward looking information, which is pivotal to the robust implementation of an ECL framework. This could also result in inadequate ECL allowance levels, relative to the credit risk inherent in a DTI's loan portfolios, and could decrease consistency and comparability amongst DTIs on the application of IFRS 9 – ECL.
The risk of inadequate ECL levels is somewhat mitigated because the financial statements are audited. However, the external auditor's work is subject to materiality and provides an opinion on the fair presentation of the consolidated financial statements, not on the account level.
Option 2: Need for OSFI impairment guidance
Under this option, OSFI would develop impairment guidance that sets out supervisory expectations on the application of IFRS 9 – ECL.
IFRS 9 – ECL was developed for use by a wide range of entities, including by entities outside of the banking industry. It thus contains options that OSFI views as inappropriate for use by DTIs. Further, the requirement to incorporate forward-looking information allows a high degree of subjectivity in the ECL measurement and assessment process. Supervisory impairment guidance would address these concerns by encouraging a disciplined and high-quality approach to the application of IFRS 9 – ECL, and would increase consistency and comparability amongst DTIs.
Recommendation: OSFI should develop impairment guidance that sets out supervisory expectations on the application of IFRS 9 – ECL by DTIs. This will encourage a high quality application of the accounting standard, thereby increasing consistency and comparability amongst DTIs.
Issue B: Should updated impairment guidance be embedded in current Guidelines C-1 and C-5 or should C-1 and C-5 be rescinded and new guidance issued?
Option 1 – Revise Guidelines C-1 and C-5
Under this option, current Guidelines C-1 and C-5 would be revised to remove redundancies, update references to IFRS 9, and include impairment guidance to supplement IFRS 9 – ECL and existing supervisory requirements.
This option would require significant updates, as Guidelines C-1 and C-5 were developed under the incurred loss accounting framework and much of the existing content is not relevant under IFRS 9 – ECL.
Option 2 – Rescind Guidelines C-1 and C-5 and create new impairment guidance
Under this option, Guidelines C-1 and C-5 would be rescinded and any additional impairment guidance would be provided in a new IFRS 9 Guideline. This is the most efficient option because much of the current content of C-1 and C-5 is not relevant under IFRS 9 – ECL.
However, OSFI needs to consider if the existing practice that material changes in allowance methodology and/or level should continue to require pre-notification to OSFI, as this aspect of Guideline C-5 is relevant, regardless of the accounting framework applied.
Recommendation: OSFI recommends that Guidelines C-1 and C-5 be rescinded given that much of the existing content is not relevant under IFRS 9 – ECL. Additional impairment guidance would be set out in a new IFRS 9 Guideline. However, due to rescinding Guidelines C-1 and C-5, OSFI needs to consider whether it should retain or rescind the current requirement that OSFI be pre-notified of material changes to a DTIs allowance methodology and/or level.
Issue C: Should OSFI carry forward the existing requirement that DTIs pre-notify OSFI of material changes to their allowance methodology and/or level under IFRS 9 – ECL?
Option 1 – Discontinue the current requirement that DTIs pre-notify OSFI of material changes to their allowance methodology and/or level
Under OSFI's existing Guideline C-5, DTIs are required to pre-notify OSFI of material changes to their allowance methodology and/or level. Discontinuing this requirement more fully aligns with OSFI's reliance based supervisory framework, which relies on the external auditor's opinion on the fair presentation of the financial statements.
However, OSFI would only become aware of material allowance changes after financial statements are finalized. A lack of pre-notification could therefore increase the risk of divergence in allowance methodology and/or level amongst DTIs, as OSFI will not be able to make comparisons before finalization of the financial statements.
Option 2 – Continue the current requirement that DTIs pre-notify OSFI of material changes to their allowance methodology and/or level
The pre-notification process ensures that OSFI is aware of material changes to the allowance methodology and/or level before a DTI finalizes the change and before the financial statements are issued. Pre-notification ensures OSFI is able to review and provide feedback on the change in a timely manner. It also helps to increase consistency of allowance methodologies and/or levels amongst DTIs since OSFI is able to draw comparisons between DTIs. While pre-notification could be seen as duplicative of the work of the external auditor, the external auditor's work is subject to materiality and provides an opinion on the fair presentation of the consolidated financial statements. Supervisory work instead focuses on the account level.
Recommendation: It is recommended that DTIs continue to pre-notify OSFI of material changes to their allowance methodology and/or level. Pre-notification is an effective communication tool that ensures OSFI is aware of material changes before they occur. It also allows for early supervisory engagement and reduces the risk of prudential issues arising after changes are made. This approach encourages sound credit risk management practices, by allowing supervisors a first line of sight on the appropriateness of a DTI's allowance methodology and the adequacy of its allowances. Finally, pre-notification enables OSFI to identify and communicate inconsistencies between DTIs. OSFI’s review will focus on non-routine adjustments; however there may be instances where a routine adjustment could warrant a review at the discretion of the lead supervisor.
Issue D: What additional impairment guidance should apply to DTIs approved to use the internal ratings based approach for Pillar 1 credit risk purposes (IRB-DTIs) and Standardized DTIs?
The content of OSFI impairment guidance is considered separately for IRB-DTIs and Standardized DTIs. This approach recognizes the ability of IRB-DTI's to leverage their existing credit risk framework in the implementation of IFRS 9 – ECL, as compared to Standardized DTIs. This also considers the nature, size, complexity and risk profile of IRB-DTIs relative to Standardized DTIs.
