How to estimate expected credit losses – ECL – for provisioning under IFRS 9

Purpose - This paper provides an objective approach based on available market information capable of reducing subjectivity, inherently present in the process of expected loss provisioning under the IFRS 9. Design/methodology/approach - This paper develops the two-step methodology. Calibrating the Credit Default Swap (CDS)-implied default probabilities to the through-the-cycle default frequencies provides average weights of default component in the spread for each forward term. Then, the impairment provisions are calculated for a sample of investment grade and high yield obligors by distilling their pure default-risk term-structures from the respective term-structures of spreads. This research demonstrates how to estimate credit impairment allowances compliant with IFRS 9 framework. Findings - This study finds that for both investment grade and high yield exposures, the weights of default component in the credit spreads always remain inferior to 33%. The research's outcomes contrast with several previous results stating that the default risk premium accounts at least for 40% of CDS spreads. The proposed methodology is applied to calculate IFRS 9 compliant provisions for a sample of investment grade and high yield obligors. Research limitations/implications - Many issuers are not covered by individual Bloomberg valuation curves. However, the way to overcome this limitation is proposed. Practical implications - The proposed approach offers a clue for a better alignment of accounting practices, financial regulation and credit risk management, using expected loss metrics across diverse silos inside organizations. It encourages adopting the proposed methodology, illustrating its application to a set of bond exposures. Originality/value - No previous research addresses impairment provisioning employing Bloomberg valuation curves. The study fills this gap.