Estimates of expected losses under the European accounting regime IFRS 9 will be more guesswork than model-based predictions, as no existing approach can assess the impact of the novel coronavirus pandemic on the economy.

While banks can use the flexibility offered by the accounting standard to limit the write-downs they should recognize on loans subject to COVID-19 stress, the economic outlook plays an important role in these estimates. Banks will have to tap into the dark for much of their loss modeling, because economists and market watchers are still only theorizing about the pandemic’s impact on the real economy.

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ECL arithmetic

New International Financial Reporting Standards regime, called IFRS 9, changed the way banks provision for credit losses, requiring that capital be set aside for expected losses rather than those already suffered. Banks criticized the expected credit loss model, or ECL, before IFRS 9 came into effect on January 1, 2018, despite concerns, this would increase procyclicality as it requires higher provisions in downturns and lower provisions in good times.

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As the COVID-19 pandemic spread, banks called on regulators for relief on reporting IFRS 9 loan loss provisions. Regulators have responded by advising lenders to carefully assess the short-term and long-term effects of the crisis before increasing their provisions.

The European Securities and Markets Authority, or ESMA, said issuers should consider the impact of economic support programs and bank forbearance measures provided to borrowers before assigning higher risk to financial instruments. of their wallets.

Under IFRS 9, if a loan has experienced a significant increase in credit risk since its initial recognition, banks must change the provisioning for that loan to a lifetime ECL, or stage 2, from an ECL to 12. months, or step 1. By doing the the bank assumes that there is an increased likelihood of default throughout the life of the loan instead of just over the next 12 months.

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If banks decide that the effects of the pandemic on borrowers’ ability to repay will be limited in the long run, they don’t automatically need to switch to a lifetime ECL classification, according to Osman Sattar, accountant and director of financial institutions. EMEA at S&P. Global assessments.

Even if there is a significant increase in credit risk for some loans and banks are required to recognize lifetime ECLs, provisions for these lifetime losses could be lower if government guarantees on exposures are taken into account, such as ESMA advised it, Sattar said in an interview. .

COVID-19 does not fit any model

The Basel Committee on Banking Supervision said on April 3 that it expects lenders to continue to apply the relevant frameworks.

“Banks should use the flexibility inherent in these frameworks to account for the mitigating effect of extraordinary support measures related to COVID-19,” said the committee, which oversees global prudential regulation of banks.

The Bank of England said on March 26 that ECL’s estimates should be based on “the most sound, reasonable and supportable assumptions possible in the current environment” as this will help reduce the risk of a significant overestimation of ECL which could lead to an unnecessary tightening of credit conditions.

Even if such assumptions are applied, the BoE said that “any changes made to ECL to estimate the overall impact of COVID-19 will be subject to very high levels of uncertainty as there is currently so little reasonable forward-looking information. and justifiable on which to base these changes.

COVID-19 presents a unique challenge for modeling future losses, as there are still more questions than answers about the epidemic’s impact on the global economy. “No prospective model could have predicted the characteristics of the COVID-19[female[feminine medical situation and its implications, ”wrote the risk advisers at Deloitte in a March 20 blog post.

Existing models for accounting for expected losses on financial assets take into account the interaction between macroeconomic indicators and predictors of expected losses, they said. However, to assess the The economic fallout from COVID-19 is when the blockages will be lifted and commercial activity can resume, where production will be positioned and how quickly consumer demand will pick up, they said. The pace of recovery in some sectors will be slower and others will have to transform completely due to the health crisis, Deloitte said.

Conjectures

Economists are still wondering what form the post-COVID-19 economic recovery will take and what the effect of mitigation measures taken by regulators and governments will be. In this environment, it is difficult to measure bank balance sheets head on.

Although NPL levels are likely to increase after COVID-19 given expected business defaults, it is too early to predict the magnitude of that increase, according to Sattar. Bad debt levels will be higher if economic stress lasts longer or if the recovery is weaker than expected, Alexandre Birry, head of financial services research and analysis at S&P Global Ratings, said in a webinar on March 27.

Currently, ratings assume a strong economic rebound in Europe in the second half of 2020 and through 2021, suggesting that banks’ short-term forbearance activity may now limit credit losses later.

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