Barbara Wasmus (Wasmus Consulting) on how IFRS9 is affecting MFIs' balance sheets

Based in Amsterdam Barbara Wasmus, is a senior MSME banker with over 15 years of experience. She is a Certified Expert in Risk Management and has a strong affinity with the design and implementation of operational and internal control systems in the context of greenfields, turnarounds, and major technological innovations in banks/MFIs. Barbara held senior executive positions in financial institutions (founding-CEO of ProCredit Bank Angola, deputy-CEO of ProCredit Bank Kosovo) and implemented various short-term consultancy assignments. Barbara also gained significant experience in investing in development as former senior investment officer at Triple Jump. Aside from her consulting work, Barbara holds non-executive directorships in inclusive finance institutions and she serves as an investment committee member of US-based Developing World Markets. Currently she is a partner in Wasmus Consulting (https://www.wasmus-consulting.com/). She received an MA in International Relations from the University of Groningen.

In this episode Barbara, provides fascinating insights into why implementation of IFRS9, and in particular over-reliance on Expected Credit Loss (ECL) models, could be dangerous.  

This podcast is brought to you by Financial Due Diligence Associates, a multilingual consulting partnership founded by Guy Rodwell and Zinaida Vasilenko, specialised in holistic, relevant and concise analysis of financially inclusive companies. 

FDDA also helps impactful asset managers access French institutions through an alliance with Oxondo, a leading Paris-based third party marketer. 

You can reach FDDA by contacting Guy Rodwell or Zinaida Vasilenko on LinkedIn, or by emailing us at info@fdda-consulting.com. 

Transcript

Guy: 

It gives me great pleasure to introduce Barbara Wasmus, a Dutch national, who has an incredible pedigree in microfinance. 

Barbara is a certified expert in risk management and has a strong affinity with the design and implementation of operational internal control systems, in the context of greenfields, turnarounds and major technological innovations in banks. 

She has held senior executive positions in financial institutions, including being CEO of Pro Credit Bank Angola, Deputy CEO of Pro Credit Bank Kosovo, and she's implemented various short term consultancy assignments.

She's also gained significant experience investing in development as a former Senior investment officer at Triple Jump. 

Aside from her consulting work, Barbara has held various non-executive director roles with MFIs and she serves as an investment committee member of Developing World Markets based in Stamford, CT in the USA. 

Barbara holds an MBA in international relations from the University of Groningen in the Netherlands

I've known Barbara for about three years, and I have to say she is the person in the meeting who will see things from an angle that others don't, and we'll ask questions about the one point that other people are missing, so it makes me very happy indeed to have her on the show. 

Barbara, welcome.

Barbara:

Thank you so much Guy

Guy:

So, Barbara, perhaps you can start by giving a short intro into your background how you came to work in microfinance, talk a little bit about your experiences working for Pro Credit and Triple Jump, and also as a non-executive director and then finally what you do today you have Wasmus Consulting, which I believe you operate with your husband, and perhaps you can talk a little bit about that. 

Barbara:

Sure, pleasure. I think it all started with an enormous fascination for entrepreneurship. I grew up in an entrepreneurial family. My parents were store owners in the centre of Amsterdam. So, I grew up with a notion that being your own boss was a credible and honourable way to earn a living.

I'm also a child of the 70s and 80s. I was a teenager when the Berlin Wall came down. And I was absolutely mesmerized by this vast part of the world that suddenly became more accessible, after it had been closed off entirely.

I was always fascinated by the idea that until that moment, private entrepreneurship had simply not been an option in that part of the world, and then suddenly people were confronted with the opportunity to start your own business or become a shareholder in a privatized company.

I literally went to Russia after the Berlin Wall came down to visit kolkhozy and sovkhoz, Soviet state-owned farms, where people had been labourers all their lives, and suddenly these huge agricultural enterprises were privatized, and people were given a small piece of land and they had to start their own farm. So, what was it like to move from being a labourer all your life to being your own boss? Take all the risk and earn the returns. So I literally went there to ask people such questions. Pretty annoying I have to say, in retrospect!

