Dear CFO letter

The PRA has written to the CFOs of selected deposit-takers with thematic feedback from the 2020/2021 round of written auditor reporting.

Each year the PRA receives a written report from firms' auditors responding to questions of particular supervisory interest. The main thematic findings are collated and then shared in a Dear CFO letter - individual firms and auditors are not identified. Firms also receive specific feedback through their supervisory continuous assessment meetings and through trilateral meetings with supervisors and auditors.

This year's Dear CFO letter focused on thematic findings related to IFRS9 expected credit losses (ECL), benchmark reform and climate change. 

The PRA expects firms to implement ECL approaches as well and as consistently as possible. It has previously set out its views on “high quality practices” and expects firms to make available appropriate resources and budgets to enable ECL methodologies to evolve. The PRA welcomed progress made in some areas but cautioned that temporary changes made to strengthen ECL processes under the stress of the pandemic need to be made more permanent. 

The PRA's observations focus on model risk, economic scenarios and recovery strategies:

Model risk:

Model performance deteriorated in 2020. This was partly due to distortions in credit data resulting from high levels of government support, but also to limitations in firms' approaches, including a lack of granularity in reflecting sector-specific risks. Risk model controls operated with an inherent lag and varying degrees of disruption, and, in general, failed to identify the full scale of model performance issues.

Firms relied on post-core model adjustments (PMAs) informed by ad hoc processes and data that sat outside their core controls. This placed increased pressure on limited credit risk modelling resource and management's ability to oversee complex models effectively.

Firms are expected to:

• Ensure adequate resourcing, infrastructure and governance to monitor model performance.
• React to weaknesses identified. 
•  Formalise frameworks for assessing sectoral risks and integrating relevant pandemic data into models.
•  Make appropriate use of PMAs based on expert judgement to ensure that provisions reflect actual credit risk expectations. 
• Prioritise strategic plans for longer-term model redevelopment to reduce reliance on PMAs.

Economic scenarios:

Use of peer benchmarking and sensitivity analysis to inform challenge around alternative economic assumptions increased but processes were time-consuming and manual. Access to timely, granular and comparable data to support peer benchmarking was limited, particularly for severe downside scenarios.

Firms are:

• Expected to develop capabilities to perform more comprehensive economic sensitivity analysis more quickly to inform robust governance and support comparable public disclosures. They will need to define the capabilities they need and set realistic timelines for implementing them. 
• Encouraged to work together and with the PRA to improve access to peer benchmarking data in times of uncertainty. The PRA continues to support efforts to enhance public disclosures, including through the Taskforce on Disclosures about Expected Credit Losses (DECL) recommendations.

Recovery strategies:

Recovery strategies were reviewed for the first time in the last auditor reporting cycle. Firms made less progress in adopting high quality practices relating to recovery strategies used in estimating Loss Given Default (LGD) than in other areas of ECL. There was limited use of adjustments to LGD to reflect the elevated risk that past experience may not be a good predictor of future recovery rates. 

Firms should:

• Monitor the impact of unwinding of government support so that they can make realistic assumptions about recovery strategies for vulnerable sectors. COVID-19 lessons learned.

COVID-19 lessons learned

The PRA identifies eight areas as a result of lessons learned from the pandemic where firms need to take further mitigating action to recognise changes in credit risk in a timely way. The first five relate to model risk, the sixth and seventh to recovery strategies and the eighth to economic scenarios.

Firms should:

1. Set strategic plans for longer-term model development, recalibration and validation, and consider the sufficiency of resourcing in modelling teams to deliver those plans.
2. Develop clear strategies and processes for integrating data from periods of stress into models that can be consistently applied over time. 
3. Build capabilities for more granular sector level analysis and establish formal frameworks to assess vulnerable sectors and high-risk retail cohorts in times of stress. 
4. Embed more agile and robust control frameworks that can adapt to the need to increase the use of ad hoc data in stress, including the scope of validation for models and data used to calculate PMAs. 
5. Define operating boundaries for models and put in place metrics to identify when those boundaries are likely to have been breached, to help inform more focused use of PMAs. 
6.  Consider whether the historical recovery experience used to calculate LGD is consistent with the firm's forward strategy for working with customers, to inform challenge of LGD. 
7. Consider whether and how recovery strategies and rates for higher risk sectors are likely to differ. 
8. Use robust quantitative analysis to inform judgements relating to probability weights.Use robust quantitative analysis to inform judgements relating to probability weights.

The transition to alternative Risk-Free Rates (RFR) remains a significant financial and operational risk. The PRA reiterates the benefits of automated systems to support aggregate reporting of IBOR exposures and the importance of controls over manual processes. It also identifies opportunities for:

• More active management of transition risks and for ensuring plans to mitigate these risks are kept up to date. 
• Greater use of independent review and challenge of RFR transitioning plans. 

The PRA will use next year's round of written auditor reporting to explore risks related to climate change. The PRA's main supervisory concern in relation to financial reporting is that firms may not fully capture the impact of climate-related risks on balance sheet valuations.

Auditors will be asked to provide view on the robustness of firms' risk assessments of the impact of climate change on balance sheets and the quality of underlying data, models and processes to support these assessments.