IFRS 9 | 2Q23 results update: the end of boom and bust?

As an update to our last IFRS 9 results blog, 1Q23 results update and “cost of living” focus, and our special piece on IFRS 9 and the Mortgage Charter this post gives a 2Q23 update on the loss reserving trends and outlook for UK banks.

Overall, the quarter was uneventful in terms of ECL KPIs, although not in terms of movements in interest rate expectations. Credit performance remained strong with Stage 3 assets as a proportion of total loans broadly stable. Nevertheless, there were signs of delinquency creeping up at the margins, especially on mortgage portfolios. The UK economic outlook shifted too, with improvements in GDP and unemployment expectations offset by higher base rate predictions and falls in property prices. Overall though, these factors had a limited impact on ECL.

Cost of risk and ECL cover were both broadly flat in the quarter and running at “normal” pre-Covid levels. Banks’ outlook statements suggested that the aggregated year-end cost of risk would be c. 35bp, implying an impairment charge of c. £8bn. With the 1H23 charge at c. £3bn (equivalent to an annualised cost of risk of c. 27bp), this implies a further c. £5bn to come in 2H23, (c. 46bp aggregated cost of risk). The contribution of Post Model Adjustments (PMAs) to ECL was also broadly flat in the quarter.

Loan books appear to be fundamentally stronger than in the past and the larger banks seem to consider that an average borrower will probably weather the storm under the current economic outlook and that risk is likely confined to the tail of more marginal borrowers with higher indebtedness and more limited debt service capacity.

The question for UK lenders is, with household and business debt service capacity having been under pressure for some time with little credit response to show for the pain, whether it really is “different this time” and whether improvements in portfolio fundamentals might smooth the cycle?

There is, after all, some risk that this is wishful thinking and that there exists a ticking “time bomb” buried in banks’ balance sheets from the lagging transmission of monetary policy and the erosion of liquidity hoarded during the Covid crisis. Time will tell. But, if the labour market and general economy stay as strong as currently predicted, it seems unlikely that a sudden trigger event will occur, limiting losses to the margins of mainstream portfolios and specific “hot spots” rather than becoming a widespread issue.

The second half of 2023 will be interesting then as we see the wave of mortgage refinancing wash through at higher interest rates, with the potential knock-on consequences for mortgage delinquencies and contagion into consumer lending. However, the Mortgage Charter and other fundamental improvements may yet alleviate some of this risk, leaving us all still guessing at year-end.

As usual, we have analysed the aggregate position of Barclays, HSBC, Lloyds, NatWest and Santander UK as a proxy for the wider UK banking sector (on a “volume weighted” basis to prevent distortions from balance sheet size). More detail below with crunchy analysis to support our narrative.

1. Credit performance remains strong, (again!) with Stage 3 assets as a proportion of total loans remaining broadly stable (again!).

Credit performance stayed strong, albeit several banks noted some increases in delinquency at the margin. Some of this related to portfolio growth and a slight relaxation of lending criteria, as well as early stress in banks’ variable rate mortgage portfolios. Consistent with this, we noticed an uptick in MLAR mortgage new-to-arrears volumes together with a slightly smaller uptick in repossession volumes in 1Q23 versus pre-Covid levels. Overall, arrears and delinquency remained low and Stage 3 as a proportion of loans and advances was flat (figure 1).

Despite the pressure on household finances, personal insolvencies stayed below 2019 levels (figure 2). However, it’s worth noting that applications for “breathing space” per the , which are a potential leading indicator for unsecured lending defaults have increased in recent quarters to an average of c. 22k registrations per quarter from c. 18k per quarter over 2022 (Insolvency Service Statistics).

While corporate insolvencies continued to increase (figure 2), this was limited to small businesses with very limited bank borrowing and isn’t translating into stress on bank balance sheets, notwithstanding higher observed default rates on BBL borrowers.

2. An improving economic picture, and a brighter outlook for GDP and unemployment, offset by higher base rate predictions and expectations of falls in property prices, led to a limited net impact on ECL.

For some time we have looked at average weighted peak UK unemployment as a simple(!) metric for tracking economic outlook.

While there has been an improvement in the unemployment outlook over the quarter, the shift to higher base-rates and sustained inflation blunt the effectiveness of this approach. Figure 3 below shows how the average and range peak UK unemployment expectations have changed over time.

