Over the past few weeks, Europe has been gripped by ever grimmer headlines related to the spread of COVID-19 and the Novel Coronavirus. The ratcheting up of restrictions on movement and economic activity by the governments has been accompanied by announcements of unprecedented levels of stimulus. These measures will hopefully lead to blunting some of the most negative consequences of the sudden supply and demand shock to the economic activity but are unlikely to prevent it altogether. We are therefore likely to see a noticeable deterioration in asset quality and hence an increase in non-performing loans (NPLs) ratios across the European banks universe. And this is where IFRS 9, the accounting standard for provisioning of financial assets introduced only recently in January 2018, could inadvertently contribute to making the economic consequences of COVID-19 even worse.
The genesis of IFRS 9Before delving into specifics of IFRS 9 and its predecessor IAS39, let us first start with a few general observations. The question of how is a bank to protect itself from loans which may not be repaid is by no means new. Even Jakob Fugger, the legendary banker in the middle ages who allegedly bankrolled Charles V bid to become the Holy Roman Emperor in 1519, only did so after being provided with ample collateral in the form of mines and mining rights in Tyrol and Upper Hungary. Of course in those days, things were not so easy and attempting to foreclose on collateral might have landed a hapless banker in the dungeons. And it is perhaps no exaggeration to say that this was one of the ways that the age old practice of ‘extend and pretend’ developed and has survived until well into the 21st century.
The introduction of IFRS 9 was meant to blunt some of the worst abuses of extend and pretend by introducing the concept of dynamic provisioning (the framework is also referred to as Expected Credit Loss discussed in detail in the next section). The principle behind dynamic provisioning was that rather than only making provisions for those loans that have already become NPLs, a bank would also need to make a provision for the expected losses on the entire loan book including those loans that were performing. Of course the extent of coverage on performing loans would need to be much lower than on NPLs, but nevertheless this is very different to prior accounting standards whereby a bank only needed to provision for assets that were already non-performing or were likely to become so due to significant deterioration of borrower’s credit fundamentals. In the following section we provide a brief overview of IFRS 9, feel free to skip this section if you are already familiar with IFRS 9.
IFRS 9 basicsIn July 2014, the International Accounting Standards Board (IASB) issued International Financial Reporting Standard 9 – Financial Instruments (IFRS 9), which introduced an Expected Credit Loss (ECL) framework for the recognition of impairment. European banks have adopted IFRS 9 as of 1 January 2018 with a five year transition period. So what’s different about impairment recognition under IFRS 9? Under IAS 39, the standard that preceded IFRS 9, the “incurred loss” framework required banks to recognise credit losses only when evidence of a loss was apparent. Under IFRS 9’s ECL impairment framework, however, banks are required to recognise ECLs at all times, taking into account past events, current conditions and forecast information, and to update the amount of ECLs recognised at each reporting date to reflect changes in an asset’s credit risk.
Three stages of impairment as it applies to loans
Impairment of loans is recognised on an individual or collective basis in three stages under IFRS 9:
Stage 1 – When a loan is originated, ECLs resulting from default events that are possible within the next 12 months are recognised (12-month ECL) and a loss allowance is established. On subsequent reporting dates, 12-month ECL also applies to existing loans with no significant increase in credit risk since their initial recognition. Interest revenue is calculated on the loan’s gross carrying amount (that is, without deduction for ECLs). In determining whether a significant increase in credit risk has occurred since initial recognition, a bank is to assess the change, if any, in the risk of default over the expected life of the loan (that is, the change in the probability of default, as opposed to the amount of ECLs).
Stage 2 – If a loan’s credit risk has increased significantly since initial recognition and is not considered low, lifetime ECLs are recognised. The calculation of interest revenue is the same as for Stage 1.
Stage 3 – If the loan’s credit risk increases to the point where it is considered credit-impaired, interest revenue is calculated based on the loan’s amortised cost (that is, the gross carrying amount less the loss allowance). Lifetime ECLs are recognised, as in Stage 2.
Twelve-month versus lifetime expected credit losses
ECLs reflect management’s expectations of shortfalls in the collection of contractual cash flows. Twelve-month ECL is the portion of lifetime ECLs associated with the possibility of a loan defaulting in the next 12 months. It is not the expected cash shortfalls over the next 12 months but the effect of the entire credit loss on a loan over its lifetime, weighted by the probability that this loss will occur in the next 12 months. It is also not the credit losses on loans that are forecast to actually default in the next 12 months. If an entity can identify such loans or a portfolio of such loans that are expected to have increased significantly in credit risk since initial recognition, lifetime ECLs are recognised.
