PRA Dear CEO letter on IFRS 9, capital requirements and loan covenants

29 April 2020

Bank of England PRA Dear CEO COVID-19 Letter: IFRS 9, capital requirements and loan covenants summary

On 26th March 2020, the PRA published a Dear CEO letter that set out guidance on the consistent and robust application of IFRS 9 and the regulatory definition of default, the treatment of borrowers who breach covenants due to COVID-19 and the regulatory capital treatment of IFRS 9.

The PRA is considering a range of regulatory and supervisory measures to alleviate the financial impact of the coronavirus as well as maintaining the safety and soundness of authorised firms. The measures are set out to ensure that banks continue to lend to retail customers and businesses, to ensure the economy is supported and also provide detailed market disclosures.

The letter sets out guidance in three areas:

The consistent and robust IFRS 9 accounting and the regulatory definition of default

  • The sudden onset of COVID 19 makes it difficult to estimate Expected Credit Losses (“ECL”). Given the current uncertainty and lack of reasonable and supportable forward-looking information that IFRS 9 requires, the PRA clarified that firms are not to under or overstate ECL but recognise appropriate levels of ECL. Overstatement of ECL could risk unnecessary tightening in credit conditions.
  • The PRA have requested firms to consider the governance process around economic scenarios, probability weights and additional overlays. Although it is for each firm to form its own view as to appropriate ECL levels that adhere to the requirements of IFRS 9, the PRA sets out the standards that it believes are required to ensure well-balanced judgements about ECL are made in light of COVID-19.
  • The PRA also asked that, where the borrower makes use of a payment holiday or other government relief, then this need not automatically trigger a default under the Capital Requirements Regulation (“CRR”) or automatically consider this to be an indicator of significant increase in credit risk (“SICR”). The firm should assess whether this due to short-term illiquidity or credit deterioration. 

The treatment of borrowers who breach covenants due to COVID-19

  • During the pandemic, it is more likely that a borrower will breach ‘normal’ covenants. For example, a breach may arise due to a loss of earnings or delays in audited financial statement being provided. Due to the likelihood of this occurring, the FCA and PRA, in a joint statement, have asked firms to not impose charges or restrictions on a customer following a covenant breach.
  • The PRA have also requested that a breach of a covenant relating to the modification of an audit report should not automatically trigger a default under the CRR.

The regulatory capital treatment of IFRS 9.

  • Transitional arrangements in CRR mean that the regulatory capital impact of ECL is being phased in over time and during 2020, firms can add back to CET1 up to 70% of IFRS 9 ECL provisions.
  • In terms of the regulatory capital treatment of IFRS 9, firms are asked to consider the guidance in the annex to the Dear CEO letter when taking decisions about ECL and regulatory capital estimates in the coming days, weeks and months.

The PRA notes that the measures outlined in the letter, which have been evolving rapidly and could evolve further, are expected to remain in place through the period of disruption cause by the COVID-19 pandemic.

Annex: Guidance on estimating expected credit loss (“ECL”) and the regulatory definition of default

The uncertainties caused by the COVID-19 pandemic and the response to it are raising a number of important ECL application issues.

This annex discusses two issues that are particularly relevant to March period-end reporting and also discusses the related regulatory capital treatment of the definition of default.

The objective in discussing these issues is to encourage a robust response that is consistent and based on reasonable and supportable forward looking information so as not to under or over estimate ECL.

IFRS 9 and forward-looking information

Changes to ECL will be subject to very high levels of uncertainty as there is a lack of reasonable and supportable forward-looking information on which to base these changes due to the current COVID-19 crisis.

As a result, it is crucial that ECL is applied well and on the basis of the most robust reasonable and supportable assumptions possible in the current environment. The PRA believes that the immediate implication for financial reporting is on (i) economic scenarios and probability-weights and (ii) model adjustments.

The PRA have recommended that firms make well-balanced and consistent decisions that involve:

  • Considering not just the potential impact of the virus, for which there are clear signs that economic and credit conditions are worsening but also take account of the unprecedented level of support provided by governments and central banks domestically and internationally to protect the economy.
  • Reflecting that the economic shock from the pandemic should be temporary.  Although its duration is uncertain, the actions that are being taken to support borrowers, which include payment holidays and offering facilities that are allowing normal repayments to resume, mean that some borrowers will not suffer a deterioration in their lifetime probability of default.
  • Considering forecast periods is likely to involve, in many cases, a shortening of the period for which the impact of COVID-19 is forecasted, with a much quicker return to the long-term historical trend.
  • Avoid double-counting between any adjustments for COVID-19 and existing adjustments for other uncertainties such as EU withdrawal.

