The PRA have now provided several pieces of guidance on the impact of Covid-19 for lenders, including specific guidance on IFRS 9 in the form of a letter from Sam Woods addressed to CROs on the 26th March. Here’s what it means for you.
The PRA, FCA and Treasury have so far maintained a relatively clear and consistent message to banks to have a carefully balanced response to Covid-19. They should recognise that whilst an economic disruption is inevitable, government responses are aiming to minimise this and that banks should contribute to the national cause by keeping lending and therefore the economy going.
The guidance on IFRS 9 is consistent with this general message by encouraging firms to treat customers impacted only by Covid-19 at the same level of credit risk as before the crisis and place emphasis on reliable short-term forecasts. However, the guidance also recognises that the purpose of IFRS 9 is to be forward-looking and as such firms cannot ignore the fact that an impact is inevitable.
Additionally, the PRA again reminded firms that the impact to CET1 could be partially mitigated through the use of the IFRS 9 transitional arrangements. In 2020, this allows 70% of ‘new’ IFRS 9 provisions to be added back to CET1 and hence significantly reduce the capital impact of Covid-19.
All of this guidance is aimed at ensuring firms continue to support households, businesses and the economy through continued lending, whilst confidence is maintained through consistent and reliable reporting.
Here are the five key takeaways
1. Treatment of Payment Holidays and Other Schemes
The PRA stated their clear view that all else being equal a payment holiday due to the impact of Covid-19 should not result in an account being deemed as higher risk. This means the account should remain in Stage 1 for IFRS 9 and be treated as not in default for capital purposes.
The rationale for this is that unlike a payment holiday granted in normal times, with each individual’s financial situation reviewed, on this occasion the lender is granting a payment holiday based upon a government-led initiative to support the economy as a whole. Given the sheer scale and immediacy of granting these holidays the lender has little ability to truly differentiate the underlying lifetime credit risk of those requesting the measure. Despite this , lenders should continue to assess whether customers requesting a payment holiday due to Covid-19 show other indicators of increased credit risk or unlikeliness to pay and continue to allocate customers to stages 2 and 3 where this occurs.
For lenders that don’t currently offer payment holidays, the initial priority will have been to apply system changes and tactical measures to enable them to quickly issue these breaks to meet demand and support the economy. Focus will now need to move to the on to the many downstream implications to be considered such as the correct modification to contractual terms and ensuring the prevention of any negative impact to customer’s credit ratings as stipulated by the FCA.
2. Economic scenario and weightings
The PRAs guidance is clear that economic scenarios and/or weightings should be changed to reflect the new reality but that there is limited reliable information as to what the likely macro-economic outcome will be.
In particular, the PRAs guidance is clear that economic scenarios should not be used if they do not give appropriate consideration to the unprecedented government interventions and the potential for these to return the economy to its long-term trend sooner rather than later.
In light of this, Jaywing’s view is that firms should not be as simplistic as to just use their previous worst-case scenarios as the base case, or to simply apply a higher weighting to this, but rather they should be considering whether the shape of any scenario truly reflects a very sharp short-term disruption and relatively quick return to long-term trend after this.
3. Impact of Loan covenants
It is expected a higher than normal number of customers will breach loan covenants due to Covid-19. As examples, the PRA expect borrowers to struggle to provide financial accounts and third-party asset valuations. Similarly, to payment holidays, it expects firms to apply a Covid-19 lens when considering whether this indicates whether a customer has increased in risk. If the covenant has been breached simply due to Covid-19, the PRA believes this is not a significant increase in risk or an unlikeliness to pay and expects the firm to reflect this by maintaining the customers previous stage.
On an operational basis, the PRA also outline that they expect such customers to be treated in good faith and not be hit by penalties or restrictions due to this. Again, this reflects the need for lenders to play their part in keeping business going and not increasing costs associated with Covid-19.
4. Governance for Overlays and Changes
Due to the sudden and changing nature of Covid-19 and the governments, customers and markets reactions to this, it is likely that IFRS 9 models will require substantial changes or model overlays in the short-term to reflect the most up-to-date situation. This may come in the form of changing the economic scenarios, applying manual adjustments to those on payment holidays or including new risk drivers in the models.
In any of these situations, and especially in the case of model overlays, the PRA view that it is essential that high-quality governance is in place.
We expect that in the short-term it is likely that expert judgement will impact each firms provision more than ever, and hence it is vitally important that a robust process and truly independent challenge is in place for these judgements.
5. IFRS 9 Transitional Arrangements
Lenders have a hugely important role currently in preventing this crisis from becoming a crisis of confidence in the underlying economy. In order to prevent this the PRA is aware banks must continue to lend and allow customers to create demand and businesses to function as well as possible. The PRA is encouraging banks to minimise capital requirements and free up funds for lending through using the IFRS 9 transitional arrangements. Whilst this may have been of less importance to firms whilst the IFRS 9 impact was low, given the impact is likely to grow in the short-term lenders should be considering this option.
Due to Covid-19 and its impact on the wider economy, there is significant uncertainty for firms applying IFRS 9 now. The PRA are trying to provide guidance to help firms manage this uncertainty in a consistent manner and one which maintains confidence in the financial sector. There is a long way to go and many unforeseen issues will emerge over the next few months, but firms should be aware of and closely following the latest advice.