Meanwhile, figure 4 below looks at the change in base case (which is the most powerful driver of Multiple Economic Scenarios ECL) across our sample of banks between 4Q22 and 2Q23.

The expected HPI fall-to-trough has increased although, interestingly, the range has narrowed considerably. Despite these worrying YoY HPI movements, house prices didn’t move much between 4Q22 and 2Q23 (between -2% and +2% depending on which index you look at, refer to figure 6 below). However, the mortgage market does look weaker (figure 5). After borrowers had started to recover from the first round of rate changes, further hikes starting in May threw that into reverse delivering a knock-on impact on house prices. Commensurate with this, expectations for peak bank rate have increased.

The change in interest rate environment has also hit Commercial Real Estate (CRE) prices. In the July 2023 Financial Stability Report the Bank of England commented that UK CRE prices have fallen by “nearly 20% since their mid-2022 peak” (although we acknowledge that this is a bit of a blunt statement for a very diverse asset class. The London Office Crane Survey Summer 2023 | Deloitte UK and the Regional Crane Surveys | Deloitte UK provide a more segmented view on CRE confidence). The published base case scenarios for our sample of banks suggest the fall has nearly bottomed-out, with a further c. 5% to go to the trough (compared to c. 40% peak-to-trough in the Global Financial Crisis).

On the other hand, the outlook for GDP improved with fears of recession replaced by an expectation of sluggish growth. Despite early signs of the tightness in the labour market unwinding, expectations for unemployment were also broadly stable, and significantly better than the 20-year average unemployment rate of 5.6%16. These two factors provide a strong underpinning to the UK credit environment and will likely limit default risk.
 

3. Demand for lending is muted. Corporates are continuing to de-leverage and, with the changing interest rate environment, mortgage growth has slowed significantly. Conversely, demand for consumer lending, especially credit cards, saw growth in 2Q23.

Figure 7 below shows lending balances for different asset classes rebased to Dec 2019.

After the initial dash for liquidity, when smaller businesses drew on existing facilities and government-backed facilities, they started de-leveraging in early 2021 and this trend has continued. For larger businesses the initial growth in borrowing has been sustained with balances staying broadly flat after mid-2020 and no concerns over near-term refinancing needs.

Mortgage lending has been the engine of balance sheet growth over the last few years but, with the change in interest rate environment, has taken a big hit. Gross mortgage lending saw a big decline in the first half of the year with a commensurate increase in remortgage activity as house purchases have dropped. However, credit cards and other consumer lending both saw growth in 2Q23 albeit with balances still sitting well below 4Q19 levels.
 

4. Stability in credit fundamentals and the offsets between the changes in different elements of the economic outlook delivered flat ECL metrics in the quarter.

Cost of risk and ECL cover were both broadly flat in the quarter, running at “normal” pre-Covid levels. Banks’ outlook statements suggested that the aggregated year-end cost of risk would be c. 35bp, implying an impairment charge of c. £8bn. With the 1H23 charge at c. £3bn (c. 25bp annualised cost of risk), this implies a further c. £5bn to come in 2H23 (c. 45bp aggregated cost of risk).

5. The landscape for Post Model Adjustments was stable too

Banks’ models are still struggling to cope with aspects of the high interest rate, high inflation environment and firms are using PMAs to make sure that ECL balances cover the complete range of risks. After the distinct change in the make-up of ECL at 4Q22, where the downgrade in economic outlook prompted a big increase in model provision and Covid-related PMAs were largely unwound, the picture has been stable over 1H23.

6. Loan books appear fundamentally stronger than in the past.

In several of our previous blogs we have commented that, on average, portfolios are now less risky compared to 4Q19 and to 2007/8 in the run up to the Global Financial Crisis (GFC). The longer-term drivers of this trend are:

• Post-crisis de-risking of balance sheets, including continued run-off of lingering legacy assets.
• Continued discipline in origination and underwriting practices after an initial tightening in 2009/10.
• Regulatory intervention around affordability testing for retail lending: for regulated mortgages via MCOB affordability testing, the use of stressed interest rates for affordability assessments, and Loan-to-Income limits; for Buy-to-Let via SS13/16 clarification on affordability testing standards; and for consumer lending via CONC rules on affordability testing and rules on persistent debt for credit cards.
• This means that businesses and individuals are now less indebted than they were in the run-up to the GFC. The Bank of England assessed in its July 2023 Financial Stability Report that, if the current expectations for interest rates were fully priced in, debt service profiles and indebtedness would still be better than historic highs.
• Changes to conduct standards for supporting borrowers in financial difficulty with lenders are also more likely to lead to forbearance than in the past.