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So, I went to the University of Groningen to study international relations and I met this professor in transition economics, who turned out to be a great teacher and who provided my youthful enthusiasm with the necessary academic and intellectual framework, and allowed me to do a Master’s thesis on entrepreneurship in post-Soviet Russia and look at the factors that influenced whether people chose or did not choose to become private entrepreneurs. Great teachers matter.

After a brief episode at EBRD and also a stint of university teaching and international relations, I went on to work for IPC and the Pro Credit Network. 

I first joined the team in Kosovo who had just founded the first bank there in post-war Kosovo. Only two weeks before I arrived, the bank had opened. I started there as a trainee and over the years I gradually climbed the ranks to deputy general manager.

It was an enormous “school” for me. Everything was experienced there. I guess for the first time at the scale that it happened there because we were the only bank at that time in post war Kosovo, for, I think at least 2 1/2 years and that is a totally different role from many of the traditional microfinance banks that we see out there.

Subsequently, I moved to Africa and founded the first microfinance bank in Angola, immediately after the end of the Civil War. I stayed there, managed the bank during the first years of operations and following some further wanderings in Africa, we finally returned to the Netherlands.

Not really knowing what to do with myself, I thankfully got the opportunity to work as an investment officer at Triple Jump and also started to get to know the impact investing perspective on our business, aside from the practical field experience I had gained until that moment.

In 2013, my husband and I started our own consultancy firm Wasmus Consulting. We advise financial institutions, banks, as well as their funders and donors on various issues, varying from very hands-on assistance with start-ups, any practical issue with credit operations or loan officer training, digitization, risk management or more strategic issues like business planning, governance. We also advise funders. 

We've done market studies, feasibility studies, establishment of risk management frameworks, governance advice.

The common denominator is that we are both very pragmatic and hands on and fuelled by on-the-ground real life experience that we also try to keep alive by things like being on boards of banks still, and to maintain that real life feeling what's happening out there.

Guy:

We could talk for hours just about your career, which is incredibly interesting. But we have to move on, so thank you very much for that. What we're going to do today is talk about our structural topic straight away, which is IFRS9 and its impact on microfinance institutions.

It may seem somewhat odd to devote the podcast segment to an accounting standard but this is a very important subject for funding practitioners in microfinance.

I'm going to hazard a definition of IFRS 9 without getting too technical or going into the weeds, and please correct me if I've missed anything. 

So, my understanding is that it's an accounting standard that was introduced by the International Financial Reporting Standards Foundation or IFRS and was effective from 1 January 2018.

Among other things, it specifies how you should classify and measure financial assets, financial liabilities, and some contracts to buy or sell non-financial items.

And it's especially relevant to microfinance in the area of asset impairment.

Before, MFIs used to provide against credit losses, using formulas to apply a percentage provision, based on the number of days a loan was already delinquent, i.e., once losses have been incurred. And for instance, depending on the country, you would apply a provision of 4% of loans that were 31 to 60 days past due or 11% of past due loans of greater than 90 days etc.

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Now, however, by contrast, you have to use an expected credit loss model, or ECL, and this basically forces MFIs to estimate expected losses over the life of a loan.

Whereas the previous standard allowed them to rely simply on already incurred losses, now it's more of a forward-looking approach than its predecessor, and will result in a timelier recognition of credit losses.

So first of all, Barbara, do I have that right, and second, it's already 4 years old, roughly, so why should we be worrying about it in the context of microfinance?

Barbara: 

Yeah, and why on Earth do we want to go into such a potentially boring subject at all, right?

Guy:

Yeah, true, you said it!

Barbara:

So, before I go into it, let me just say I’d really like to stress I'm not an accounting expert, I'm really speaking solely as a practitioner who has, like many others, being confronted by what appears to be a rather complex accounting measure and which affects our day-to-day business to an extent that it sometimes concerns me. But you've given a great overview of what the measure entails and you asked a great question. So, I think we first need to take a slightly closer look to what loan loss provisioning really aims to do. Now let's get the boring stuff out of the way.

As you rightly pointed out, loan loss provisioning is of course merely an accounting exercise that aims to distribute the cost of credit losses over time. The key aim of that being to reduce volatility in losses, thereby reducing volatility in your P&L and ultimately your capital position and solvency.

