At this moment in time, we face great uncertainty.
The COVID-19 pandemic does not appear to be abating, with hospital admissions in the UK rising steeply. Several prominent leaders have either had or are recovering from COVID-19. Many government support schemes are coming to an end. The economic outlook, both in the UK and globally, is extremely uncertain.
Dealing with this uncertainty represents the first major test for the additional judgements and modelling introduced by IFRS 9 Financial Instruments.
In response to the economic impact of COVID 19, the largest banks in the UK have significantly increased their allowances for Expected Credit Losses (ECLs). The interim results, as at 30 June 2020, for the four largest UK banks, show that their aggregated allowance for ECLs has increased by approximately 63% since 31 December 2019.
Key macroeconomic variables are expected to worsen in the second half of the year, for example, the Office for Budget Responsibility’s central scenario shows unemployment peaking in Q4 2020 at a rate of 11.9% and house prices declining through to Q1 2021.
However, despite this, it is possible the banks’ allowances for ECLs may start to unwind in the second half of 2020.
Below are three of the key factors that may impact how ECLs unwind over time.
Forward-looking scenarios
IFRS 9 requires that ECLs are calculated each period end considering all reasonable and supportable information available at that date without undue cost and effort.
However, Banks must apply considerable judgement: firstly, to determine what constitutes reasonable and supportable forward-looking information and, secondly, to assess what the forward-looking information is relevant to the group of financial instruments being considered. These judgements are particularly challenging at this time of great uncertainty.
This has led to an increased divergence in approach, particularly in terms of the number of scenarios used, weights allocated to these scenarios, and the assumptions made about key economic variables in these scenarios.
The economic scenarios disclosed by the largest UK banks, as at 30 June 2020, show the negative economic impact of COVID-19 peaking in Q4 2020 or early in 2021. After this negative impact peaks, the models forecast the key macroeconomic variables (unemployment rate, house price growth etc.) to revert toward long-run averages in the medium term. These assumptions around when a gradual recovery will commence are key to how these ECLs will unwind over time.
To address COVID-19 related uncertainty many banks have allocated less weight to the central scenario and / or have introduced additional COVID-19 specific scenarios.
The use of these scenarios will evolve over the second half of the year and investors will be interested to see how the scenarios used and weightings applied differ at 31 December 2020.
Staging
Assessing the staging of loans has always been judgemental under IFRS 9. However, the level judgement required has increased in the current circumstances; particularly in respect of customers who have been given COVID related payment deferrals. The PRA provided guidance at the beginning of June as the first wave of payment deferrals came to an end, stating that “Further payment deferrals do not automatically mean a SICR or credit impairment; nor should the assumption be that all the loans involved remain in stage 1”.
This left banks to consider other information and apply judgement to make staging assessments for such borrowers as at 30 June 2020.
As COVID-19 payment holidays come to an end and are potentially replaced with tailored forbearance arrangements, the PRA has updated its guidance to state that “such tailored forbearance arrangements are likely to be as good an indicator of SICR, credit impairments or defaults as forbearance was prior to the pandemic.”
This could potentially lead to a glut of transfers to stage 2 and an increase in ECL allowances at 31 December 2020.
Post model adjustments
Banks’ ECL models may struggle to capture the unusual economic circumstances thrown up by COVID-19. Thus, many banks have had to make greater use of judgmental post model adjustments to attempt to capture aspects (such as additional adverse economic outcomes caused by COVID-19 and the impact of government support), which were not adequately reflected in the underlying models.
It is unclear whether these significant post model adjustments will reverse in the second half of 2020.
Conclusion
The key judgements about economic scenarios, SICR application and the use of post model adjustments will play an important role in determining how ECLs unwind over time.
Whatever the outcome, it will be important that banks provide clear disclosures of judgements and estimates, so that investors can understand what has driven the key movements in allowances for ECLs.
Investors will be interested in disclosures on coverage ratios and loss rates, but it is also likely that there will be more focus on the disclosures that help explain the level of estimation uncertainty, including sensitivity analysis, the scenario weightings, the assumptions on mean reversion and explanation of material post model adjustments.