The Hidden Cost of Compliance: How IFRS 9 is Reshaping East African Credit Risk (and SME Access)

In the dynamic world of global finance, accounting standards serve as crucial guideposts, promoting transparency and stability. One such standard, International Financial Reporting Standard 9 (IFRS 9), ushered in a paradigm shift for how financial institutions recognize and measure financial instruments. While universally lauded for its forward-looking approach to credit risk, its implementation in East Africa has unearthed a hidden cost: a tightening of credit for the region’s vital Small and Medium Enterprises (SMEs).

The Shift: From Incurred to Expected Losses

Before delving into the East African context, it’s essential to understand the core change introduced by IFRS 9. Its predecessor, IAS 39, operated on an “incurred loss” model, meaning banks only provisioned for loan losses once objective evidence of impairment existed. This “too little, too late” approach was criticized for exacerbating financial crises, as losses were often recognized long after the underlying problems emerged.

IFRS 9, conversely, mandates an “expected credit loss” (ECL) model. This requires banks to provision for losses from the moment a loan is originated, based on forward-looking information and probabilities of default over the loan’s lifetime. The goal is to ensure that banks hold sufficient capital to absorb potential losses, thereby strengthening financial stability and preventing future systemic shocks.

The Good: Enhanced Prudence and Transparency

For East African banking sectors, often characterized by rapid growth, evolving regulatory environments, and sometimes higher Non-Performing Loan (NPL) ratios, the promise of IFRS 9 was clear:

• Improved Risk Management: Banks are forced to adopt more sophisticated risk assessment frameworks, integrating macroeconomic forecasts and scenario analysis into their lending decisions.
• Enhanced Financial Stability: Earlier provisioning means banks are better capitalized to withstand economic downturns, reducing the risk of sudden shocks to the financial system.
• Greater Transparency: Financial statements now provide a clearer, more realistic picture of a bank’s true financial health and potential future liabilities.

These benefits are undeniably crucial for fostering robust and resilient financial markets in the region.

The Hidden Cost: A Credit Squeeze for SMEs

However, the pursuit of global best practices has a complex interplay with local economic realities. For East Africa, where SMEs represent the backbone of economies – accounting for a significant percentage of GDP, employment, and innovation – IFRS 9 presents a significant challenge.

Here’s why:

1. Perceived Higher Risk of SMEs: From a bank’s perspective, SMEs often exhibit characteristics that lead to higher assessed credit risk. They may have shorter operating histories, less robust financial reporting, less diversified revenue streams, and are more susceptible to economic volatility.
2. Immediate Higher Provisions: Under the ECL model, loans to perceived higher-risk entities require larger provisions from day one. This means a bank lending to an SME immediately incurs a higher “cost” on its balance sheet compared to lending to a large, stable corporation or government entity.
3. Data Deficiencies: Accurately calculating ECL for SMEs requires granular historical data on default rates, recovery rates, and macroeconomic sensitivities. Many East African banks, particularly smaller ones, lack the sophisticated data infrastructure and analytical capabilities to generate these precise models for their diverse SME portfolios. This often leads to more conservative, and thus higher, default assumptions.
4. Impact on Lending Behavior: Facing higher capital charges and provisioning costs for SME loans, banks are logically adjusting their strategies. This often translates into:
   • Higher Interest Rates: To offset increased provisioning, banks may raise interest rates for SME borrowers, making credit more expensive and less accessible.
   • Tighter Lending Criteria: Banks become more selective, demanding more collateral, stricter repayment terms, or simply rejecting applications that previously might have been approved.
   • Shift to “Safer” Assets: Some banks may opt to redirect their lending focus towards large corporates, established businesses, or even government securities, which carry lower perceived risk and thus lower IFRS 9 provisions.

The ultimate consequence is a potential credit crunch for SMEs, limiting their ability to invest, expand, and create jobs. This not only stifles economic growth but also hinders poverty reduction efforts and entrenches income inequality in a region where these businesses are critical for economic upliftment.

Navigating the Paradox: Finding the Equilibrium

Addressing this hidden cost requires a multi-pronged approach involving regulators, banks, and policymakers:

1. Regulatory Flexibility and Guidance: East African central banks and financial regulators play a crucial role. They can provide clearer, localized guidance on IFRS 9 implementation, potentially allowing for proportional application, staggered timelines, or specific frameworks that recognize the unique challenges of SME lending in the region.
2. Investment in Data and Analytics: Banks must proactively invest in improving their data collection, management, and analytical capabilities. Better data on SME performance will lead to more accurate ECL calculations, potentially revealing that some SME segments are less risky than generic models suggest.
3. Developing Local Expertise: The demand for quantitative analysts, data scientists, and risk modelers is immense. Investing in local talent development through partnerships with universities and training programs is crucial to reduce reliance on expensive external consultants.
4. Innovative Lending Models: Explore alternative lending models that de-risk SME financing. This could include partnerships with fintechs for alternative data scoring, guarantee schemes (government or donor-backed), or supply chain finance solutions.
5. Policy Dialogue: Open dialogue between financial sector regulators, government ministries, and SME associations can help identify bottlenecks and devise targeted interventions to ensure that IFRS 9 compliance does not inadvertently undermine the very economic growth it aims to protect.

Conclusion

IFRS 9 is undoubtedly a progressive standard designed to foster greater financial stability. However, its implementation in East Africa underscores a critical lesson: global accounting standards, while universal in principle, must be applied with an acute awareness of local economic context. The hidden cost of compliance, manifested as reduced access to credit for SMEs, poses a significant threat to East Africa’s developmental trajectory. By fostering collaboration, investing in localized solutions, and promoting intelligent regulatory approaches, the region can harness the benefits of IFRS 9 while continuing to fuel the growth engine that is its vibrant SME sector.