Financial institutions (banks, credit unions and lending entities) have been accounting for provisions for credit losses using an expected credit loss model since the adoption of IFRS 9 Financial Instruments (IFRS 9). The current economic environment as a result of the COVID-19 pandemic presents financial institutions with significant challenges to estimating ECLs on their loan portfolios. The current COVID-19 impact and negative forward-looking macroeconomic factors resulted in the six largest Canadian banks recording approximately $7 billion in total provisions for credit losses during the third quarter, of which nearly $3 billion represent provisions for Canadian portfolios. Since the beginning of the fiscal year, total credit loss reserves have increased approximately 70% on average. Similar or higher increases in ECLs are expected for mid-size banks, credit unions and lending entities. Many governments, capital market regulatory authorities and central banks across the globe have introduced relief measures to ease the financial and economic impact of COVID-19, including payment moratoriums, capital regulatory reporting guidance and government stimulus packages. As the pandemic continues to evolve, it is difficult to estimate the full extent and duration of the crisis as well as the future business and economic impact.
This ambiguity creates challenges for financial institutions to estimate ECLs. In particular, there are two key areas of judgment under the standard: determining whether there has been a significant increase in credit risk (SICR) and applying forward-looking factors in the measurement of ECLs. SICR is the first step to determine if a lifetime or twelve month ECL should be estimated on a loan, and the standard provides principals to be followed but does not set out clear criteria to be used.
Information that is reasonable and supportable to assess SICR and to measure ECL is rapidly changing as the pandemic persists, and mid-size and smaller financial institutions may find it difficult to apply forward-looking factors to their ECL models due to the increased resources required to capture current and relevant data points. To aid management in implementing the requirements of the standard while also easing pressure on regulatory capital, several regulators and the International Accounting Standards Board (IASB) provided guidance on how key IFRS 9 principles should be applied. For example deferral or payment holidays on loans should not automatically result in loans being considered an SICR. Events that would have likely triggered an SICR pre-pandemic may not be appropriate in the current economic climate, particularly if the borrower is experiencing temporary cash flow disruption. The challenge for financial institutions is to determine which borrowers were likely to experience payment difficulties prior to the onset of the global crisis. Financial institutions would therefore need to consider other indicators to determine the appropriate treatment, which may include among others, the borrowers’ current employment status, the industry the borrower is in or exposed to, and the ability of the borrower to return to regularly scheduled payments as restrictions due to the pandemic ease. Entities are likely to have limited borrower-specific information to make these determinations on an individual borrower-basis and might need to make holistic assessments that look beyond past due information and use of payment deferrals.
The IASB suggests entities avoid applying the standard mechanistically and to use the flexibility inherent in IFRS 9 when estimating ECL. The standard requires entities to develop ECL estimates based on information about past events, current conditions and forecasts of future economic conditions reflecting the best information available. The IASB recognizes that it is likely to be difficult to incorporate the specific effects of COVID-19 and government support measures on a reasonable and supportable basis and if the effects of COVID-19 cannot be reflected in ECL models, entities should consider management overlays or adjustments. Additionally, greater emphasis should be placed on disclosures in order to provide increased transparency and information for users to better understand how uncertainties have been considered to estimate ECL.
Canadian and European banks reported an increase in ECLs in their most recent quarter earnings (Canada–July 31, Europe–June 30) as compared to previous years. There was also an increase in loss allowance ratios and an increase in the percentage of loans classified as stage 2 (loans that experienced a SICR). Banks updated their base line and downside forward-looking information scenarios to reflect the pandemic’s economic impact. Some banks also used management overlays on top of the amounts calculated by their ECL models in response to uncertainty in the pandemic’s economic impacts.
Mid-size credit unions and lending entities are expected to face similar complexities and uncertainties in their estimation of ECLs. Credit unions that adopted IFRS 9 in the previous year would be required to revisit their estimates, models and accounting policies to determine if their approach to SICR and impairment reporting is still appropriate. It is advisable for management to update their estimates and review the appropriateness of historical loss information used in their ECL estimations at their quarterly reporting, to signal early warnings in advance of their year-end reporting. This would enable management to assess if management overlays would be required over and above ECL generated by their models.
At RSM our team of IFRS 9 professionals in technical accounting, credit risk modelling, economics and risk consulting work with credit unions and lending entities to review and update ECL models.