Company C is the holding company of a group that operates in a cyclical production
industry. Bank B provided a loan to Company C. At that time, the prospects for
the industry were positive, because of expectations of further increases in global
demand. However, input prices were volatile and given the point in the cycle,
a potential decrease in sales was anticipated.
In addition, in the past, Company C has focused on external growth, acquiring
majority stakes in other companies in related sectors. As a result, the group structure
is complex and has been subject to change, making it difficult for investors to analyse
the expected performance of the group and to forecast the cash that will be available
at the holding company level. Even though leverage is at a level that is considered
acceptable by Company C’s creditors at the time that Bank B originates the loan,
its creditors are concerned about Company C’s ability to refinance its debt because
of the short remaining life until the maturity of the current financing. There is also
concern about Company C’s ability to continue to service interest using the dividends
it receives from its operating subsidiaries.
At the time of the origination of the loan by Bank B, Company C’s leverage
was in line with that of other customers with similar credit risk and based on
projections over the expected life of the loan, the available capacity (i.e.,
headroom) on its coverage ratios before triggering a default event, was high.
Bank B applies its own internal rating methods to determine credit risk and
allocates a specific internal rating score to its loans. Bank B’s internal rating
categories are based on historical, current and forward-looking information
and reflect the credit risk for the tenor of the loans. On initial recognition, Bank B
determines that the loan is subject to considerable credit risk, has speculative
elements and that the uncertainties affecting Company C, including the group’s
uncertain prospects for cash generation, could lead to default. However, Bank B
does not consider the loan to be originated credit-impaired.
Subsequent to initial recognition, Company C has announced that three of its
five key subsidiaries had a significant reduction in sales volume because of
deteriorated market conditions, but sales volumes are expected to improve
in line with the anticipated cycle for the industry in the following months.
The sales of the other two subsidiaries were stable. Company C has also
announced a corporate restructure to streamline its operating subsidiaries.
This restructuring will increase the flexibility to refinance existing debt and
the ability of the operating subsidiaries to pay dividends to Company C.
Despite the expected continuing deterioration in market conditions, Bank B
determines, in accordance with paragraph 5.5.3 of IFRS 9, that there has not
been a significant increase in the credit risk on the loan to Company C since
initial recognition. This is demonstrated by factors that include:
(a)
Although current sale volumes have fallen, this was as anticipated by
Bank B at initial recognition. Furthermore, sales volumes are expected
to improve, in the following months.
(b) Given the increased flexibility to refinance the existing debt at the operating
subsidiary level and the increased availability of dividends to Company C,
Bank B views the corporate restructure as being credit enhancing. This is
despite some continued concern about the ability to refinance the existing
debt at the holding company level.
(c) Bank B’s credit risk department, which monitors Company C, has
determined that the latest developments are not significant enough
to justify a change in its internal credit risk rating.
As a consequence, Bank B does not recognise a loss allowance at an amount equal
to lifetime ECLs on the loan. However, it updates its measurement of the 12-month
ECLs for the increased risk of a default occurring in the next 12 months and for
current expectations of the credit losses that would arise
if a default were to occur.