Over the shorter-term, other drivers come into play. These include:

• The slight change in asset mix since 4Q22, away from consumer lending toward lower-loss rate mortgages, with an increase in state-backed Covid-era lending to businesses.
• Tighter underwriting criteria since 4Q19 leading to a general improvement in risk profiles, especially for term portfolios like personal loans and auto finance where the whole book will now have been originated under these more stringent terms.
• There have been significant increases in house prices and car prices since 4Q19 (c. 24% and c. 27% respectively).
• Work from the Bank of England in the June 2022 Financial Stability Report showed that lower income households, who are most impacted by inflation, have a smaller share of household debt while higher income households, who tend to hold debt, have a higher savings ratio.
• Specific crisis forbearance interventions such as Covid temporary payment holidays and the recently announced Mortgage Charter.

This improvement in risk profile was supported in the Bank of England's 2022/23 ACS stress testing results through lower credit impairments (five-year impairment of £125bn vs. £134bn in 2019 at constant currency) despite similar economic severity in the stress scenario and the headwinds from higher inflation and bank rates at the starting point (which were judged to have increased impairments on mortgages by 15% and on unsecured lending by 30% and for 70% of the impairments on mid-corporates due to higher risk sectors affected by inflation/supply chain issues).
 

7. Credit risk isn’t a game of averages – losses come from the tail and there are “hot spots” that may lead to higher losses.

Despite these trends, there are still some areas of concern that may lead to higher losses.

Mortgage refinancing, for example, currently presents a specific credit risk. Although c. 4.5m mortgage accounts have already experienced an increase in payments since rates started to rise, a further 4m are still to refinance before the end of 2026 and will likely experience a higher payment shock.¹⁷

Figure 12 below illustrates the average stressed underwriting rate used at the date of origination (calculated by adding 3pp to the average reversion rate at the time of origination until 1 Aug 2022, falling to 1pp thereafter) vs. current quoted average 2-year and 5-year 75% LTV mortgage interest rates. For almost all customers originated since mid-2018, the stressed interest rate used at origination for affordability testing is higher than the average quoted rate available today. While this is comforting at aggregate level, there are still a minority of borrowers who will experience a significant payment shock upon refinancing (Chart 2.3 in the July 2023 Financial Stability Report gives an interesting view on this showing the number of mortgage holders who will experience a different levels of payment shock).

Buy-to-Let presents a particular risk, with the source of cash for servicing debt coming from the tenant rather than the borrower’s income. Tenants tend to have lower incomes, higher unsecured borrowing and are potentially more susceptible to inflation. Landlords are also under pressure from significant increases in mortgage costs and an erosion of margin in other areas (e.g. the reduction in tax-deductibility of mortgage payments and a need to comply with more stringent energy efficiency regulations).

In response, there is some evidence that smaller landlords are exiting the market with recent RICS survey data showing a consistent net negative balance in landlord instructions. However, the same data shows rental demand increasing with ferocious competition between prospective tenants. Rightmove rental data shows that new rents are 33% higher than before Covid. The level of competition in the market for rental properties, the benign unemployment outlook for tenants, and landlords’ ability to increase prices gives some comfort over credit prospects for the buy-to-let asset class. However, as with owner occupier mortgages, there will be some cases in the tail where the business case on a portfolio doesn’t stack up when a refinancing event kicks in.

The same themes apply to corporate and consumer borrowers, with a likely tail of obligors who are in a more marginal position and less able to cope with erosion in real income/profit margins and the increasing cost of debt. In corporate lending, some sectors are also likely to be vulnerable to higher interest rates, inflation, and supply chain issues. For example, in the results of the 2022/23 ACS, the Bank of England calls out manufacturing, wholesale and retail trade, real estate, and construction.

And, in-line with the theme of risk being more focussed around indebtedness, the Bank of England has also expressed concern that highly leveraged lending to corporates may also be a “hot spot” as interest rates rise.
 

