Following its statement on 20 March, the PRA published a letter to the CEOs of UK Banks on 26 March providing further guidance on the treatment of payment holidays and similar schemes offered by banks and building societies on all loans (not limited to government-endorsed payment holidays on mortgages) as well as economic forecasts used in calculating expected credit losses (ECL) in terms of IFRS 9:
It is not considered appropriate to assume that there has been a significant increase in the lifetime credit risk on all loans to borrowers that make use of government endorsed payment holidays and other similar schemes voluntarily offered by firms due to short-term liquidity constraints. Some high-level, but balanced, method, taking into account materiality, would need to be used to allocate a portion of these loans to Stage 2 so as to comply with the principles underpinning IFRS 9.
The letter also clarifies that payment holidays are not expected to trigger the counting of days past due or automatically result in a borrower being considered unlikely to pay under Capital Requirements Regulation (CRR). Banks are asked to carefully consider the breaches of loan covenants due to COVID-19. And finally, the PRA reminds firms that, in 2020, they are able to add CET1 equivalent to up to 70% of `new' provisions due to IFRS 9 back to capital as part of the transitional arrangements in CRR.
The PRA letter is helpful in providing specific guidance to assist banks in navigating the significant judgements required to comply with IFRS 9 in uncertain conditions and follows similar statements from the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) this week.
The ESMA statement is broadly aligned with the guidance provided by the PRA and emphasises that assessing whether credit risk has increased significantly is a holistic assessment of a number of quantitative and qualitative factors and should capture changes in lifetime risk of default i.e. over the entire expected lifetime of the instrument.
It also provides guidance on accounting for government guarantees and assessing whether economic support measures offered to borrowers should be accounted for as a modification. If a modification provides temporary relief to a borrower and the net economic value of the loan is not significantly affected, then it would be unlikely to be considered substantial.
ESMA highlights the importance of disclosing significant risks and judgements in the financial statements.
The EBA statement contains similar guidance on the application of IFRS 9, also noting that payment holidays should not automatically be considered “forbearance” and that unlikeliness to pay should be considered on a case-by-case (or portfolio) basis.
It is clear that in addition to promoting consistency, the PRA and the European regulators want to ensure that banks to do not overstate ECL based on unsupported assumptions, as this could prompt behaviour that leads to unnecessary tightening in credit conditions.
However, the pragmatic approach urged by the regulators does not give free rein - an appropriate balance needs to be struck between regulatory guidance and IFRS 9 accounting requirements.
This presents major operational challenges to banks. The PRA letter suggests that the models and assumptions used by banks in normal times cannot necessarily be relied upon in these exceptional circumstances. It could prove difficult for banks to gather incremental and up-to-date information needed to assess forbearance, significant increase in lifetime risk of default and to calculate any overlays required to provide robust ECL at Q1 reporting and beyond. Banks need to consider strategic enhancements to data architecture and credit processes to allow greater flexibility in times of significant change and uncertainty.
The Financial Conduct Authority (FCA), Financial Reporting Council (FRC) and Prudential Regulation Authority (PRA) also issued a joint statement (PDF 487 KB) on 26 March to companies, auditor, investors and other stakeholders that includes:
Changes to previous market practices are likely to include:
The joint statement by the FCA, FRC and PRA acknowledges the challenges of financial statement preparation and audit in the current environment. Users of financial statements would also expect to see sufficient disclosures around the risks posed by COVID-19 to a firm's operations and the steps the firm is taking to mitigate these risks.
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