To counter the impact of COVID 19, financial institutions have announced a slew of measures to ensure Businesses and Individuals smoothly resume economic activities.
While the measures can take a variety of reforms, lending institutions should carefully consider the related impact on Financial Reporting, in particular with respect to IFRS 9.
For Financial institutions, it is essential to mandate necessary adjustments at the next reporting date of IFRS-9, which will help them navigate COVID-19 effectively.
In order to navigate COVID 19 effectively, banks are required to follow specific sets of IFRS-9 guidelines and estimate ECL taking into account - “Reasonable & supportive information of the past event, current information and future forecast at reporting date".
Top-Down Approach for SICR
IFRS-9 ECL accounting standard is already a forward-looking capital provisioning measure incorporated with the future macroeconomic forecast. As in, when the GDP forecast changes it directly impacts the probability of default (PD) and based on that, eventually financial assets are transferred to different stages by lending institutions.
So when we apply the same macroeconomics forecasts (low growth in GDP) or other information, for a homogeneous group of borrowers i.e. at a collective pool level, it will increase the PD measures and absorb it as significant increase in credit risk (SICR) as a whole, even though this increase will be not affect all borrowers in the same way.
To avoid this backdrop banks can update their policy and include Top-down approach for SICR while distinguishing stages and recognising lifetime expected credit loss at a specific proportion of the portfolio.
When options like Blanket Payment holiday or moratorium period, for e.g. term loan is offered to an entire group of people, it will be inappropriate for lenders to classify the entire category of borrowers either in Stage1, 2 or 3.
There might be borrowers who face temporary shortage of liquidity but their lifetime credit risk does not increase at all, these borrowers should then be placed in Stage 1. However, there may be many borrowers who actually suffer a SICR, these borrowers will need additional measures to move into Stage 2 or 3 - This signifies the importance of setting up a robust internal Credit Risk assessment procedure and re-examining staging criteria’s to distinguish the stages of the borrowers effectively. The government relief for lenders and borrowers should not be considered for determining the stages, since the classification should be solely based on Probability of default.
For stress testing, the basic assumption used by the banks is the “V” shaped economic recovery post a crisis time zone. While most regulators, earlier anticipated post COVID 19 economic recovery by the end of 2020, current trends indicate partial recovery only by 2021/2022. Going forward we also might just see a “new normal” economy where the association of Society and goods/ services it chooses to use may fundamentally change.
Economic growth may follow a more extreme “L” or “U” shaped recovery, post crisis period (as indicated in the graph above) and hence banks really need to consider the severity of multiple economic forecasts, which will have significant impact on the Banking Industry as a whole.
Macroeconomic Scenario Forecast
1. Banks should include short-term forecast of macroeconomic factors, provided by their regulatory body (or forecasted independently) during this crisis period along with long-term forecasts to create baseline macroeconomic scenarios.
2. To create baseline scenario, assign weights to each specific economic factor based on relevance.
3. Assign more weightage to short term forecasts and gradually decrease weights as economy stabilises.
4. Once the specific forecast for the short-term period loses their relevance, we can continue with the long-run macroeconomic forecast.
Article Author: Ramen Borah, Business Analyst, Care Risk Solutions.