Treatment of payment holidays and similar schemes

The PRA’s expectation is that eligibility for, and use of, the UK Government’s policy on the extension of payment holidays should not automatically trigger, other things being equal, the loans involved being moved into Stage 2 or Stage 3 for the purposes of estimating ECL or trigger a default under the EU Capital Requirements Regulation (“CRR”).

The PRA do not consider the use of a COVID-19 related payment holiday to trigger the counting of days past due or generate arrears under CRR. They also do not consider the use of such a payment holiday to result automatically in the borrower being considered unlikely to pay under CRR.

Firms are reminded to apply sound risk management practices regarding the identification of defaults. Firms should continue to assess borrowers for other indicators of unlikeliness to pay, considering if this is a temporary measure due to the crisis.

To date, payment holidays granted in response to financial difficulty have generally been regarded as a reliable proxy for identifying whether a Significant Increase in Credit Risk (“SICR”) has occurred. Where government-endorsed payment holidays (and similar schemes) have been agreed, the position is different and it should not be assumed that those borrowers have suffered a SICR. The PRA does not consider the use of government-endorsed payment holidays by a borrower to trigger the counting of days past due for the 30 days past due backstop used to determine SICR or the 90 days past due backstop used to determine default on its own.

Assuming a SICR has occurred for all the borrowers that benefit from a payment holiday as a result of COVID-19 is likely to be a poor reflection of the reality of the situation. Use of payment holidays may indicate short-term liquidity or cash flow problems but is likely to provide little information to enable banks to differentiate between borrowers’ lifetime credit risk.

The PRA’s understanding is that, in the short-term, the circumstances surrounding a request for a payment holiday may not be investigated sufficiently for the lender to obtain sufficient information to be able to use the granting of the payment holiday as a sole indicator that SICR has occurred or even as the basis to adjust the borrower’s probability of default.

The treatment above is consistent with payment holidays being granted as part of an unprecedented government-led effort to support the economy and is similar to FCA guidance in regards to mortgage payment holidays, for example:

‘There is no expectation under this guidance that the firm investigates the circumstances surrounding a request for a payment holiday’, and

‘There should be no negative impact on the customer’s credit score because of the payment holiday’.

Customers now have additional rights to payment holidays to manage liquidity, regardless of whether this was a feature of their original contract.

To assist firms identifying where a stage transfer is required, the PRA observes that:

  • Some high-level but balanced method would need to be found to allocate a proportion of the loans on which payment holidays have been granted to Stage 2 so as to comply with the principles underpinning IFRS 9. It is unlikely to be appropriate simply to assume a SICR event unless there is evidence to the contrary due to the absence of detailed information.
  • Provided lenders’ other SICR criteria operate effectively, a method that the PRA considers to be credible is to assess whether the overall impact on ECL could be material by considering the differential between 12 month and lifetime ECL for the volume of customers that have received a payment holiday but show no other indicators of SICR. If deemed material, an overarching allocation could be made based on a sample of accounts.

To achieve consistency in the longer-term, it may be necessary for lenders to establish new SICR policies and processes for monitoring and accounting for the adverse economic impact of the virus.

Treatment of borrowers who breach covenants

Due to the pandemic, a covenant breach or waiver of a covenant relating to a modification of the audit report attached to audited financial statements, all things being equal, should not automatically result in the loans involved being moved into Stage 2 or Stage 3 for the purposes of estimating ECL or trigger a default under CRR.

This expectation extends to other covenant breaches and waivers of covenants that are directly linked to the COVID-19 pandemic, with firms needing to make appropriate assessments.

The PRA consider that, in the short-term, such delays, modifications and material uncertainties will be much more frequent and may be due to factors that are not sufficiently closely related to the borrowers’ credit risk to be used as a reliable proxy for identifying SICR.

The underlying reason for delays, modified audit opinions or material uncertainties about going concern in the context of the current environment will need to be assessed on a case-by-case basis. If an assessment outcome is not related to the solvency or the liquidity of the borrower, then the conclusion will generally be that neither a SICR nor default has occurred.