Update IFRS 9: Current implementation challenges and solution approaches

Risk EMEA conference, 10 May 2017 Implementation of IFRS 9 is much more than just a simple Change in Bank Accounting – enormous changes and challenges to be considered

Impact of IFRS 9 on financial institutions

Impact of IFRS 9 Challenges for Top Management

— IFRS 9 Accounting rules will replace actual Standard IAS 39 per 1.1.2018 GET guidance for — IFRS 9 defines new standards for P&L & equity impact financial instruments with significant 1 impact on financial institutions FOSTER co-operation — IFRS 9 directly affects P&L and Strong Impact between Risk and balance sheet positions, regulatory of IFRS 9 Finance function capital and major KPIs challenges Top — In addition, due to numerous new Management MANAGE high change regulatory requirements business, and run the bank costs process and IT dependencies with IFRS 9 need to proactively considered and managed PREPARE EBA “stress test” 2018 with focus — Therefore a change management for on IFRS 9 impact the organization, processes and IT landscape is necessary

1 With new requirements for the insurance contract insurance companies have a longer transition period with 2021. Big players have started in 2017 with goal to complete in 2018.

Source: zeb Risk EMEA Conference 2017 20170510_IFRS 9 impact - 2 IFRS 9 implies significant economic and organizational impact on banks which report their financial statements according to IFRS

IFRS 9 impact on banks Based on EBA Impact Study

Survey results based on a sample of 58 institutions zeb view

1 CET1 ratio is estimated to decrease on “What effect does IFRS 9 have on existing equity?” average by up to 80 bps and total capital Equity <-10 bps >-70bps ratio by up to 50 bps. require- “What effect does IFRS 9 have on P&L volatility?” ments P&L volatility will arise from new IFRS 9 0% >+20% requirements e.g. due to changes in loss allowance methodology.

2 “What effect does IFRS 9 have on CTB and RTB cost?” Introducing IFRS 9 will not only result in high Opera- slight major change-the-bank (CTB) cost but also in tional impact RTB CTB impact cost increased run-the-bank (RTB) cost.

3 “What effect does IFRS 9 have on organizational processes?” Changes to the bank management have slight major not yet been sufficiently specified. impact impact Bank However, clear need for further in-depth co- Mgmt. “What effect does IFRS 9 have on lending practices?” operation between risk & finance function slight major impact impact The impact on new product design & product maturity needs to be considered.

4 “What effect does IFRS 9 have on the IT architecture?” As part of IFRS 9 implementation existing IT IT/ major systems slight systems need to be adjusted and new IT impact impact components have to be introduced.

Source: EBA impact assessment IFRS 9 (11/2016); zeb assessment IFRS 9 Classification & Risk EMEA Conference 2017 20170510_IFRS 9 impact - 3 complete Measurement Impairment For IRBA banks1 an average increase of ~20% in loss provisions due to IFRS 9 requirements has noticeable negative impact on available capital2

1 I IRBA Bank example m IFRS 9 impact 1p The increase in IFRS risk provisions is followed by an equity adjustment… a — Reduction of Common

inc € m Old approach (IAS 39) New IFRS 9 approach Equity Tier 1 (CET 1) t capital due to IFRS 9 +20% assumed to be less than 8.000 <10% by most zeb IFRS o IAS 39 clients f 500.000 1.600 IFRS 9 — However, negative 492.000 I 490.400 macroeconomic F developments in R Gross loans Impairment Gross loans Increase in Gross loans combination with other S less impairment impairment less impairment regulatory changes (e.g. Basel IV) may further 29 … which reduces the Common Equity Tier 1 (CET 1) ratio. endanger CET 1 ratios

2,8% CET 1 o 14,0 % — zeb recommendation: reduction new: n 13,6 % Increase overall scenario

1.600 700 simulation capability b Adjustment based based on IFRS 9 figures to 32.000 a on estimated 31.100 derive relevant mgmt. l IRB expected loss impulses early in advance shortfall a (also in preparation of CET 1 - IFRS 9 n CET 1 - IAS 39 future EBA stress testing) 1 IRBA=c Internal Ratings Based Approach, risk measurement approach acc. to Basel guidelines based on bank‘s own 2 Average estimated loss provision increase based on zeb IFRS 9 survey internal estimates Risk EMEAe Conference 2017 20170510_IFRS 9 impact - 4

