Credit-Impaired (Stage 3): a Worked Example

The standard is IFRS 9 for the UK's IFRS reporters, NZ IFRS 9 in New Zealand and AASB 9 in Australia, and the definition is the same in all three. A loan is credit-impaired when one or more events with a detrimental effect on its expected cash flows have occurred. The standard lists the observable evidence. For a business loan the relevant items are significant financial difficulty of the borrower; a breach of contract such as a default or a payment past due; a concession the lender would not otherwise consider, granted because of that difficulty; and a growing probability of bankruptcy or another financial reorganisation. No single event is required, and several together can be enough.

The standard ties this to the bank's own idea of default. It asks each bank to use a default definition consistent with the one its credit risk management uses, and presumes that default has happened by the time a loan is 90 days past due unless the bank can support a later point. In practice many banks align stage 3 with the default definition their supervisor sets, so a loan that becomes unlikely to pay or reaches 90 days past due usually moves into stage 3 at the same time.

The customer's contract does not change. Interest goes on accruing on the account at the contract rate, and the bank goes on asking for it. What changes is the share of it the bank reports as income. Because the allowance is a discounted amount, it grows each period as the discount unwinds, and that growth absorbs the interest the bank charged but did not count. The loan returns to the gross basis only if its credit risk improves so that it is no longer credit-impaired, and the improvement can be linked objectively to an event after the move. When the bank has no reasonable expectation of recovering some or all of the loan, it writes that part off.

A boatbuilder, constructed for this page like every figure in it, owes US$3.0m on a term loan at 9%, with no fees, so the effective rate equals the contract rate. A cancelled order leaves it two quarters in arrears, and the bank defers principal for a year because the business could not otherwise survive. That concession, with the arrears, takes the loan into stage 3. The workout team expects to recover US$1.8m in present value from the yard, the plant and the next order, so the allowance is US$1.2m. The allowance and the rate belong to the example, not to a market norm.

The allowance rose by US$108,000, exactly the interest charged and not counted, and no new impairment charge was needed because nothing in the bank's expectations had changed. Then the order book recovers and another lender refinances the boatbuilder, repaying US$3.27m in full. The bank receives US$1,308,000 more than the loan's amortised cost. That gain is reported as a reversal of impairment losses, including the US$108,000 of interest left out of income in stage 3, not as interest revenue. The IFRS Interpretations Committee concluded in 2019 that this presentation is required when a credit-impaired loan is cured, which it read as including payment in full, and noted that the reversal can exceed the impairment losses booked over the loan's life, as it does here.

Stage 2 also carries a lifetime allowance, so the two are often confused. The tests are different. A loan reaches stage 2 when its credit risk has increased significantly since it was made, a comparison against its own starting point that looks forward. It reaches stage 3 when the loss event has already happened. A stage 2 loan still earns interest on its gross amount; a stage 3 loan earns it on the net amount. The move from 2 to 3 is therefore the point at which the loan's income in the bank's accounts falls, not just its provision.

Leaving stage 3 also runs on a different clock from a supervisor's. IFRS 9 returns a loan to the gross basis when the objective improvement is there, with no minimum period. A probation period for a forborne loan is a prudential rule, which can keep the regulatory label in place after the accounts have moved.

DEFINED IN ONE PARAGRAPH → · PROVISION COVERAGE RATIO → · EXPECTED LOSS, WORKED →

Once a business loan is in stage 3, its allowance is usually an individual estimate, and the estimate is the workout plan in numbers: what the security will fetch, when, and at what cost. Timing counts because the recoveries are discounted. If the boatbuilder's US$1.962m of expected proceeds slipped from one year away to two, their present value at 9% would fall from US$1.8m to about US$1.65m, and the allowance would rise by about US$149,000 with the price unchanged. A slow sale costs the bank in its accounts before it costs anything in cash.

The second effect is on restructuring. A concession granted because the borrower is struggling is itself evidence of impairment, so a credit committee asked to defer principal or cut the rate is choosing between a loan that may survive in stage 3 and an enforcement that crystallises the loss now. Any change to the cash flows that does not end the loan is recalculated at the original rate, and the difference is booked as a modification loss. The third is the bank's own reported numbers, where stage 3 balances and their cover are the first thing an analyst of bank results reads.

WHEN A LOAN GOES BAD → · STAGE 3 BACK TO STAGE 1? THE EXAM QUESTION →