COVID-19: IFRS 9, capital requirements and loan covenants

On the 26 March, the PRA wrote to CEOs across the banking industry to provide guidance on three key areas related to COVID-19:

“…(i) consistent and robust IFRS 9 accounting and the regulatory definition of default; (ii) the treatment of borrowers who breach covenants due to COVID-19; and(iii) the regulatory capital treatment of IFRS 9.” The aim is to ensure that banks maintain safety and soundness whilst also remaining open for business and continuing to lend. The fear potentially being that organisations overestimate the risk impact of COVID-19 and subsequently reduce risk appetite due to higher default rates, rising impairment allowances and reducing capital ratios.

One of the main ways for these financial impacts to manifest is through the consideration of economic adjustments within IFRS 9 models. However, this is seemingly discouraged due to the fact that “…little reasonable and supportable forward-looking information is currently available on which to base those changes.” Instead approaches utilising overlays are recommended with the further note that “This makes it even more important that ECL is implemented well and on the basis of the most robust reasonable and supportable assumptions possible…”. While this may be the PRA’s current view, it is worth noting that their position is moving quite quickly – the MPC minutes issued on the same day expressed the view that the UK economy would suffer “a very sharp reduction in activity”.

The PRA guidance is also based on a degree of uncertainty of how well existing models can perform in the current environment and that this should be considered in the derivation of the overlays resulting in it being “…essential that overlays are the subject of high quality governance, given the unprecedented nature of the current situation and the significant uncertainties that exist.” This is due to large shocks to the economy, potentially being offset over the longer-term through Government intervention – and the consideration of these effects being outside of that which can be relied on from model output or pure analysis. It is likely that these overlays will deliver a reduction in provision relative to modelled results using current economic outlooks.

Outside of the forward-looking considerations of IFRS 9, there is the additional consideration of how to deal with current impacts. The letter is clear that the non-payment due to the Government-endorsed payment holidays or breach of covenants for short term COVID-19 related issues, should not be treated as a Significant Increase in Credit Risk (SICR), default or even a trigger to begin counting days past due. However, there is still the requirement to understand other triggers not related to COVID-19 “Firms should continue to assess borrowers for other indicators of unlikeliness to pay, taking into consideration the underlying cause of any financial difficulty and whether it is likely to be temporary as a result of COVID-19 or longer term”.

Clearly differentiating between COVID-19 related difficulties and other longer-term issues would present challenges in any circumstances even if full disclosure was obtained from the customer via a detailed collections review. However, this will be even more difficult as the PRA expects that “…in the short-term the circumstances surrounding a request for a payment holiday will not be investigated sufficiently…” However, if an investigation isn’t expected to take place when offering forbearance the question is posed – what is the correct way to offer such a strategy to customers bearing in mind current impact on reporting, operational capacity, Government expectations, regulatory expectations and future use of data?

One quite extreme option is to undertake a mass communication to all customers indicating that if they are unable to pay due to the impacts of COVID-19, they can cancel their Direct Debits with no recourse. This would remove any operational pressure, both in terms of collection calls and adjustment of reporting, as all arrears increments would be suspended. This would meet the Government’s aim of supporting consumers. However, this could result in exploitation by customers and an unnecessarily dramatic reduction in bank cash flow. Additionally, data from this period will be unusable for any future investigations into the impact of the COVID-19. There is also the likelihood that this is not the intention of the Bank of England, given one of its aims is to ensure banks “…provide robust and consistent market disclosures” which will clearly be impacted by this approach and result in significant under reporting of risk without any further adjustments.

Therefore, consideration has to be given to an approach whereby a full review is undertaken, with forbearance only being recognised as COVID-19 related where there is clear evidence to support. This would allow for a better understanding of the impact and ensure current reporting and future data was as accurate as possible. However, there will still be a level of subjectivity required to determine cases wholly or largely caused by COVID-19 and there still may be cases of customer exploitation (our clients have already indicated they have received contact from people financially unaffected who are requesting payment holidays) and consequently there will still need to be interpretation of any reports and data collected. This approach and its difficulties is recognised by the PRA who acknowledge that they “understand that some lenders intend to try to differentiate between borrowers who request a payment holiday to manage liquidity due to short-term cash-flow disruption” and that “This is right in principle but likely to be operationally complex.” The operational complexity will result in potential changes to systems as well as large resource demands to obtain the information from the customer and record. Additionally, making accept/decline decisions on payment holiday applications may result in some consumers being incorrectly declined, which is clearly not in line with the Government’s expectations.

A compromise option between the previous two extremes outlined, is that organisations will allow forbearance on request with minimal challenge and simply assume that any forbearance put in place during the coming weeks and months is COVID-19 related and therefore won’t result in arrears or default. This approach brings in challenges seen with the two previous options but to a lesser extent. Clearly this will still result in the under reporting in current disclosures and reduces the usability of future data. It does, however, reduce the risk of customers exploiting the situation, as the requirement to apply for a mortgage holiday will likely deter people who are not truly in need of it. However, this could introduce a new opposing issue of some customers in need of and eligible for a payment holiday not applying due to understanding or inclination, therefore resulting in false positive arrears increases. Finally, whilst this approach does not bring the operational complexity or resource demands of a full review, there will still be increased requirements. If organisations don’t currently offer payment holidays without arrears accrual as standard forbearance, changes will have to be made to systems. Additionally, there will still be resource pressures to process the volume of applications even if a detailed review is not undertaken.

As previously stated, for IFRS 9 it is not expected that consequences of COVID-19 on customers is a SICR and that arrears should not accrue – thus ensuring that there is no requirement to rebut the 30dpd SICR assumption. As outlined above, the only way to do this without suppressing most or all arrears increases, is to undertake a detailed review of new collections contact – an approach that the PRA accept is operationally complex.

It is likely that solutions for IFRS 9 will involve more probabilistic based approaches, accepting that individual customer identification is unattainable. To achieve this, analysis can be undertaken to identify evidence of financial difficulties prior to the crisis or trajectories through the crisis similar to previous risk deterioration e.g. increasing indebtedness prior to missed payments. This analysis can then be used to balance weight the proportion of non-payers (holiday or otherwise) that should be deemed as SICR and potentially default. This analysis will utilise credit bureau information prior to the crisis, income data (where available from current accounts) and prior behavioural patterns including utilisation, spend and payments. Whilst this approach will require initial effort to set-up, the ongoing cost will be minimal regardless of the duration of the current climate.

If you would like to speak to us about using analytics to inform your risk identification for IFRS 9, default and collections plans please contact Chris at christopher.warhurst@4-most.co.uk