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c a p i t a l IFRS 9 negatively affects change-the-bank (CTB) costs and run-the-bank (RTB) costs

2 Cost impact

Estimation of CTB and RTB cost zeb key observations

— Change-the-bank cost − IFRS 9 implementation budgets in

40% 2016 & 2017 among the highest 30% project budgets in nearly every bank − Still budget overruns in many cases 14% 16% due to project inefficiencies: Need for

< €5m €5m < €25m €25m < €100m > €100m strong, result-focused program Expected IFRS 9 implementation budget management; tight budget controls; > €600bn €200bn < etc. €600bn • Run-the-bank cost − Expected to be significant due to < €200bn current focus on compliance while efficiency often only treated with 63% secondary priority Sample of financial institution 37% categorized by total assets − Still many follow-up efforts anticipated due to replacements of short-term workarounds and < €1m €1m < €5m resolving of auditor findings Expected 1-year post-implementation cost

Source: zeb IFRS 9 client survey

Risk EMEA Conference 2017 20170510_IFRS 9 impact - 5 Risk professionals’ advice on IFRS 9-based risk modelling will remain crucial to prevent unwanted effects on IFRS financial statements

3 IFRS 9 Impact on risk management organisation

— Internal advisor for the organisation with regards to IFRS 9-based risk modelling (e.g. expected credit “Advise“ losses): Support New product design – reduce potential negative FS impact; advise accounting dept., etc.

— Assessment of macroeconomic developments and consideration/integration into IFRS 9 ECL models “Define” — Definition and updating of stress scenarios for simulations and for impairment calculation — Analysis of credit and market risk results at each IFRS reporting date and derivation of recommendations “Analyse” — E.g. assessment of credit risk parameter effects with Risk managers‘ role regards to IFRS 9 impairment (decompose ECL results) in IFRS 9

— Optimisation of calculation methods, parameter “Optimise” estimations, etc. in order to lower negative IFRS P&L and Balance Sheet impact

— Reconciliation of IFRS 9 ECL calculation results with expected loss figures from RWA reporting and from “Reconcile” internal capital adequacy assessment (ICAAP) at each reporting date Source: zeb Risk EMEA Conference 2017 20170510_IFRS 9 impact - 6 IFRS 9 strongly affects other bank management areas, such as regulatory capital, pricing, ALM as well as internal reporting

3 Further bank management dependencies

Bank management areas (selection) IFRS 9 impact & zeb key observations (selection)

Interest margin 5 5 5 5 5

Risk premium 20 20 20 20 20

perspective Revenues 25 25 25 25 25

Standard risk -20 -20 -20 -20 -20 costs (EL, 12M) Controlling Market result 5 5 5 5 5 — Valuation changes of financial assets – volatile fair values or ECL (Stage 1/2) -20 -20 -20 -20 0

ECL (Stage 3) 0 0 0 0 -100 Loss provision expected credit losses have to be considered and managed as part 0 20 20 20 20 amount perspective Loss provisions -20 0 0 0 -80 of asset liability management Risk result 0 20 20 20 -60

Accounting Accounting P&L results 5 25 25 25 -55 Pricing / ALM / Pricing Equity 5 30 55 80 25

Period 1 2 3 4 5

1 The increase in IFRS-provision is followed by … 2 …equity adjustments …

in m EUR Loans outstanding: Gross and net amounts ECL approach

+20% 8.372

466.208 1.674 1.674

457.836 41.280 456.162 39.606 — IFRS 9 linked effects work directly on steering KPIs – direct Gross loans and Total impairments Net loans Expected Credit Loans Equity Equity advances to customers Losses2) (IFRS 9) (IAS 39) (IFRS 9) 3 … and the impact on the core capital quota (CET 1)2). impact especially on overall profitability ratios and on capital ratios Additional impacts on the 13,5 % risk-bearing capacity and new: leverage ratio to be 12,7 % estimated 1.674 ECL 213.092

KPI impact KPI RWA

28.754 27.080

CET1 (IAS 39) CET 1 (IFRS 9)

