Treatment of sovereign risk under IFRS 9 - proposed approaches and application for the Lebanese banking sector

Abstract

The new impairment requirements stipulated by IFRS 9 (the Standard) represent a true challenge for the banking industry in terms of implementation effort, cost and time. The Standard was introduced as a direct response to address the banking sector’s weaknesses exposed by the recent financial crisis, which resulted in a delayed recognition of credit losses and accordingly huge losses borne by banks internationally. The Standard advocates a forward-looking impairment methodology for the calculation of Expected Credit Loss (ECL) on all portfolios held by financial institutions so as to build adequate provisions right upon initiation, even before any signs of actual impairment exist, based on holistic and forward-looking credit information. The institution must then track specific indicators of significant increase in credit risk and build provisions over the lifetime of those exposures which show signs of credit deterioration over time. IFRS 9 impairment requirements were applied by Lebanese banks in line with the Central Bank of Lebanon (the Regulator or BDL) requirements through issued guidance. One major implementation issue is the treatment of Sovereign exposures, which remains an unaddressed area by the current local guidance and a top item on the agenda of many Risk Managers. The present work intends to explore the available methodologies for computing ECL on the Sovereign portfolio and to propose an analytical framework for understanding and quantifying Sovereign credit risk within the Lebanese context. By reviewing the available market approaches adopted by other developed and developing countries along with those studied in the Sovereign risk literature, the research assesses the resulting approaches against Standard requirements and proposes potential options for consideration within the Lebanese context.