Business model and expected credit losses under IFRS 9
In 20X5, Kestrel Bank holds a portfolio of $500m fixed-rate corporate loans. The business model is to hold the loans to collect contractual cash flows; the loans pay interest and principal only. However, Kestrel sells 5% of the portfolio each year to manage liquidity, and has sold loans with 10% of the portfolio's original principal over the last two years. The bank also holds $100m of convertible bonds that pay fixed coupons and are convertible into a fixed number of Kestrel shares; Kestrel intends to hold them to maturity. For the loan portfolio, 12-month expected credit losses for stage 1 loans are $6m; lifetime ECL for the $50m of loans with significant increase in credit risk is $15m; lifetime ECL for the $10m of credit-impaired loans is $40m. Kestrel asks how to classify the financial assets and measure the loss allowance.
1. Classify the corporate loans and the convertible bonds under IFRS 9, explaining the business model and SPPI tests.
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Corporate loans: The contractual cash flows are solely payments of principal and interest, so the SPPI test is met. The business model is not purely hold to collect. Kestrel sells 5% of the portfolio every year and has sold 10% of original principal over two years. Those sales are more than infrequent and more than insignificant; managing liquidity does not automatically make them consistent with hold to collect. The business model is therefore hold to collect and sell, and the loans are measured at FVOCI, with qualifying interest revenue in profit or loss and fair value movements in OCI.
Convertible bonds: The bonds pay fixed coupons but are convertible into a fixed number of Kestrel shares. The conversion feature exposes the holder to equity price changes, so the contractual cash flows are not solely payments of principal and interest. The SPPI test fails. The entire hybrid financial asset is classified at FVTPL; it cannot be measured at amortised cost despite the intention to hold to maturity.
2. Calculate the total loss allowance and explain how staging and interest revenue operate for the loan portfolio.
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Staging and loss allowance:
- Stage 1 (12-month ECL): loans not significantly deteriorated = $500m − $50m − $10m = $440m. ECL = $6m.
- Stage 2 (lifetime ECL): $50m with significant increase in credit risk. ECL = $15m.
- Stage 3 (lifetime ECL): $10m credit-impaired. ECL = $40m.
- Total loss allowance = $6m + $15m + $40m = $61m.
Because the loans are FVOCI, the allowance is recognised in OCI and does not reduce the carrying amount of the loans in the statement of financial position; it is presented as a deduction from the fair value in OCI. Interest revenue for stage 1 and stage 2 is calculated on the gross carrying amount. For stage 3, IFRS 9 requires interest revenue to be calculated on the amortised cost net of the loss allowance (the net carrying amount), not on the gross amount. The ECL is remeasured at each reporting date.