The regulatory landscape continues to respond rapidly during the COVID-19 pandemic and the current focus is on how debt should be categorised and accounted for.
This is particularly important due to the implications for modelling, which can be tricky with market volatility and unpredictability.
Concerns over IFRS 9
IFRS 9 has been a subject of much debate in the last few weeks, with concerns that the expected credit loss models and immediate provisioning for the life of a loan will have a cyclical effect under stressed conditions. As such, several regulators have made statements to clarify how debt should be categorised and managed in the context of COVID-19.
Application of the prudential framework
The EBA has issued additional guidance to banks about the application of the prudential framework, specifically around debt classification and response. To avoid penalising customers unduly, it has clarified that debt moratoria should not automatically trigger classification under default or forborne status, or against IFRS 9. Effective risk management is extremely important, and banks should focus on individuals and their potential to repay debt in the longer term.
Banks should also focus on conduct and make sure customers are treated fairly, with no hidden charges or automatic downgrading of credit ratings.
ESMA has issued guidance over the application and interpretation of IFRS 9 during COVID-19, looking at the following areas:
Derecognition: Government and central bank intervention may substantially modify a financial asset, which would lead to derecognition. What counts as substantial is largely a judgement call and ESMA have stated that if debtor relief is temporary and the economic value of the asset is not significantly changed, then it should continue to be recognised. Issuers should clearly disclose their policies and judgements in their financial statements.
Where assets continue to be recognised, firms should consider:
Significant increase in credit risk (SICR): Issuers should look at the lifetime risk of default when assessing SICR and, under debt moratoria, it should not automatically be triggered by a payment default of more than 30 days. Qualitative and quantitative factors, including past data and financial intervention programmes, should be considered and similar instruments may require collective assessment.
Expected credit loss (ECL) models: Issuers should consider the entire life of the instrument and focus on the long term impact on its value. ECL will be difficult to model in the short term and ESMA does not expect a blanket approach to provisioning. When identifying ECL, issuers should factor in the effect of relief programmes and the maturity of their financial instruments.
Public guarantees on issued exposures: Partial or full guarantees against losses will not affect SICR assessments but they might impact ECL measurement, depending on the individual instrument. Specifically, if credit enhancements are an integral element in the contract and if they are recognised separately by the issuer. Impact on ECL will be a judgement call in some instances and financial statements should reflect this.
Transparency: Full and interim financial statements should clearly demonstrate the judgements regarding IFRS 9, including the policies and reasoning behind them. This should include disclosures around SCIR and ECL, and broader information on their financial standing for investors.
The PRA has issued a Dear CEO letter to help banks continue lending during the COVID-19 outbreak. In keeping with the statements from the EBA and ESMA, the PRA has provided guidance in three key areas:
IFRS 9 and defining default
It is important to calculate a realistic ECL, but it’s a difficult balancing act and with a risk of overstating expected losses, reducing banks’ willingness to lend. When calculating ECL, banks should consider the impact of government and central bank programmes, as well as long term economic trends. Support available for borrowers should also be taken into consideration, and using these options should not automatically trigger a default under CRR or escalation of ECL.
Treatment of borrowers breaching covenants
Banks should consider if the covenant has been breached due to borrower specific issues, or if it is directly related to the pandemic. If the latter, banks should consider waiving the covenant breach. Businesses who breach covenants due to updated audit statements for financial reports should not automatically trigger a default under CRR or escalation of ECL.
Regulatory capital under IFRS 9
The transitional arrangements for IFRS 9 allow firms to take up to 70% of new provisions and add them back to CET1 capital. The PRA encourages firms to make use of this option to reduce the impact of expected credit losses on capital.
Collectively, these publications highlight the importance of having a realistic understanding of expected losses, while taking into account the measures in place to reduce the long term impact. It is also important to maintain a focus on conduct and treating customers fairly throughout, by not automatically taking action in response to debt moratoria or intervention programmes.
What should firms be thinking about?
These issues have significant implications on modelling and firms should consider the following:
1 Reviewing the underlying assumptions and model parameters for ECL calculations, which may no longer hold true
2 Identifying models that may no longer be reliable. This could be because they’re based on historical data, which have not yet incorporated future economic shocks, eg the use of probability of default estimates in IFRS 9 models. It could also be due to models being unable to handle high volatility data.
3 Making sure monitoring considers overlays, post model adjustments, scenario analysis and stress testing. Applying macroeconomic overlays and associated probabilities will be challenging when the future is uncertain.
4 Availability of senior management to oversee and decide on appropriate modelling scenarios, as well as the availability of key staff and IT infrastructure to support scenario development.
5 Mitigating downside scenarios given the government, central bank and regulatory intervention.
6 Reconciling regulatory advice with current market movements, such as how and when market movements dictate scenarios.
But looking beyond modelling, there are other implications to consider. Such as the impact of stress tests and capital/liquidity allowances in ICAAPs, ILAAPs and RRPs. Or how to maximise the benefits from the Basel III deferral – specifically for back book positions. Firms should also consider their reporting and accounts and speak to external auditors early in the process to avoid significant filing disagreements.
Contact us for more information on these changes and what they mean for you.