Under the Basic Indicator Approach used to compute own funds requirements for operational risk, how should the interest revenues from impaired loans be considered in the calculation of the Relevant Indicator (RI), namely, applying the effective interest rate on the gross carrying amount of the loans (before allowances/impairment) or on the recoverable amount, after deduction of impairment?
Under IAS 39, loans are measured after initial recognition at amortised cost using the effective interest rate (IAS 39.46). An individual loan or a group of homogenous loans is impaired and an impairment loss is recognised if there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition and that loss event has an impact on the estimated future cash flows of the loan or group of loans that can be reliably estimated (IAS 39.59). This impairment loss will be computed as the difference between the loan’s carrying amount and the present value of estimated future cash flows of the loan discounted at the original effective interest rate of the loan. The carrying amount of the loan shall be reduced to the recoverable amount either directly or through the use of an allowance account (IAS 39.63). Consequently, according to IAS 39, once for a loan or for a group of similar loans, an impairment loss has been recognised, the interest income to be recorded in the Profit and Loss will be computed using the same effective interest rate used to discount the future cash flows for the purpose of measuring the impairment loss (i.e. the original effective interest rate in this case), but applied to the recoverable amount (IAS 39 AG93),. The debtor must still pay the entire interest service, according to the contractual terms. This adjustment is made in order to present a fair and comparable view of the financial position of the credit institution as Art. 316 of CRR stipulates that, when calculating the own funds requirements for operational risk using the Basic Indicator Approach, in the calculation of the RI, institutions shall include among other elements, the interest receivable and similar income, without mentioning what will be the treatment in case of the interest income coming from impaired loans.
For institutions applying accounting standards established by Directive 86/635/EEC, Article 316(1) of the Regulation (EU) No 575/2013 (CRR) determines the basis for the calculation of the Relevant Indicator (RI). Article 316(2) specifies that when institutions apply different accounting standards the relevant indicator is determined on the basis of data that best reflect the definition set out in Article 316(1).
The specification in Article 316(1)(a) that the relevant indicator should be calculated ‘before the deduction of any provisions…’ should be understood to refer to credit risk adjustments as defined in Article 4(95) CRR.
It should be noted that: a) own fund requirements for operational risk address the risk of income loss due to operational risk events; and b) in general the amount of income related to certain activities that can be lost is the amount of income recognised in accounting terms.
Regarding the specific question on how impaired loans should be treated in the calculation of the relevant indicator (RI), it should be highlighted that these assets can generate the recognition of interest revenue and, as such, this income should still be considered in the calculation of the RI. Under IFRS 9 (replacing IAS 39), the amount of interest revenue to be recognised for impaired loans (classified in Stage 3) is calculated based on the amortised cost (i.e., the gross carrying amount adjusted for the loss allowance) or, in other words, on a net basis. In practice, this means that the amount of income that can be potentially lost is the amount of interest recognised on a net basis and, therefore, this net amount of interest should be the one considered in the calculation of the RI.
For Stage 1 and Stage 2 instruments, interest revenue is recognised on a gross basis (meaning, taking into account the gross carrying amount of the financial asset).
As a general rule, for the purposes of calculating the RI in the context of own funds requirements for operational risk under Article 316, the interest revenue amount should correspond to the amount recognised under the respective applicable accounting framework.
Pursuant to Article 315(1) CRR (last sentence) when audited figures are not available, institutions may use business estimates (see Q&A_2013_580).