So, what it then does is it creates a buffer for absorbing loan losses. It's very simple, straightforward, just like that.

Importantly, and that's what all the critics will always come back on, is that loan loss provisioning in itself does not reduce credit risk. And that's of course true.

It only affects how and when the costs of materialized credit losses are recognized.

Still, you need to make good loans in order to prevent losses. Let's be very clear on that.

While defining your loan loss provisions, we need to anticipate credit risk and that includes all sorts of assumptions about matters that are as yet probably unknown because they simply lie in the future, like macroeconomic developments, political instability, climate events, government interventions that may affect our clients, businesses, or households, or disease or death of our clients, potential legal matters that may affect our recovery rates in the future, and so on.

So, this is pure fact, that it includes the need for anticipation, that, by definition, contains an element of subjectivity. This anticipation is subjective anyway.

I think what we what we've always seen is that some bank managers may overstate the value of their loan portfolio, which may not be performing as everybody hopes, or they may in fact understate by increasing loan loss provision expenses if it helps in reducing their tax bill.

So, it's traditionally always been a tool that's more or less used for manipulation. That did not change much with IFRS9. That was the same with the former standard which was IAS39 and same for local regulatory provisioning standards. Nothing new there.

And then as you explained along came IFRS9, which for MFIs led to important changes in loan loss provisioning mainly. As you said, it was introduced in 2018, and I think we've seen the impact mostly since 2019-2020 when it started appearing, the results started appearing in MFIs’ balance sheets.

So, actually, your first question, why now? I think by now we have a fair idea as to the mere fact that that there are consequences.

So essentially, as you explained, IAS required objective evidence of increased credit risk before you could pass a loss provision, so there had to be some sort of trigger event, like when a client missed the payment or you missed the payment by a certain number of days. 

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That's when banks could pass along loss provision.

IFRS 9 changed that in an important way, indeed, by taking more forward-looking approach by asking what will the credit risk likely be over the next 12 months and in some cases over the lifetime of a loan, based on our experience, what we know about our portfolio, our clients, what we expect to happen in the macroeconomic environment and so forth. 

So, whereas before the probability of default (PD) was perceived as more or less stable and based on your average historical performance, under IFRS 9 loan loss provisions are expected to be estimates of the future.

Now, the first problem is created by the fact, I think, that the way in which the model has been presented is perceived by many as very complex. 

So you're expected to come up with all sorts of statistical modelling in order to justify provisions, and audit companies have offered their services in building so-called IFRS9 models.

I think that most MFIs and microfinance banks are currently using some variant or other of such an audit firm build, or at least audit firm-advised model.

And they are effectively little machines whereby on a monthly basis, the MFI feeds its loan portfolio data into the machine. The machine turns the wheels, hisses, produces a lot of smoke and then spits out the desired loan loss provisions to be maintained and the related journal entries to be parsed. 

But what happens inside that machine I think in many instances remains vague and abstract and a total black box, even. 

We have a sort of vague notion what goes on inside, but if the outcome is unexpected or undesirable even, we don't know what to do about it and we have no tools available to improve that box and that, to me, is dangerous.

So, for example, if there is an indication of increased credit risk as a result of, for instance, a global pandemic, IFRS 9 (at least my understanding of it) requires that an increase be made in your Stage One loan loss provisions, but many simply don't know how to technically achieve that because the box doesn't tell you.

Guy:

Right, so the box isn't calibrated to take into account a kind of Black Swan event, a completely exogenous event which is out of all expectation; the box isn't able to integrate that.

Barbara:

No, boxes never will, because boxes just do what you tell them to do. 

In a way it reminds me of what I've often witnessed when it comes to banks, IT departments and core banking systems. So there the attitude is often: “Let's leave it to the IT guys. I don't really understand it. By asking questions, I may look stupid”, right?

So, we know what happens next.

Before you know it, your core banking systems, your network configs, everything becomes a total black box and your IT manager de facto runs your bank.

I've seen that happen so often.

And then I ask: if we all agree that automation and digitization are currently at the core of modern micro finance and banking, then I ask: why is the IT department hardly ever located on the executive floor, but rather somewhere in a derelict corner of the basement?

