Calculating lifetime expected loss for IFRS 9: which formula is measuring what?

Abstract

PurposeThe 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/approachThis study provides exact formulas for lifetime expected credit loss derived analytically together with the mathematical proofs of each expression.FindingsThis 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 implicationsFor 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/valueWhile 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.