IFRS 9 And COVID-19: Classifying Forbearance And Problem Loans PDF

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IFRS 9 and COVID-19: classifying forbearance and problem loansIFRS 9 and COVID-19: classifyingforbearance and problem loans00

IFRS 9 and COVID-19: classifying forbearance and problem loansIntroductionOn Thursday 26th March the PRA published guidance to help firms consider importantECL implementation issues caused by the COVID-19 pandemic. The overall aim is tosteer firms and auditors to account for the positive effects of government interventionin their financial risk measurement to “reduce the risk of firms recognisinginappropriate levels of ECL” and ensure the financial system is “a source of strength forthe real economy during this challenging period”.This note looks at the first two elements of the guidance, which relate to theidentification and classification of problem loans. Firms’ choices in this area will havesignificant financial and disclosure effects for them in the coming months and years.Practice in this area has improved significantly in recent years to address the issuesfrom the 2008/9 crisis, making balance sheet credit quality (especially during stress)more transparent and incentivising firms to deal with legacy stocks of non-performingloans. This has been seen as a critical remedy to the slower economic recoveryexperienced by those countries that did not quickly and effectively address the qualityof their banks’ balance sheets coming out of the 2008/09 recession.How firms choose to categorise exposures as “forbearance”, a Significant Increase inCredit Risk (i.e. Stage 2) or “bad” is important. The choice can lead to more intensivereporting and monitoring requirements, increased Risk Weighted Assets (i.e. capitaldemand), and increases in balance sheet ECL and impairment stock/charge.In our view, the new guidance indicates a subtle change in the direction of regulationin this area over the last ten years. Indeed, the PRA acknowledges that: “some of theassumptions that we have all been making no longer hold so it is important that wetread carefully and think through things afresh and in detail, in the context of thecurrent unprecedented situation. That will take time. We intend to discuss these issuesfurther with both firms and auditors.” 1In Europe there are three sets of rules for categorising forbearance and problem loans.We consider all three in this note: the IFRS 9 rules for allocating credit risk exposure to Stage 2 and 3;the rules on capital definition of default (including article 178 in the CRR and newEBA rules due to come in to force by end 2020); andthe FINREP definitions, which also underpin the ECB/EBA rules regarding themanagement and disclosure of non-performing loans.Note that the PRA’s guidance is very similar to that issued by the ECB on 25 th Marchand, for simplicity, we refer only to the PRA note. The rationale is equally valid for theECB statement.1PRA Dear CEO letter from Sam Woods, 26 March 2020 ts-andloan-covenants01

IFRS 9 and COVID-19: classifying forbearance and problem loansFigure 1: European Central Bank illustrative connection between NPE, defaultedand impaired definitions 2Main driver of thedifferences (if they exist)is the extent to which theautomatic factor of 90days past due used in NPEis not applied for impairedNPE: EBA-ITSDefault: CRR Art. 178Impaired: IAS/IFRSMain driver of the differences (ifthey exist) are the extent towhich automatic factors used inNPE are not applied for default,such as: 1 year cure period toexit NPE Other exposures pastdue 90 days past dueprevent existing NPE NPE due to secondforbearance or 30 dayspast due of aperforming forborne inprobation NPE due to 20%Although there may be some differences in categorisations, for most exposures the three concepts are aligned(impaired default NPE)1. Economic background (and outlook)The guidance must be interpreted in the context of the PRA’s view of the current andfuture economic situation:“ while the reduction in activity associated with COVID-19 could be sharp and large, itis likely to rebound sharply when social distancing measures are lifted. In addition, inthe intervening period, while activity is disrupted, substantial and substantivegovernment and central bank measures have been put in place in the UK andinternationally to support businesses and households. These measures, which havebeen evolving rapidly and could evolve further, are expected to remain in placethrough the period of disruption.”“ there are clear signs that, taken in isolation, economic and credit conditions areworsening. It is, however, equally important also to take into account the significanteconomic support measures announced by domestic and international fiscal andmonetary authorities and the measures – such as payment holidays and new lendingfacilities – that are being made available to assist borrowers affected by the COVID-19outbreak to resume regular payments.”“ the economic shock from the pandemic should be temporary, although its durationis uncertain. While it is plausible to assume that the economic consequences of thepandemic could mean that some borrowers will suffer a long-term deterioration incredit risk, many will need the support measures in the short-term but will not suffer adeterioration in their lifetime probability of default.”Why does this matter? If deterioration in the macro-economic outlook indicates that apopulation of customers have increased default risk (e.g. based on macro adjustmentsto future probability of default) compared to the default risk at origination, then firmsshould consider moving some or all impacted loan exposures to Stage 2.2Figure 1 has been extracted from the guidance provided by the European Central Bank pdf/guidance on npl.en.pdf02

