What is meant by significant increase in credit risk
Significant increase in credit risk (SICR)
At each reporting date an entity shall assess whether the credit risk on a financial instrument is increased significantly since initial recognition. The entity is required to assess the change in the risk of a default occurred over the expected life of the financial instrument and not the change in the amount of expected credit losses. The effect of this is that the risk of default occurring on the financial instrument as at the reporting date is compared with the risk of default occurring on the same financial instrument as at the date of the initial recognition. If based on the reasonable and supportable information available without undue cost and effort, it is found that that there is significant increase in credit risk as compared to the credit risk on initial recognition, the financial instrument moves to stage-2 in the impairment methodology.
An entity cannot rely solely on past due information while determining whether the credit risk has increased significantly. However, when forward looking information relevant for making the assessment of enhancement in credit risk is unavailable, then the entity may use past due information. It should be noted that there is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. This implies that if the entity has reasonable information that demonstrates that the credit risk has not increased significantly since initial recognition despite the contractual payments being overdue for more than 30 days, then the entity can rebut this presumption. The entity may also determine that there has been significant increase in credit risk even before the contractual payments are more than thirty days past due, in which case, there is no scope for the rebuttable presumption to apply.
The following list of information may be relevant in assessing changes in credit risk:
- Significant changes in internal price indicators of credit risk as a result of a change in credit risk since inception, including, but not limited to, the credit spread that would result if a particular financial instrument or similar financial instrument with the same terms and the same counter-party were newly originated or issued at the reporting date.
- Other changes in the rates or terms of an existing financial instrument that would be significantly different if the instrument was newly originated or issued at the reporting date (such as more stringent covenants, increased amounts of collateral or guarantees, or higher income coverage) because of changes in the credit risk of the financial instrument since initial recognition.
- Significant changes in external market indicators of credit risk for a particular financial instrument or similar financial instruments with the same expected life. Changes in market indicators of credit risk include, but are not limited to:
- the credit spread;
- the credit default swap prices for the borrower;
- the length of time or the extent to which the fair value of a financial asset has been less than its amortised cost; and
- other market information related to the borrower, such as changes in the price of a borrower’s debt and equity instruments.
- An actual or expected significant change in the financial instrument’s external credit rating.
- An actual or expected internal credit rating downgrade for the borrower or decrease in behavioural scoring used to assess credit risk internally. Internal credit ratings and internal behavioural scoring are more reliable when they are mapped to external ratings or supported by default studies.
- Existing or forecast adverse changes in business, financial or economic conditions that are expected to cause a significant change in the borrower’s ability to meet its debt obligations, such as an actual or expected increase in interest rates or an actual or expected significant increase in unemployment rates.
- An actual or expected significant change in the operating results of the borrower. Examples include actual or expected declining revenues or margins, increasing operating risks, working capital deficiencies, decreasing asset quality, increased balance sheet leverage, liquidity, management problems or changes in the scope of business or organisational structure (such as the discontinuance of a segment of the business) that results in a significant change in the borrower’s ability to meet its debt obligations.
- significant increases in credit risk on other financial instruments of the same borrower.
- An actual or expected significant adverse change in the regulatory, economic, or technological environment of the borrower that results in a significant change in the borrower’s ability to meet its debt obligations, such as a decline in the demand for the borrower’s sales product because of a shift in technology.
- Significant changes in the value of the collateral supporting the obligation or in the quality of third-party guarantees or credit enhancements, which are expected to reduce the borrower’s economic incentive to make scheduled contractual payments or to otherwise have an effect on the probability of a default occurring. For example, if the value of collateral declines because house prices decline, borrowers in some jurisdictions have a greater incentive to default on their mortgages.
- A significant change in the quality of the guarantee provided by a shareholder (or an individual’s parents) if the shareholder (or parents) has an incentive and financial ability to prevent default by capital or cash infusion.
- Significant changes, such as reductions in financial support from a parent entity or other affiliate or an actual or expected significant change in the quality of credit enhancement, that are expected to reduce the borrower’s economic incentive to make scheduled contractual payments. Credit quality enhancements or support include the consideration of the financial condition of the guarantor and/or, for interests issued in securitisations, whether subordinated interests are expected to be capable of absorbing expected credit losses (for example, on the loans underlying the security).
- Expected changes in the loan documentation including an expected breach of contract that may lead to covenant waivers or amendments, interest payment holidays, interest rate step-ups, requiring additional collateral or guarantees, or other changes to the contractual framework of the instrument.
- Significant changes in the expected performance and behaviour of the borrower, including changes in the payment status of borrowers in the group (for example, an increase in the expected number or extent of delayed contractual payments or significant increases in the expected number of credit card borrowers who are expected to approach or exceed their credit limit or who are expected to be paying the minimum monthly amount).
- Changes in the entity’s credit management approach in relation to the financial instrument; ie based on emerging indicators of changes in the credit risk of the financial instrument, the entity’s credit risk management practice is expected to become more active or to be focused on managing the instrument, including the instrument becoming more closely monitored or controlled, or the entity specifically intervening with the borrower.
- Past due information, including the rebuttable presumption.
