Interest Accrual on a Restructured Term Loan
A bank holds a USD 12 million five-year bullet term loan to a logistics company, priced at 9% fixed, with USD 1.1 million of accrued interest outstanding. The borrower missed the last two quarterly interest payments and admits its refinancing is uncertain. The bank proposes an 18-month principal moratorium, a tenor extension to seven years and a rate cut to 7%. Management's memo says: "The client is cooperating, so keep accruing contractual interest at 9% and leave the loan in Stage 1 with a 1% general provision; the property collateral is worth USD 9 million." Cash-flow projections show DSCR of 1.05x under the new terms. The bank reports under IFRS 9.
1. Is the restructuring a substantial modification leading to derecognition? Set out the analysis.
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Assess both qualitatively and quantitatively.
Qualitative: the change is driven by the borrower's financial difficulty, not a commercial renegotiation. That makes it forbearance and a strong indicator of increased credit risk, irrespective of the size of the cash-flow change.
Quantitative: discount the revised contractual cash flows at the original effective interest rate (9%) and compare with the present value of the original cash flows. The rate cut of 200bp plus an 18-month moratorium plus a two-year extension will typically produce a present-value change in the mid-single digits. If the change is not substantial, the loan is not derecognised; the gross carrying amount is adjusted to the new present value and a modification loss is recognised in profit or loss, with a new effective interest rate calculated.
Note a common error: the 10% cash-flow test is a bright-line rule for financial liabilities under IFRS 9. For financial assets there is no prescribed 10% threshold; the assessment is qualitative plus quantitative. Applying "under 10%, so ignore it" would be wrong reasoning even if the conclusion happens to be similar.
2. Should the bank continue accruing contractual interest at 9%? What is the correct treatment?
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No. Continuing to accrue 9% contractual interest on a loan that is not performing overstates income, capital and the loan's carrying value.
Reasoning:
- Two missed quarterly payments put the exposure around 180 days past due - beyond the typical 90-day default definition. The loan is credit-impaired, i.e. Stage 3.
- For Stage 3 assets that are not purchased or originated credit-impaired, interest revenue is calculated on the net carrying amount (gross amortised cost less loss allowance) using the effective interest rate. It is not the contractual coupon on the gross balance.
- Many banks also place interest on non-performing exposures into interest suspense rather than crediting income, releasing it only on cash receipt.
The management memo's position (keep accruing 9%, Stage 1, 1% provision) is not defensible and would be an audit and regulatory finding. The correct entries are: stop recognising contractual coupon income on the gross balance, recognise interest on the net carrying amount (or suspense it per policy), and restate the staging.
3. What ECL staging and measurement should apply, and what does the collateral do to the numbers?
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Staging: at minimum Stage 2 (significant increase in credit risk), and in substance Stage 3 given the missed payments and refinancing uncertainty. Stage 2 requires lifetime ECL; Stage 3 requires lifetime ECL with interest on the net balance.
Measurement:
- EAD ≈ USD 13.1 million (principal plus accrued interest), adjusted for the restructuring.
- PD is high - default has effectively occurred.
- LGD is driven by collateral: USD 9 million property, less forced-sale haircut and costs and discounting for time to recovery. A realistic recoverable value may be well below USD 9 million.
- Illustratively, if recoverable collateral net of costs and discounting is USD 7.5 million, LGD ≈ 1 − 7.5/13.1 ≈ 43%, and the lifetime loss allowance is roughly EAD × LGD.
The 1% general provision is far too low. The gap between the required allowance and the 1% general provision is the adjustment needed. Also test the DSCR of 1.05x: it leaves almost no headroom, so a small EBITDA miss triggers default under the revised terms, which should feed into the PD assumption.