In my previous article, I discussed the accounting considerations when assessing whether or not a substantial modification exists regarding COVID-19 measures taken by lenders, such as payment holidays or moratoria.
As promised, in this article I will explore the impact of these measures on the expected credit loss (ECL) model in more detail.
As communicated by the International Accounting Standards Board (the Board) and regulators, entities shouldn’t just continue to apply their existing ECL methodology mechanically. Instead, they must consider what changes are necessary for their approach to faithfully represent ECLs in the context of COVID-19. As a reminder, we are not only talking about simple loans but also debt securities measured at amortized cost as well as financial guarantees, commitments, trade and lease receivables — basically, all instruments that are in the scope of the ECL model.
Significant increase in credit risk (SICR)?
When granting payment holidays, lenders should consider whether the measure is caused by a SICR. The SICR assessment considers changes in the risk of default that occurs over the instrument’s lifetime. According to paragraph B5.5.27 of IFRS 9, the lender compares the risk of default at the reporting date based on the modified contractual terms with the risk of default on initial recognition based on the original, unmodified contractual terms.
The lender’s previous approach may have been to estimate that all payment holidays and similar reliefs were a qualitative indicator that automatically transferred an exposure to stage 2 or stage 3. However, the Board has stated that, in the context of COVID-19, “The extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR.”
Equally, a lender shouldn’t assume that all exposures subject to rescheduling should remain at stage 1. And, as the SICR assessment is a holistic assessment of several quantitative and qualitative factors that must capture changes in the lifetime risk of default — i.e. over the entire expected lifetime of the instrument — careful analysis is required to determine to what extent the modified financial assets should be moved to stage 2.
As a result of the COVID-19 pandemic, borrowers could face short-term liquidity constraints but also receive support from the government or another third party. In this case, the lender could rebut the presumption under IFRS 9 that a SICR arises when contractual payments are more than 30 days past due, if there is reasonable and supportable information that will resolve these constraints, and there are no other indications of a significant increase in the individual borrower’s credit risk.
The European Banking Authority (EBA) states in its guidelines that a rebuttal of the presumption should “…be accompanied by a thorough analysis clearly demonstrating that 30 days past due is not correlated with a significant increase in credit risk. Such analysis should consider both current and reasonable and supportable forward-looking information that may cause future cash shortfalls to differ from historical experience.”
In general, the impact of the COVID-19 crisis represents a credit deterioration that affects many borrowers. Therefore, lenders will need to distinguish between cases where the payment holiday provides the borrower relief from short-term liquidity constraints that don’t result from a SICR considering the entire life of the instrument, versus cases where there is a significant increase in default risk over the instrument’s entire remaining life because of longer-term liquidity or solvency problems.
To be able to make this challenging distinction, lenders will need to apply broader views on the macroeconomic impact. For example, the depth and duration of the macroeconomic problems; when and how quickly could longer-term “normal” economic trends return; and the nature, extent and duration of direct government support to borrowers.
Is the financial asset credit-impaired?
After following the steps of my previous article to determine whether or not the financial asset should be derecognized, the following considerations must be made if the financial asset is not derecognized.
The first consideration is whether the modified financial asset is credit-impaired. This may be the case if the borrower was already in significant financial or economic difficulties and the modification would not immediately dispel these difficulties. Another consideration is whether the relief provided to the borrower is significant and exceeds the relief granted to other borrowers.
It may be appropriate to write-off a portion of a loan if it is credit-impaired and the modification reflects the borrower’s reduced payment capacity resulting from their significant financial difficulties. In these cases, payment holidays would represent traditional forbearance; therefore, the part of the asset that isn’t reasonably expected to be recovered should be written-off. After this, the loan modification could be close to zero and no longer represent a substantial part of the loan, as the main part of the modification may already be written-off.
As recommended by national and local supervisors — EBA, the European Securities and Markets Authority (ESMA) and the Commission de Surveillance du Secteur Financier (CSSF), as well as the Board — lenders should apply a flexible and pragmatic application of the requirements of IFRS 9 to foster consistency and avoid an overstatement of the ECL.
Estimation of the ECL
The CSSF’s COVID-19 FAQ highlights that, in the current circumstances, lenders should consider the following when estimating ECL to avoid excessively procyclical assumptions in their IFRS 9 models.
- Lenders should apply a top-down approach to stage transfers when estimating the ECL on a collective basis and recognize lifetime ECL only on the portion of the financial assets that suffered SICR.
- Lenders should give greater weight to long-term macroeconomic forecasts that are evidenced by historical information. These forecasts should cover at least one economic cycle and avoid bias to mitigate the current high range of uncertainty in generating reasonable and supportable forecasts.
While lenders are being asked to use the flexibility provided by IFRS 9, they are still required to continue applying sound and prudent risk management to reflect the impact of COVID-19-related risks appropriately. However, bear in mind that a SICR assessment is a holistic assessment of several quantitative and qualitative indicators to capture the changes in the lifetime risk of default.
Therefore, the granting of payment holidays shouldn’t automatically trigger a SICR in the current circumstances. However, distinguishing whether the borrower is only experiencing a temporary liquidity constraint or if it actually represents a significant increase in their credit risk could be quite tricky.