Application to IRB-DTIs
Option 1 – Provide minimal OSFI impairment guidance for IRB-DTIs
Under this option, IRB-DTIs would only be subject to the requirement to pre-notify OSFI of material changes to their allowance methodology and/or level.
This option would be the least complex for IRB-DTIs since there would be little guidance beyond that contained in IFRS 9 – ECL. However, this option could result in Canada's largest and most sophisticated DTIs using accounting simplifications that reduce the quality of their IFRS 9 – ECL implementation. This option could also result in inadequate ECL allowance levels relative to the credit risk inherent in the portfolio. While this risk is somewhat mitigated because the financial statements are audited, the external auditor's work is subject to materiality and provides an opinion on the fair presentation of the consolidated financial statements, not on the account level.
Requiring only pre-notification could also decrease consistency and comparability amongst IRB-DTIs and with global peers. As such, this option does not encourage IRB-DTIs to leverage and integrate their existing capital IRB framework with their ECL accounting framework.
Option 2 – Require IRB-DTIs to apply the Basel Committee's Guidance on Credit Risk and Accounting for Expected Credit Losses (GCRAECL)
Under this option, IRB-DTIs would be subject to GCRAECL through its incorporation into domestic guidance. Requiring IRB-DTIs to apply GCRAECL would promote a high quality ECL implementation, adequate allowances, and consistency/comparability amongst IRB-DTIs and with global peers. While there would be increased complexity associated with IRB-DTIs' application of requirements beyond those in IFRS 9 – ECL, GCRAECL was developed considering its application by internationally active IRB banks. As well, the added requirements encourage IRB-DTIs to leverage their existing Basel IRB capital framework.
Recommendation: It is recommended that IRB-DTIs apply the Basel Committee's Guidance on Credit Risk and Accounting for ECL in order to encourage a high quality and consistent application of IFRS 9 – ECL and adequate levels of loan loss allowances. This also encourages IRB-DTIs to leverage their Basel IRB capital frameworks in the development of their accounting estimates and improves comparability amongst Canada's most sophisticated banks and with global peers.
Application to Standardized DTIs
Option 1 – Provide minimal OSFI impairment guidance
Under this option, Standardized DTIs would be subject to only the requirement to pre-notify OSFI of material changes to their allowance methodology and/or level.
Given the different nature, size, complexity and risk profile of Standardized DTIs compared to IRB-DTIs, the complexity of additional guidance may not outweigh the benefit of ensuring robust allowance levels and consistency across DTIs.
However, this option would allow the use of accounting simplification by Standardized DTIs that could reduce the use of forward-looking information in their IFRS 9 – ECL implementation. This could result in inadequate ECL allowance levels, relative to the credit risk inherent in the portfolio. While this risk is somewhat mitigated because the financial statements are audited, the external auditor's work is subject to materiality and provides an opinion on the fair presentation of the consolidated financial statements, not the account level.
Option 2 – Require Standardized DTIs to apply the Basel Committee's Guidance on Credit Risk and Accounting for Expected Credit Losses (GCRAECL)
GCRAECL was developed by the Basel Committee to ensure a high quality and consistent implementation of ECL accounting frameworks across internationally active banks. Under this option, GCRAECL would be applicable to Standardized DTIs.
This option would encourage a high quality implementation of the IFRS 9 – ECL requirements for all DTIs, which would increase the use of forward-looking information and consistency and comparability between IRB and Standardized DTIs. Conversely, this option could entail increased complexity for Standardized DTIs, as they would be required to implement ECL guidance beyond that contained in IFRS 9 and that is tailored to internationally active IRB banks. This option does not take into consideration the small size and reduced risk profiles of Standardized DTIs.
Option 3 – Develop impairment guidance specific to Standardized DTIs
Under this option, Standardized DTIs would not be required to apply Basel's GCRAECL. Instead, OSFI would develop new domestic impairment guidance that would emphasize two key elements needed to ensure that Standardized DTIs implement IFRS 9 – ECL in a forward-looking manner:
- Standardized DTIs must consider forward-looking information in the development of ECL accounting estimates; and
- Standardized DTIs should limit their use of the IFRS 9 simplification that relies on past due status to determine when loans transfer to lifetime ECL measurement, because delinquency is a lagging (rather than a forward-looking) indicator of impairment.
This option fully considers the nature, size, complexity and risk profile of Standardized DTIs relative to IRB-DTIs by narrowing the additional supervisory requirements to only those essential to ensure that IFRS 9 – ECL is implemented in a forward-looking manner.
Recommendation: It is recommended that OSFI develop new domestic ECL accounting guidance specific to Standardized DTIs. This approach considers the nature, size, complexity and risk profile of Standardized DTIs, relative to IRB-DTIs. The specific guidance for Standardized DTIs would ensure the robust incorporation of forward-looking information in their ECL framework and would limit their use of the IFRS 9 simplification that relies on past due status to determine when loans transfer to lifetime ECL measurement because delinquency is a lagging (rather than a forward-looking) indicator of impairment.
V. Summary of Recommendations
- Guidelines C-1 and C-5 to be rescinded.
- Continue current requirement to pre-notify OSFI of material changes to their allowance methodology and/or level. OSFI’s review will focus on non-routine adjustments; however there may be instances where a routine adjustment could warrant a review at the discretion of the lead supervisor.
- Apply the Basel Committee's Guidance on Credit Risk and Accounting for ECL.
- Standardized DTIs
- Continue current requirement to pre-notify OSFI of material changes to their allowance methodology and/or level.
- Require consideration of forward-looking information and limited use of past due information to determine when loans transfer to lifetime ECL measurement.