We have a tendency, I think, to not be very interested in things we don't really understand, or that we find tedious or complex.

I agree loss provisioning under IFRS 9 has become pretty tedious, and also a little complex.

But like with IT systems, I would argue no manager should accept that any machine play a part in its institution without knowing how it works, how it can be changed if it doesn't work to satisfaction.

And I think we all have a responsibility to know and understand and really engage, and, yes, to ask stupid questions.

Guy:

So in terms of the objective results of what's happened, that potentially the black boxes have not taken into account COVID and not having understood the level of delinquency that could potentially occur, in the companies that you have overseen or that you run into through your various activities, do you feel that there is potentially a significant under-provision which has resulted from that? 

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Is it an issue which might impact, systemically, MFIs in certain markets? 

Barbara:

I think that, especially now that COVID has emerged, the concern would be that provisioning based on past experiences, and the models, of course, that that were built for us by these audit firms were largely based on past experiences, and they simply may underestimate losses in this particular crisis.

What we should do is to consider increasing Stage One loan loss provisions or passing certain segments of our loan portfolio to Stage Two, probably on the basis of their increased credit risk.

But then the problem of the government-imposed moratoria and the aftermath of those is that from the cold facts it is now unclear how a non-payer today compares to a traditional non-payer. 

Traditionally we knew the conditional probability of default. So if a client is current today, what was historically the chance that he would actually move into portfolio at risk and ultimately be written off. That's what conditional probability of default essentially means. 

So now we don't know if non-payment is because of the moratorium, or if there may be a real problem.

In other words, the historic modelling and the modelling on historic data lose significance in the present crisis, and the only way to know is to speak to your customers and ensure that the relationship between the MFI and the clients in the field remains good or even improves, and to continue making a realistic conservative prognosis of what you actually expect to receive back, and to provision accordingly. 

So, what do I see happening now? 

In practice you see all sorts of problems with the model: 

·         Overestimation of loss given defaults; 

·         Banks overvaluing collateral that they've registered for the clients; or not taking into account the fact that the crisis may even impact proceeds from sale of collateral - historic recovery rates may be much more optimistic than they are today - ; 

·         Mistaken exposure defaults; 

·         All sorts of misleading assumptions related to the conditionality of portfolio quality with resulting undervalued probabilities of default; 

·         Scoring models built on two small databases where you see inadequate backtesting. 

I've done some very superficial analysis of what happened between 2018 and now, with the risk coverage ratio, the loan loss provisions divided by PAR30 of fifteen of the major well-known MFIs that I think are in in most of the MIVs’ portfolios. Interestingly, in 2018, their risk coverage, on average, was 114% and in 2021 that had reduced to 66%, so [cut] by half.

So that essentially means that their equity is less well protected against unexpected credit losses.

Guy: 

That's incredible.

I was recently looking at an extremely well run extremely well managed and basically when they brought in IFRS 9 their provision coverage, basically did the same thing – it halved. 

What they've subsequently done is put in place, overlay provisions to build up the war chest because I think they've they probably realize that the model is, as you say, flawed, and it doesn't take into account these kinds of major risks, but that's fascinating.

Barbara:

Yeah, so I think I mean the example that you are giving now, I think they're doing an excellent job, but they are an exception because I mean we, we talked about how loan loss provisions are a nice tool for manipulation. 

Most won't even go there.

And the problem is, I think, if we accept that COVID and IFRS are used as an excuse. 

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So basically MFIs say OK, we have an increase in bad loans, that's due to COVID, and we have a decrease in risk coverage, well, that's due to IFRS9 - if we all accept that then how do we distinguish between MFIs going through a rough time but with their shop essentially well managed and in order, and MFIs who started to run to the bottom but nobody notices because they structurally overvalue their nonperforming loans – there are bad loans, but they just tell us that they are temporarily bad due to COVID.

So we should be careful that COVID and IFRS9 are not used as an excuse for maintaining a smoke screen that that keeps us from having clear sight on the underlying strength of the business, and I think the MFI that you just gave as an example is actually a great example for the world.

That's what banks should do if they want to be prudent. 

Guy:

Sure, they add overlay provisions basically because they say, well, the model is not really up to scratch.

