How to assess the impact of tariffs on IFRS 9 provisions

Over the past month, geopolitical tensions among major global economies have escalated due to the introduction of new tariffs. The potential for a full-blown trade war threatens economic stability and international relations.

As models may not fully capture evolving geopolitical risks, many institutions are employing Post Model Adjustments (PMA) to better align IFRS 9 provisions with future expectations. This was also noted by the European Central Bank (ECB) in their July 2024 article on novel risks.

In this article we lay-out why IFRS 9 models struggle to deal with geopolitical risks and what financial institutions can do to quantify the impact of tariffs.

Why IFRS 9 models struggle to deal with geopolitical risks

IFRS 9 models are built on historic data, heavily relying on past defaults and macroeconomic indicators. Trade wars and tariffs are relatively rare and not well-represented in historic datasets. Next to concerns around data, model methodologies are subject to many assumptions and limitations. During periods of heightened geopolitical uncertainty, traditional statistical relationships might break down, leading to model outputs that no longer represent the best estimate of expected credit losses. We have seen this before during major events like the COVID-19 pandemic and the Russia-Ukraine war.

Three key steps for considering tariffs in IFRS 9 provisioning

We recommend that financial institutions consider three steps for quantifying the impact of tariffs.

1. Define the transmission channels through which tariffs hit your portfolio

The implementation of tariffs can lead to increased defaults, materialising through microeconomic and macroeconomic transmission channels. From a macroeconomic perspective, tariffs impact inflation and have consequences for interest rates and GDP, with knock on effects on credit risk. On the microeconomic side, tariffs disrupt supply chains and profitability of individual businesses or sectors. Portfolio characteristics matter: the impact on a corporate portfolio may differ significantly from that on a mortgage portfolio. Gaining a comprehensive understanding of the transmission channels requires collaboration across departments, including economics, risk, and business.

2. Evaluate if your IFRS 9 models and scenarios can handle the impact of tariffs

Once you’ve obtained a thorough understanding of the transmission channels, perform a thorough assessment of your IFRS 9 models and scenarios. Example questions to consider:

• Are the current macroeconomic variables used in your IFRS 9 model still adequate? The recent surge in inflation in developed nations is an example of a macroeconomic variable that might not have been selected during model development, however, turned out to be a relevant driver for many portfolios.
• Is your IFRS 9 model sufficiently responsive and forward-looking? Model inputs may include lagging indicators such as arrears for mortgages or financial statement information for corporates that are slow to respond.
• Do the macroeconomic scenarios and their weights reflect the impact of tariffs? Many financial institutions have reconsidered scenario weights during times of economic uncertainty.

3. Quantify the impact of tariffs in relation to learnings from previous events

During COVID-19, PMAs were applied to sectors significantly impacted, such as leisure and hospitality. The Russia-Ukraine war prompted PMA for companies based in Russia or reliant on Russian supply chains, leading to higher risk parameter estimates and the reclassification of exposures to stage 2 or 3.

We have also seen financial institutions increase the weight of downward scenarios. In hindsight, we learned that many of these targeted adjustments overestimated IFRS 9 provisions as losses did not always materialise. One possible cause is double counting, such as adding a PMA on top of revised macroeconomic scenarios.

To ensure IFRS 9 provisions remain best estimate and unbiased, financial institutions should reflect on prior exercises and adopt a disciplined review of their processes. A data-driven assessment of tariff impacts on specific sectors, companies, and countries can support in quantifying the impact of tariffs while being wary of potential double counting.

Need more guidance?

Get in touch if you want to learn more about how we can support your organisation navigate the evolving geopolitical landscape – info@4-most.co.uk.