Calculating lifetime expected loss for IFRS 9: which formula is measuring what?
ISSN: 1526-5943
Article publication date: 22 July 2021
Issue publication date: 19 November 2021
Abstract
Purpose
The purpose of this article is to derive formulas for lifetime expected credit loss of loans that are required for the calculation of loan loss reserves under IFRS 9. This is done both for fixed-rate and floating rate loans under different assumptions on LGD modeling, prepayment, and discount rates.
Design/methodology/approach
This study provides exact formulas for lifetime expected credit loss derived analytically together with the mathematical proofs of each expression.
Findings
This articles shows that the formula most commonly applied in the literature for calculating lifetime expected credit loss is inconsistent with measuring expected loss based on expected discounted cash flows. Formulas based on discounted cash flows always lead to more conservative numbers.
Practical implications
For banks reporting under IFRS 9, the implication of this research is a better understanding of the different approaches used for computing lifetime expected loss, how they are connected, and what assumptions are underlying each approach. This may lead to corrections in existing frameworks to make applications of risk management systems more consistent.
Originality/value
While there is a lot of literature explaining IFRS 9 and evaluating its impact, none of the existing research has systematically analyzed the calculation of lifetime expected credit loss for this purpose and how the formula changes under different modeling assumptions. This gap is filled by this study.
Keywords
Acknowledgements
The author thank an anonymous referee for very helpful comments.
Citation
Engelmann, B. (2021), "Calculating lifetime expected loss for IFRS 9: which formula is measuring what?", Journal of Risk Finance, Vol. 22 No. 3/4, pp. 193-208. https://doi.org/10.1108/JRF-05-2020-0113
Publisher
:Emerald Publishing Limited
Copyright © 2021, Emerald Publishing Limited