So I mean when you take it to its full extent Barbara, with the figures you gave, in terms of halving coverage, what risks does that sort of leave these leave these MFIs open to in the future? 

Do you think we're going to see that losses will be bigger than they expected, and therefore they'll have to raise provisions, and then there will be an impact on capital? How concerned are you by that?

Barbara:

Well, very concerned because what it does is indeed that. So if your risk coverage is below 100%, and I think in in many cases we see it closer to 50% than 100%, it just means that your capital is exposed to sudden losses if and when they materialize.

And as we've said before, loan loss provisions do not improve your credit risk profile in the sense that you still have to make good loans to start with. 

But what it does is that it provides a buffer before your capital is hit unexpectedly further down the line, especially in circumstances where you see PAR increasing. That I think is a major concern and should be a concern to all of us.

Guy:

So what do you think can be done about it? What would you like to see done?

Do you think that regulators need to sort of tighten up on it?

There is a view that IFRS9 was brought in essentially to solve the last crisis, the Global Financial Crisis, and that the biggest impact is on developed world financial institutions where there were perceived to be problems in the run up to the GFC which were laid bare because they hadn't provided properly. 

And therefore it's not particularly relevant or adequate for MFIs to operate the same model.

So do you think that globally an exception should be made for MFIs, and should they potentially go back to what they were doing before?

Should models should be somehow improved or re-tweaked, or there should be some sort of global standard?

What would you prescribe if you were a regulator?

Barbara:

Yeah, I think you're right, the model was introduced as an answer probably to the 2008 financial crisis, and rightly so. Of course, then the problem was caused by lower house prices than expected with problems for repayment of mortgages - so essentially sub quality loans in assets and a liquidity crunch, which had not been foreseen. So banks were severely under provisioned. That's, I think, the basis of the crisis.

And a major reason for that under provisioning at the time was the inability under IAS39 the provisioning standard, to maintain general loan loss provisions against future losses of loans that are as yet performing. 

And then that was fuelled by relaxation of capital requirements by the regulators, which allowed investment banks to over leverage and so forth.

So what IFRS9 essentially does is to reintroduce that concept of general loan loss provisions, the ability to maintain provisions against a portion of the loan portfolio that is at this moment current and performing well. 

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However, the outcome of the fact that people think they need to comply with IFRS 9 through complex models, that they don't understand, and whose outcome is low risk coverage, essentially means that what we see now is the overvaluing of loan assets resulting in underprovisioning. 

It’s essentially the same thing, almost as what we see in in the time heading up to 2008, in that it artificially keeps capital levels up, so allowing banks to leverage and increase their assets further, until it becomes clear that part of the asset base is not worth with everybody thinks and losses start to appear.

So what begins with tight liquidity situations (clients don't repay) may easily spill over into capital crisis and ultimately insolvency if the underlying assets are not properly valued.

And loan loss provisioning is essentially the mechanism for helping to prevent this.

I think in a way IFRS9 has given us tools to improve from that period.

But the problem is that it's perceived as so complex, so either we say we don't accept that it's too complex for us to understand - we ask the stupid questions we need to ask, we don't accept models that we can't tweak to our needs and we don't accept black boxes. And, we may not be rocket scientists, microfinance bankers, but we understand the basic nitty gritty of effective interest rates and vintages and migration analysis of our loan portfolio. 

So I don't think there is a reason to be afraid of what goes on in the black box of the IFRS9 model.

However, if we can't get to that level, I'd even prefer to go back to the local regulatory provisioning standards which were easy to understand, but which often did include a general loan loss provision.

Rather, make it clear than so complex that you don't know what to do with it anymore and be clear on the risk coverage that you expect to have as: shareholders, Board, management and funders of microfinance institutions, be very specific on what you expect in terms of risk coverage ratios, because ultimately that's one of the lifesavers, I think when it really comes to it, in a crisis.

Guy:

So that's fascinating, Barbara.

I had a podcast with Daniel Rozas from the European Microfinance Platform, a fascinating discussion, and he presented in his “Weathering the Storm” report essentially a hierarchy of needs, for microfinance institutions, which starts basically with liquidity and then drills down into all the other aspects of the crisis, and quite surprisingly, I think, the capital was fairly well down the list.