Collective and individual assessment basis
Sometimes it may be necessary to perform the assessment of significant increase in credit risk only on a collective basis. This may be performed on a group or sub-group of financial instruments also known as a portfolio or a sub-portfolio. The lifetime expected credit losses should be assessed on a collective basis even if evidence of such significant increases at the individual instrument level is not available. When a financial asset becomes past due, certain borrower specific factors may be prevalent, viz, modification or restructuring of the debt, etc. When such information is available which might be forward looking, the same should be considered for assessing the significant increases in credit risk and the entity should not rely merely on the past due information. Needless to mention that the forward looking information should be available without undue cost or effort.
For financial instrument such as retail loans, updated credit risk information may not be available on an individual instrument basis until a customer breaches contractual terms. In such cases, the loss allowance based merely on the credit information at an individual financial instrument level may not capture the significant increases in credit risk since initial recognition, if any.
Also in certain circumstances, an entity may not have sufficient information on an individual basis without incurring undue cost or effort, to assess the lifetime expected credit losses. An entity in those circumstances should use the comprehensive credit risk information which incorporates both past due information as well as all relevant credit information including forward looking macro-economic information to approximate the increase in credit risk on an individual instrument level.
To assess at a group level, an entity can group the financial instruments on the basis of assured credit risk characteristics such as instrument type, group ratings, collateral type, initial recognition date, remaining term of maturity, industry, geographical location and the value of collateral relative to the financial asset or loan to value ratios, etc. However, it should be ensured that the assessment should not be obscured by grouping financial instruments with different risk characteristics. If such assessment on a collective basis is not possible, then the entity should recognise lifetime expected credit losses on a portion of the financial assets for which credit risk is deemed to have increased significantly. The assessment on a collective basis may change over time as information becomes available on individual financial instruments.
Timing of recognising lifetime expected credit losses
Lifetime expected credit losses should be recognised based on significant increases in the risk of default occurring since initial recognition. The timing of such recognition should not be based on the evidence of financial asset being credit impaired or on actual default occurring. The reason for recognising lifetime expected credit losses on this basis is that there will be a significant increase in credit risk before the financial asset becomes credit impaired or on actual default occurring on such asset.
For loan commitments, an entity considers changes in the risk of a default occurring on the loan to which a loan commitment relates. For financial guarantee contracts, an entity considers the changes in the risk that the specified debtor will default on the contract.
Thus, the risk of a default occurring will be more significant for a financial instrument with a lower initial risk of a default occurring compared to a financial instrument with a higher initial risk of a default occurring.
The risk of a default occurring on financial instruments that have comparable credit risk is higher the longer the expected life of the instrument; for example, the risk of a default occurring on an AAA-rated bond with an expected life of 10 years is higher than that on an AAA-rated bond with an expected life of 5 years.
The risk of a default occurring over the expected life usually decreases as time passes if the credit risk is unchanged and the financial instrument is closer to maturity.
However, for financial instruments that only have significant payment obligations close to the maturity of the financial instrument the risk of a default occurring may not necessarily decrease as time passes. In such a case, an entity should also consider other qualitative factors that would demonstrate whether credit risk has increased significantly since initial recognition.
Financial instruments with low credit risk
An entity may assume that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date. The credit risk on a financial instrument is considered low for the above purpose if:
- The financial instrument has a low risk of default;
- A borrower has a strong capacity to meet its contractual cash flow obligations in the near term; and
- Adverse changes in economic and business conditions in the long term may but will not necessarily, reduce the ability of the borrower to fulfil his contractual obligations (Ind AS 109 – B5.5.22).
It is not necessary for a financial instrument to be externally rated for the purpose of considering whether it has a low credit risk. An entity may use its internal credit risk ratings including methodologies that are used globally for the purpose of defining the concept of low credit risk that considers the risks and the type of financial instruments that are being assessed, eg, an external rating of ‘investment grade’, is an example of a financial instrument that may be considered as having low credit risk (Ind AS 109 – B5.5.23). Lifetime expected credit losses may still be required to be considered when it is determined that there is a significant increase in credit risk since initial recognition, warranting the entity to recognise lifetime expected credit losses. In other words, when a financial instrument no longer has a low credit risk, the general requirements for assessing whether there has been a significant increase in credit risk applies to such instruments.
More than 30 days past due rebuttable presumption
The rebuttable presumption is not an absolute indicator that lifetime expected credit losses should be recognised, but is presumed to be the latest point at which lifetime expected credit losses should be recognised even when using forward-looking information (including macroeconomic factors on a portfolio level).
An entity can rebut this presumption. However, it can do so only when it has reasonable and supportable information available that demonstrates that even if contractual payments become more than 30 days past due, this does not represent a significant increase in the credit risk of a financial instrument. For example, when non-payment was an administrative oversight, instead of resulting from financial difficulty of the borrower, or the entity has access to historical evidence that demonstrates that there is no correlation between significant increases in the risk of a default occurring and financial assets on which payments are more than 30 days past due, but that evidence does identify such a correlation when payments are more than 60 days past due.
An entity cannot align the timing of significant increases in credit risk and the recognition of lifetime expected credit losses to when a financial asset is regarded as credit-impaired or an entity’s internal definition of default.
Larger absolute increase in credit risk
To be ‘significant’, a larger absolute increase in the risk of default will be required for an asset with a higher risk of default at initial recognition than for an asset with a low risk of default at initial recognition. For example, an absolute change of 2% in the PD occurring will be more significant for an asset with an initial PD of 5% than for an asset with an initial PD of 20%. The basis for conclusions also indicates that to be significant, a larger absolute increase in the risk of default will be required for a longer-term financial asset than for a short-term financial asset.