IFRS 9 and COVID-19: classifying forbearance and problem loansHowever, if the economic shock is short term in nature, firms have to askwhether the lifetime PD has increased significantly. Such analysis will beeasier for firms who use lifetime PD as the basis of their SICR frameworkrather than shorter term 12-month PD measures which are commonly usedin the market, by way of simplification.Below we consider the prudential treatment where a previously “good”capital and interest owner-occupier mortgage is modified to allow a threemonth payment holiday and the borrower is not bankrupt or similar. Theprinciples below are equally applicable to other forms of lending e.g.consumer and corporate lending. We exclude instances where a loan’scontractual terms allow for a payment holiday – these are not amodification (although the exercise of this option by a customer may still bea sign of financial distress).2. Are government-endorsed forbearance schemes (e.g. paymentholidays) and similar measures by firms “bad” loans?The PRA says:“Our expectation is that eligibility for, and use of, the UK Government’spolicy on the extension of payment holidays should not automatically, otherthings being equal, trigger: a default under CRR; and the loans involvedbeing moved into Stage 2 or Stage 3”.“We also do not consider the use of such a payment holiday to resultautomatically in the borrower being considered unlikely to pay under CRR.Firms should continue to assess borrowers for other indicators ofunlikeliness to pay, taking into consideration the underlying cause of anyfinancial difficulty and whether it is likely to be temporary as a result ofCOVID-19 or longer term.”Days past due: if the loan is 90 days past due when the treatment isgranted the loan will be “bad” under all three regimes. However, as thecounting of days past due is suspended during the payment holiday period,the days past due backstop cannot trigger a new days past due defaultduring the treatment.Change in NPV: where lenders continue to charge interest for the period ofthe mortgage payment holiday there is typically no change in NPV. If thelender writes off the interest during the payment holiday this will usuallylead to a small change in NPV of future cash flows, thereby precluding derecognition (i.e. not a “substantial modification” or hitting the 10% rule inIFRS 9 B3.3.6) or a default indicator under the EBA’s 1% rule (although thediscount rate for regulatory purposes can differ from the EIR, changing thissituation).Non-accrued status under CRR: placing an exposure on “non-accrued”status as per article 178 of the CRR, where interest is not recognised due toa credit event, is a default trigger under the capital regime. Thefundamental purpose of a payment holiday is to suspend customerpayments so, at face value, this should trigger a default. Indeed, most firmsinclude suspension of interest in their regulatory definition of default, whichregulators have accepted for a considerable period of time.Government mandated schemes: this situation is considered in theEBA’s Guidelines on the Application of the Definition of Default which says:03

