The Covid-19 pandemic has touched every aspect of our lives, extending beyond the personal level to our professional lives as well. As governments have moved to protect supply chains and jobs, as well as market liquidity, the rules governing financial exposures are being reinterpreted, most notably the IFRS 9 and CECL regulations on credit risk. For regulated financial institutions, the response requires resilience and flexibility, in both the processes and solutions that support regulatory compliance.
Regulatory supervisors have taken measures to ensure that existing borrowers would not default on their mortgages and loans, by asking banks to freeze or delay the contractual payment schemes for a limited time to help several target groups most affected by the crisis.
These new economic circumstances and financial easing have impacted the interpretation and execution of IFRS 9 and CECL, which between them specify the standard accounting rules for financial instruments, as well as the loss-provisioning for contracts like loans and mortgages. In taking these steps, regulators are seeking to help financial institutions endure the current turbulent conditions, ensuring ongoing compliance without imposing overly burdensome measures during the crisis.
Regulators are signaling that the marketplace should expect substantial changes to processes and solutions relating to IFRS 9 and CECL, with specific focus on automated ones. For practitioners, the main question is: To what extent can current processes and solutions cope with these expected sudden changes?
Regulators’ guidance on credit risk in response to Covid-19
IFRS 9 and CECL require the consideration of past performance, current conditions and reasonable and supportable forward-looking information over the life of the exposure to measure expected credit loss (ECL). Both standards require financial institutions to use all reasonably available information to arrive at this estimate of expected credit loss (ECL).
The International Accounting Standards Board (IASB) has said that IFRS 9 lifetime expected credit losses will be recognized on assets when there is a significant increase in credit risk (moving from stage 1 to stage 2) after initial recognition. It regards a number of factors as indicators of a significant increase in credit risk, including: changes in general economic and/or market conditions; significant changes in the financial position of the borrower; changes in the amount of financial support available to an entity; potential breaches of covenants; and expected payment delays.
They also include quantitative, qualitative and backstop criteria not captured by the measures. These feature on banks’ watchlists and are typically segment and portfolio-specific: retail based on internal credit scores; corporate on external ratings; credit cards based on days past due, and so on. These are usually assigned a level of risk, based on decision tree assessments (for example, primary, secondary), as well as banks’ internal expertise. The assumption that credit risk increases significantly when contractual payments are more than 30 days past due is also often used as a backstop in business logic to capture the significant increase in credit loss if this is not captured by an increase in the probability of default.
Institutions would be expected to distinguish between obligors for which the credit standing would not be significantly affected by the current situation in the long-term, from those that would be unlikely to restore their creditworthiness. Exercising this discrimination would contribute to mitigating any potential cliff effect of transfers between stages, and would help to avoid exaggerating the effects of the shock. Banks’ income statements stemming from the recognition of the ECL and the mitigation provided by the existence of collateral or public guarantees would need to be considered.
Other supervisory bodies, including the Office of the Superintendent of Financial Institutions (OSFI), the Financial Accounting Standards Board (FASB) and the European Banking Authority (EBA), have suggested that deposit-taking institutions consider the exceptional circumstances when determining reasonable and supportable forward-looking information to assess the impact of Covid-19. The FASB, for example, has said the agency’s examiners will not automatically adversely risk-rate credits that are affected by Covid-19.
The EBA has said banks should also take into account the expected nature of the shock (i.e., whether it is expected to be temporary or not), including the scarcity of reliable information. In determining the impact on banks’ income statements stemming from the recognition of the ECLs, the EBA has suggested that the mitigation provided by the existence of collateral or public guarantees would need to be considered.
Competent authorities should also duly consider exceptional circumstances when authorizing institutions to opt for the application of IFRS 9 and CECL transitional arrangements envisaged in the Capital Risk Requirements.
Paramount to a successful approach is putting in place an integrated and automated program that can offer the required flexibility when needed. This can prove a difficult balance, with solutions providing either high degrees of automation and lack of flexibility, or flexibility but with ungoverned processes. Firms’ IFRS 9 and CECL processes still need to be audited and trailed, even in times of stress. Adopting a temporary spreadsheet replacement would go beyond the initial goal of managing the IFRS 9 or CECL process in a flexible manner, which requires any native solution to embed model and economic changes, as well as support good governance.