Lifetime ECLs are an expected present value measure of losses that arise if a borrower defaults on its obligation throughout the life of the loan. They are the weighted average credit losses with the probability of default as the weight. Because ECLs also factor in the timing of payments, a credit loss arises even if the bank expects to be paid in full but later than when contractually due. Last but not least, banks subject to IFRS 9 are required to disclose information that explains the basis for their ECL calculations and how they measure ECLs and assess changes in credit risk. They must also provide a reconciliation of the opening and closing ECL amounts and carrying values of the associated assets separately for different categories of ECL (for example, 12-month and lifetime loss amounts) and by asset class.
Potential impact of asset quality deterioration on IFRS 9 stage migration
In this section we analyse the potential impact of loan migration from Stage 1 to Stage 2 and from Stage 2 to Stage 3 due to deteriorating economic outlook. Under IFRS 9 banks are obligated to reclassify loans from Stage 1 to Stage 2 if payments are 30 days or more overdue or if the loan is subject to forbearance. Note there are also other indicators for a significant increase in credit risk which would also lead to the transition. Before we delve deeper though let’s start with the latest loans and coverage (provisions) for some of the national champion European banks as per the table below.
In the sensitivity analysis we examine three scenarios of loan migration based on deteriorating economic outlook. The first scenario assumes that 10% of Stage 1 loans migrates to Stage 2, and 10% of Stage 2 loans migrates to Stage 3. We run same analysis using a 20% and 30% threshold as well. Furthermore we assume the same level of coverage (provisioning) as before which is probably on the optimistic side but the results are not encouraging even without increasing required level of provisions for the existing Stage buckets.
At best, the additional provisions are a material drag on earnings, but for a number of institutions those additional provisions could not only wipe out earnings but start eating into capital reserves. Furthermore the increase in risk weighting of loans that became NPLs would have a negative impact on capital levels even without taking into account elevated provisions. These factors will weigh on lender’s ability to extend new credit – precisely at the worst possible time as the economy is slowing. The IFRS 9 standard was designed for more normal economic cycle, where slowdown is gradual and does not occur as a result of a simultaneous supply and demand shock that we are experiencing at present. But the real world is of course much more complicated than a financial model.
Calling for a time out from IFRS 9
Following the pleas for at least temporary relaxation of the rules from the industry, on 20 March the ECB’s Banking Supervision arm has introduced supervisory flexibility regarding the treatment of NPLs, in particular to allow banks to fully benefit from guarantees and moratoriums put in place by public authorities. The key points from the ECB statement are as follows:
We note that there is a precedent of changes to the rules in the past in times of stress. In 2008 there was an amendment to IAS 39 accounting rules such that banks were able to reclassify exposures from their trading books to AFS or Held to Maturity (HTM, loan book). As such, they did not have to recognise some mark-to-market losses on their trading portfolios.
There are a number of unanswered questions where we would like to have more clarity. For example, if banks are asked to restructure loans, do they do so such that NPV is reduced (ie bank takes part of the cost)? Or are the payments (principal and interest) delayed on NPV neutral basis such that the customer is still responsible for paying off the entire amount? Will governments step in and explicitly guarantee some of these loans (the benefit of this would be significant reduction in risk weighting for these loans)?
Where there is a big problem… there is a need for big solution
The former US senator Daniel Patrick Moynihan is credited with saying that “Everyone is entitled to have their own opinion but not their own facts.” If a borrower cannot meet the payment schedule on a loan, by any objective measure the loan has become non-performing. While regulatory forbearance can certainly give banks valuable time to deal with NPLs, the problem will not go away by itself. If European banks’ balance sheets are saddled with a high proportion of NPLs, this is a major drag on financial intermediation – a very important point in European context where banks are responsible for a vastly larger proportion of financial intermediation than in the US. The balance sheet clean-up will therefore become a matter of highest urgency if policy makers want to restart European economy following the damage caused by COVID-19. And whereas in the recent past, the NPL cleanup was very much driven by national authorities, we think this time the size of the problem might need a European rather than national solution. So what could be done? Here are a few suggestions:
At a risk of invoking some of the more dramatic pronouncements of political leaders over the past few days – we are currently in the fog of war. Nobody knows yet the extent of economic damage that will be inflicted by the prolonged reduction of economic activity due to social distancing and other measures aiming to curb the spread of COVID-19. The extent of the damage will ultimately determine the extent of the remedies needed.
Head of Research