IFRS 9 and COVID-19: classifying forbearance and problem loans“where the repayment of the obligation is suspended because of a lawallowing this option or other legal restrictions, the counting of days past dueshould also be suspended during that period. Nevertheless, in suchsituations, institutions should analyse, where possible, the reasons forexercising the option for such a suspension and should assess the possibleindications of unlikeliness to pay”. In other words, firms still need to bevigilant about the underlying reasons why customers ask to take advantageof the scheme.Unlikeliness to pay: the customer is unlikely to pay without recourse torealising security. This is the critical category and includes a wide range ofindicators. Some relevant “bad” triggers are:IFRS 9 CapitalBasel Default (not required by IFRS 9 but recommended by theBCBS and EBA) a breach of contract, such as adefault or past due eventsignificant financial difficultygranting a concession(s) that thelender(s) would not otherwiseconsider FINREP NPEStage 3 under IFRS 9 or NPE/NPE Forborne under FINREP doubts that a new distressedrestructuring will be paid in full ina timely way including:‒ a large bullet payment; ‒ significantly lower payments ora grace period at the beginningof the repayment schedule;‒ loans have been subject toforbearance more than oncesources of recurring income areno longer available to meet thepayments and/or concerns abouta borrower’s future ability togenerate stable and sufficientcash flowsThe critical items relate to: significant financial difficulty, granting aconcession that the lender would not otherwise consider and issues with acustomer’s current or future income.In terms of identifying concessions, the go-to set of rules are FINREP, whichdefine forbearance as “concessions towards a debtor that is experiencing orabout to experience difficulties in meeting its financial commitments” andmay entail “modification of the previous terms and conditions of a contractthat the debtor is considered unable to comply with due to its financialdifficulties (‘troubled debt’) resulting in insufficient debt service ability andthat would not have been granted had the debtor not been experiencingfinancial difficulties”.Typically, lenders will only grant concessions when customers are infinancial difficulty and, typically, these exposures are higher risk thanexposures without a concession (reflecting the underlying risk and customerdifficulty that has led to the modification in the first place). Again, typically,we would expect firms to include as “bad” those forbearance treatmentswhere their credit behaviour shows a higher likelihood of future default (andcustomers are, therefore, “unlikely to pay”). This may (or may not) includepayment holidays depending on a firm’s individual analysis.04Basel Default or IFRS 9 Stage 3if 20% of exposures to anobligor are more 90 days pastdue, all exposures will beconsidered NPEfor exposures that are performingforborne and were previously NPEforborne, if additional forbearanceis granted or if the exposurebecomes more than 30 days pastdue

IFRS 9 and COVID-19: classifying forbearance and problem loansHowever, the current circumstances are not typical and the paymentholiday scheme is open to all borrowers, whether in financial difficulty ornot. The PRA’s statement that a forbearance treatment should notautomatically lead to an “unlikely to pay” trigger and “bad” classification isconsistent with previously communicated regulatory definitions and, wherefirms have been more prudent, they may need to reconsider automaticforbearance-related default triggers. However, firms will need to distinguishbetween those customers that are in financial difficulty and those that arenot.This becomes more subtle when considering the point made by the PRArelating to customers experiencing liquidity rather than credit events wherethere is good confidence about a borrower’s future ability to generate stableand sufficient cash flows despite temporary financial difficulty. Each firmwould have to justify that, despite the need for forbearance, a customer’sability to repay in full without recourse to collateral remains good. Thisneeds a credit risk judgement to be made that a customer will remain goodbecause of government support in the short term (like the UK’s furloughsalary scheme) and, in the medium term, because the customer’s regularsource of income could reasonably be expected to recover when thegovernment support is wound down. Some sectors of the economy andsources of employment may emerge from the crisis in better health thanothers, which could lead to different answers for different customers.In the UK the critical source of information for understanding thesedifferences in classification is the interaction between banks’ agents andcustomers to understand their individual circumstances and decide on thebest course of action when they are experiencing financial distress.The level of rigour around these conversations and the record keepingrequired to justify firms’ decisions has increased significantly since the lastrecession. Usually, if the agent establishes that the customer’s distress isnot temporary, and payment issues are unlikely to be resolved, forbearanceis unlikely to be granted as it will not be in the best interests of thecustomer. This is very different to the situation immediately after the2008/9 recession and has made it more difficult for firms to “kick the candown the road”.The FCA has guided that, in these exceptional circumstances, “Firms canchoose to make the enquiries they consider necessary in order to judge if apayment holiday best serves the customer’s interests but there is noexpectation under this guidance that the firm investigates thecircumstances surrounding a request for a payment holiday.” 3 Combinedwith operational stress, where a surge of enquiries may inhibit firms’capacity to hold and record high quality conversations with a customer, theability to collect data

IFRS 9 B3.3.6) or a default indicator under the EBA’s 1% rule (although the discount rate for regulatory purposes can differ from the EIR, changing this situation). Non-accrued status under CRR: placing an exposure on “non-accrued” status as per article 178 of the CRR, where interest is not recognised due to