But liquidity I mean would seem to be, when you're going to a crisis, the absolute most important thing -if you don't have the liquidity you don't survive.

What we've been talking about up until now is a sort of knock-on impact on capital.

Can you talk a little bit about about liquidity in the context of what we've just been discussing and the level of importance you attach to it.

Barbara:

I loved that session that you had with Daniel Rozas. Listeners are really recommended to listen to that episode.

His point was in a crisis, liquidity is key.

Everything else, including maintaining your capital adequacy should be subordinate to preserving liquidity.

I think we all agree.

In an acute crisis, liquidity is your blood and oxygen.

Without it, death is a certainty.

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However, my fear is that neglecting capital adequacy for a little too long (in fact this COVID crisis is dragging on now) we risk ending up with a large number of MFIs in deep structural crisis because they did not have their house in order even before COVID. 

But we allow COVID and IFRS9 to be used as an excuse, for the problems that we currently see.

And so ultimately, guarding against shock is a role of capital, of solvency, of capital adequacy.

We started this session by talking about how your experiences very early on in life shape how you perceive the world today.

But I was taught when I was young to always keep cash on you, in case you are in trouble and you need to take a taxi or make a phone call to ask for help, and to keep some money in the bank for when your laundry machine breaks down, so for unforeseen setbacks. 

So liquidity and capital ultimately matter for survival. 

Guy:

OK so basically in summary you completely agree with Daniel is just that you would put sort of emphasis on capital, because if you neglect capital too long then you then basically you're sunk.

Barbara:

Yeah, that's right, you can't survive without the two. I think it's liquidity and capital that you need ultimately to survive, and that's probably what every practitioner knows. But of course I mean when it comes to the day to day struggles that we're dealing with, it may be easier to postpone certain hassles for a while in order to focus on short term survival. It's ultimately foregoing your capital adequacy concerns, foregoing on prudent provisioning, it's just short term window dressing and it will end up in severe problems further down the line that may be unrepairable at that time.

Guy:

OK so a final question then Barbara. So we've discussed in detail your concerns about IFRS9. If you are an MFI, listening, what do you advise them to do about the way they present their provisions or their provisioning policy in light of IFRS 9 to make life easier for creditors and lenders to MFIs?

Barbara:

Yeah, I think two things.

First of all, make sure that you have people in your management team that understand IFRS9 provisioning methodologies and it's again I mean with all the other things we by now understand this is doable. I think it's not the magic that audit companies like to make us think.

Second, ultimately it all comes down to what you expect your actual loss is going to be, and I would argue that MFIs are in the ideal position to know their clients - that's what they traditionally do best.

And to really know what is happening out there, what their clients are struggling with and what is the most realistic future prognosis of cash flows, actual cash flows coming in, and to prudently and realistically maintain provisions against the part that you don't expect to come in anymore.

It's as simple as that.

Guy:

OK, great and I suppose by the same token, if you're running the slide rule, doing due diligences on MFIs, you should be tackling MFIs about the adequacy of their provisioning by normal common sense standards as opposed to relying on their black box.

Barbara:

Indeed, ensure in your diligence that you are satisfied with management’s knowledge of the real credit risk of their client base and their ability to project expected credit loss, and insist on adequate risk coverage don't be fooled by the argument “Yeah, it's IFRS9 and we can't control it and we can't change it. If coverage is too low, they need to pass an overlay provision perhaps, or at least consider it.

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And to my best knowledge (again, I'm not an expert, I'm just speaking from what I see out there), but I think IFRS9 does not say that's not allowed. 

Guy:

Well, Barbara, I never thought I'd say this following a discussion about an accounting standard, but I thought that was really interesting and I thought your insights were fascinating and really appreciate it.

Can you please let people know about the best way they can get in touch with you? If they want to work with you or they want to learn about what you do, how they can, how they can contact you? 

Barbara:

I think the easiest way would be through our website - https://wasmus-consulting.com/ , or through my LinkedIn page (https://www.linkedin.com/in/barbara-w-63991743/ ).

Guy:

OK Barbara, thank you very much for your time - really appreciate it.

Barbara:

Thank you so much, it was really great pleasure talking to you.