Bleak macro view pushes Lloyds’ ECL over £5bn

Anticipated loan losses for commercial loans up 39% on end-2019

The Covid-19 outbreak darkened Lloyds’ economic forecasts, imposing a £1.4 billion ($1.7 billion) impairment charge in the first quarter and forcing the bank to revise its expected credit losses (ECL) up 25% on end-2019.

The Q1 provision wiped out almost three-quarters of Lloyds’ earnings – and further impairment charges are likely. In updating its forward-looking scenarios for estimating loan losses, the bank’s ECL amount jumped up £1 billion on end-2019. This figure reflects the probability-weighted outputs of a base case, upside, downside and severe downside scenario.

Lloyds estimates the Covid-19 crisis will take an especial toll on its commercial banking portfolio. ECL for this book increased 39% quarter-on-quarter. The amount for its retail portfolio leapt 26% and for UK mortgages 11%.

 

But home loans could inflict far greater losses on the bank if its worst-case forecast comes to pass.

Under Lloyds’ severe downside scenario – which has a 10% probability weighting in its ECL calculation – UK mortgage losses are estimated to be 96% higher than in the base case, at £2.4 billion. ECL for commercial loans are 33% higher under the severe downside scenario than under the base case, and for retail loans 17% higher.

The severe downside scenario projects -7.8% GDP growth and 6.7% unemployment for 2020. The base case pegs the GDP fall at -5% and estimates unemployment will hit 5.9%.

What is it?

Under IFRS 9, banks’ ECL provisions are calculated using forward-looking scenarios for GDP growth, unemployment, inflation and short-term interest rates, among other economic indicators.

Each scenario uses assumptions that are set using a standardised framework, supplemented with the independent judgement of the bank’s managers. A central or baseline scenario, reflecting the most likely path the economy will take, is assigned a high probability of occurring and therefore has the most influence over the size of ECL provisions. Less probable, but more extreme scenarios have a lesser role in shaping overall provisions.

Why it matters

IFRS 9 accounting rules that ushered in the ECL regime last year are hammering bank earnings. Put simply, the use of forward-looking scenarios to size impairments means that in a crisis, losses are front-loaded to reflect a firm’s soured economic outlook. 

Lloyds’ Q1 impairment charge was more than quadruple the Q4 amount, demonstrating just how fast and how far credit expectations have tumbled because of the coronavirus crisis.

But they may have some way further to fall. The bank’s mortgage book seems particularly sensitive to a worst-case scenario where unemployment rises and GDP contracts just a few percentage points more than in the base case. 

Therefore, if the UK economy undershoots expectations this quarter, Lloyds may have to ramp up provisions for its huge home loans portfolio once again, crippling Q2 earnings.

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