ISSUE 07

Target Operating Model - Engaging with the Auditors early

As the methodologies for IFRS 9 Implementation are still evolving, many banks are in the process of developing a roadmap towards implementation and are still evaluating methodologies that are likely to conform to the principles of proportionality and materiality. To meet the January 2018 deadline, several banks will not be able to embrace a textbook implementation, and will have to adopt practical approaches to several principles espoused in the guidelines. In our blog ‘Impairment Modelling – No silver bullets’, we spoke about the options that banks have with respect to Expected Credit Loss computations. To this end, banks are being advised to develop a Target Operating Model (TOM) design, which seeks to identify and document the work program required to meet IFRS 9 requirements on Impairment modeling and ECL estimation. It should identify key decision points, the stakeholders, the plan that is immediate and one that is long term. While it is impossible to ‘future-proof’ the plan, it is imperative, that these decision points be articulated and taken into account by key stakeholders. The approval of the TOM will pave the way for the next phases: the implementation of the IFRS 9 methodologies and business transition of the standards and models. The key stakeholders would include not just Finance, Treasury and Risk, but also the Audit, including the statutory auditor. It is imperative that the statutory auditor’s opinion be sought on the appropriateness of the methodologies that are intended to be adopted, right at the outset, rather than wait for the implementation and then engaging with the statutory auditor at that point. IFRS 9 guidelines entail significant changes in internal risk management, accounting policy, reporting framework of the bank, and hence, it is imperative that the beginning block, which is the TOM, is thoroughly assessed and scrutinized by the statutory auditors. For an effective independent assessment and scrutiny, they will have to “challenge” the approach and methodologies adopted by the management in the TOM developed for implementation. The role of the statutory auditors will be to check whether it meets the test of ‘proportionality’ and ‘materiality’. The Internal audit too has an important role to play not just in getting in an early look in but also act as the liaison between the implementation team and the statutory auditors. At

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the same time, it is important to note that the independence of the ‘Three Lines of defense’ needs to be maintained, and the role of auditors should be limited to providing an independent opinion on the roadmap without getting involved in the actual implementation. A few critical decision points related to ECL computation and the roadmap are elaborated below:

Area Key Aspects

Stage Assessment

� What triggers are used to identify significant credit deterioration?

� How can you demonstrate consistency of application?

What are the controls in place?

� Have 12 month PDs been used or lifetime PDs?

� Are these being done at facility level or counterparty level?

� Are these done using lifetime PDs or 12 month PDs

� What are the conditions under which 30 days rebuttable assumption can be used?

� How have practical expedients like “low Credit risk” been used? Please see our blog: Stage assessment – ‘devil is in the detail’ for our views.

IT Architecture

� Has the desired level of automation been considered by the bank?

� Is the IT architecture going to be strategic integrated system or more tactical in nature?

� How will correctness and accuracy of ECL computation be ensured? What are the controls in place?

� For more on this, please refer to our blog post: ‘IT Architecture: Go Strategic or Tactical?’

ECL Computation

� Is there a mapping between portfolio segment and the type of methodology used?

� What are the drivers for this mapping? Typically, it should include portfolio materiality, product type, data availability, or current rating system maturity.

� Is the simplified approach used? If so, for which portfolios will it be used?

� How is EAD computed for revolving products? How will off balance sheet items be treated?

� How have macroeconomic adjustments been made?

� How would transition be handled? Would provisioning levels under current calculation methodology be used as a backstop?

� Have the models been validated? Has back-testing been performed?

� Please see our blog ‘Impairment – no silver bullets’ for our views.

Governance

� What is the constitution of the IFRS 9 Working group and the IFRS 9 steering committee? Is there adequate representation from Risk, finance/Treasury as well as Business lines and Internal Audit?

� Is sufficient training being conducted for all stakeholders including the Audit committee and the relevant Board committees?

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As one can see, the list of items is non-exhaustive and is highly technical in nature. In our opinion, if banks wait till 2018 for engaging with the auditors, it could be too late for complying with the stipulated deadline. The modelling methodologies chosen can have significant ramifications on the provisioning numbers. While not the highest level of modelling sophistication is needed for computation of ECLs, it needs to be commensurate to the portfolio size and complexity. External auditors have an important role in providing an assessment of the modeling methodologies, and will need skill upgradation at their end too. In our next blog, we will look at one such modelling concept, regarding the Probability of default (PD) estimation for IFRS 9 and the seemingly confusing terminology around Lifetime and Through the cycle PD.