Segment Retail Treasury Trading Σ periodic PV-based periodic PV-based periodic PV-based 1 External loan +7,0 -3,75 3,25 2 Internal refinancing -5,5 3,89 5,5 -3,89 0 3 External refinancing -5,0 0 -5,0 4 Internal interest swap -0,2 3,64 0,2 -3,64 0 5 External interest swap 0,5 3,03 3,53 — Adaptation of internal segment reporting in order to fully reconcile PV-based result 1,64 0,05 0,09 1,78 Interest result 7,0 0 -5,0 0 0,5 0 2,5 Trading result 0 0 0 0 0 0 0 with IFRS 9 induced adjustments à Adjustments to internal vs.

Hedge result 0 -3,75 0 0 0 3,03 -0,72 0 ≈ Diff. External Σ IFRS result – external 3,25 -5,0 3,53 1,78 external -5,5 3,89 5,5-0,2 3,64-3,89 0,2 -3,64 0 external reporting reconciliation procedures Interest result 0 0 0 0 0 0 0 Internal vs. Internal Trading result

Internal Σ IFRS result – internal -1,61 5,05 -3,44 0 IFRS result incl. HA 1,64 0,05 0,09 1,78 reporting recon. reporting

Source: zeb Risk EMEA Conference 2017 20170510_IFRS 9 impact - 7 IFRS 9 also means a significant challenge to the existing financial architecture in terms of performance, capacity and flexibility

4 IT Architecture

Finance & Accounting architecture requirements1 IFRS 9 impact — IFRS 9 in general requires adjustments to various parts of a bank’s finance & risk IT architecture

— Complex calculation algorithms for IFRS 9 on high- granularity level result in potential performance challenges

— IFRS 9 data also to be timely made available to regulatory reporting and to internal mgmt. reporting - Hence, significant decrease of remaining time buffers for late adjustments and corrections

— Simultaneously, high data quality to be ensured 1 Source: zeb best practice assessment of integrated finance & risk architectures (IFRA)

Risk EMEA Conference 2017 20170510_IFRS 9 impact - 8 For lowering overall IFRS 9 impact on financial figures proactive P&L management and cost reduction efforts are top priority to the CFO

Fields of action

Fields of action / solution approaches

1 • Optimisation of the CET 1 impact via impairment model calibrations (stage criteria, parameter) Equity • Reduction of the higher regulatory capital volatility Require- ments • Adjustment on CET 1 forecast and planning • Adjustment for transparent forecast and planning processes

2 • Result-focused program management -> reduce change-the-bank (CTB) costs Cost Impact • Change of production processes -> significant cost for compliance

• Run-the-bank cost reduction program for efficient bank management processes

• Early consideration of additional capacity demand for risk professionals with regards to IFRS 3 9

Bank • Provide integrated bank planning function (e.g. with regards to future impact on interest result Management in the light of low-interest environment) • Implement IFRS 9-ready simulation function (hot topic for EBA stress test 2018!)

• Timely integration of IFRS 9 figures into internal management reporting 4 • Design and implement IFRS 9-ready integrated Finance & Risk architecture IT • Ensure fast processing of complex, granular data and high-availability Architecture • Implement high-performing data quality management procedures

Risk EMEA Conference 2017 20170510_IFRS 9 impact - 9 Our project experiences with IFRS 9 show following main Lessons Learned

Lessons Learned

Banks have underestimated the complexity of IFRS 9 and its dependencies - high pressure of time leads to softening Scope and Quality

Projects were often started as simple Accounting and/or Regulatory Project – need for integrated project work was in many cases recognized late

Introduction costs are underestimated and most banks have not yet dealt with rising run-the-bank costs

Constant need for risk experts in terms of IFRS 9, especially with regards to impairment – additional capacity demand also for run-the-bank condition

Need to bring the bank management disciplines together will upgrade the CFO & CRO area as the Gatekeeper for bank management information

There is no doubt that there is still a lot of project work to do after 01.01.2018 – banks have to work on “day two readiness” - insurance companies will follow

Source: zeb

Risk EMEA Conference 2017 20170510_IFRS 9 impact - 10 Lars Meyer For individual discussions visit us at our Senior Manager booth and take one of the IFRS 9 posters!

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