UK bank ECL scenarios may lowball coronavirus impact

BoE offers IFRS 9 relief on virus-hit loans

The stress scenarios that UK banks currently have in place to ballpark their expected credit losses (ECLs) may underestimate coronavirus-related impacts, although regulatory intervention should spare them from dramatically increasing loan-loss reserves as the economic effects of the crisis manifest.

Lenders use a series of forward-looking simulations to size ECLs under IFRS 9 accounting standards. These are unique to each bank, meaning the number of, and economic assumptions included in, these scenarios vary. Downside, central and upside scenarios are all assigned a probability weighting, and the blended outcome is used to set loan-loss amounts.

Because these scenarios are supposed to be “reasonable and supportable”, those disclosed by UK banks at end-2019 do not include the kind of unprecedented stresses caused by the coronavirus crisis.

On March 20, the Bank of England said ECL forecasts should only include these impacts if sufficient data is available and, if so, factor in the “temporary nature” of the shock.

 

Top UK banks’ downside ECL scenarios varied in severity at end-2019.

HSBC disclosed three UK downside scenarios. These projected average five-year UK GDP growth rates of 0.3%, -0.3% and -0.8%, and unemployment rates of 6.5%, 8% and 7.7%, respectively.

The bank disclosed that under the latter two scenarios, ECLs on UK retail exposures would range between $1.5 billion and $1.7 billion, and on wholesale exposures $1.9 billion to $2.1 billion. Total reported ECLs as of end-2019 were $2.8 billion.

RBS’s worst-case scenario forecasted a five-year average GDP growth rate of 0.9% and an unemployment rate of 5.2%. Actual ECL provisions as of end-2019 were £3.8 billion.

Barclays’ severe downside scenario assumed average GDP growth of -4.7% and unemployment of 8.7% over five years. ECLs as of end-2019 were £6.6 billion.

Lloyds did not disclose GDP assumptions for its scenarios, but its worst-case scenario assumed unemployment would average 7.2% over five years. Actual ECLs for 2019 were £3.5 billion.

While some of these severe downside scenarios could approximate the economic damage wreaked by the coronavirus crisis, they are assigned low probabilities by each bank, meaning they carry little weight in the overall calculation of ECLs.

Who said what

“The PRA reminds firms that forward-looking information used to incorporate the impact of Covid-19 on borrowers into the expected credit loss (ECL) estimate needs to be both reasonable and supportable for the purposes of IFRS 9. Given the sudden onset of the virus, the PRA believes there is very little such information available as yet, and regards the preparation of reliable and detailed forecasts as very challenging currently. In the event [that] firms believe such forecasts can be made, the PRA expects firms to reflect the temporary nature of the shock, and fully take into account the significant economic support measures already announced by global fiscal and monetary authorities” – Bank of England, March 20.

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. Banks have discretion over the number and severity of scenarios used to generate their ECL provisions.

Why it matters

A real-time stress test of IFRS 9 standards is under way. 

The economic fallout from the coronavirus pandemic could plunge the world into a prolonged recession. The Institute for International Finance projects world GDP will expand by only 1% in 2020, and multiple banks expect huge quarter-on-quarter GDP declines for Q2.

Such a downturn could shove mountains of loans classified as IFRS 9 stage one into stage two, causing ECLs to skyrocket. But if banks assume the coronavirus shock is temporary, and factor government guarantees and payment holidays into their credit loss projections, the uplift to loan-loss provisions could be drastically smaller than otherwise.

This would save UK banks from having to drain capital buffers to bolster their ECL provisions, leaving more retained earnings on hand to support lending and absorb losses.

Today (March 25), the European Banking Authority issued a statement that was similar in tone to the Bank of England's, telling banks to distinguish between borrowers who would see their creditworthiness bounce back after the immediate crisis and those who would be unlikely to recover in IFRS 9 accounting. 

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