8. Outlook: is this the end of “boom and bust”? (with thanks to Gordon Brown)

Credit managers feel inclined to expect and prepare for the worst, with many of us predicting a wave of defaults since early 2020 that is yet to materialise. Borrowers’ debt service capacity has been under pressure for at least 18 months now yet, other than some small increases in mortgage arrears within historic norms, there is little to see in terms of credit outcomes to date.

Do these improvements in fundamentals mean that things will be different this time and that losses will be lower? Indeed, will we even be able to tell, assuming the labour market remains robust and the UK economy avoids a recession?

The larger banks consider their “average” borrowers will likely weather the storm under the current economic outlook and that credit risk is confined to the tail of more marginal borrowers with higher indebtedness and more limited debt service capacity. This is evidenced in two ways:

• Firstly, with ECL coverage at 2019 levels, with lower default rates and higher quality portfolios, on a like-for-like basis, reserving is more cautious than in 4Q19. This feels about right; back then the concerns were focused on the potential impact of Brexit, but arguably the economic outlook is weaker now.
• Secondly, the Bank of England Credit Conditions Survey tells us banks are reporting improvements in default rate expectations for all segments except for mortgages, while small businesses remain slightly elevated.

Figure 13 and 14 show the change in default rates per portfolio since the start of the 2008 financial crisis.

However, bank write-offs are at historic lows (figure 15) and will surely normalise at some point, although it might be difficult to tell the difference between normalisation and the start of a bigger problem when they start rising!

History has had an uncomfortable habit of showing claims that “it’s different this time” to be hubris. There is an alternative view: is there a ticking time bomb from the lagging transmission of monetary policy and the switch to a predominantly fixed-rate stock of mortgages, as well as businesses and individuals eating through liquidity hoarded during Covid? Are we wilfully ignoring early warning signs like the uptick in payment holiday registrations?

Time will tell. But, if the labour market and general economy stay as strong as currently predicted, it seems unlikely there will be any kind of sudden trigger event, and that losses will be limited to the margins of mainstream portfolios and specific “hot spots” rather than becoming a widespread issue.

The second half of 2023 will be interesting as we see the wave of mortgage refinancing washing through at higher interest rates with potential knock-on consequences for mortgage delinquencies and contagion into consumer lending. However, the Mortgage Charter and other fundamental improvements may smooth some of this out leaving us guessing at year-end.

Aside from trying to predict the future trajectory of credit, there are several more practical areas of IFRS 9 where lenders need to remain vigilant:

• Model monitoring and calibration: in the context of a changing economic environment, high quality model monitoring is essential to ensure that models are fit-for-purpose. Checking that outputs are accurate and calibrating where necessary are critical steps towards high quality ECL practices. This includes clarity over the treatment of Covid-era data (especially LGD) and high inflation data (especially survival rates).
• Non-linearity and ranking of scenarios: practices around MES are still developing and some firms have weaknesses in relation to their assessment of the appropriateness of the ranking of economic scenarios in terms of loss outcomes and the adequacy of the extent of non-linearity for the more severe scenarios.
• Significant Increase in Credit Risk: SICR continues to show significant variation in market practice. This is the main source of ECL volatility and is a significant area where firms must exercise judgement. Practices are still emerging in testing, justifying, and monitoring the effectiveness of selected quantitative and qualitative triggers.
• Quality of assessment of model limitations and weaknesses…and mitigation required: the current UK economic environment is very different to that found in most models’ training data, leading to potential model limitations not present in the past. High quality assessment of model weaknesses and risks that may not be adequately captured by models or data, and consideration of relevant mitigation, is a critical consideration.
• Governance, documentation and control of Post Model Adjustments (PMAs): while the prevalence of PMAs has reduced since the peak of Covid, they are still playing an important role in reserving adequacy given model limitations and the judgement required to assess future risks. High quality governance, documentation, controls, and reporting remain essential.

We hope you found this quarterly assessment useful. You can find previous blogs in this series here. Alternatively don’t hesitate to contact one of our team who will be happy to discuss any of the topics covered here.

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1. Company reports, Deloitte Analysis
2. National Statistics - Company & Individual Insolvency Statistics
3. Company reports, Deloitte Analysis
4. Company reports, Deloitte Analysis
5. Bank of England Interactive Database - Mortgage approvals; HM Land Registry - Residential transactions
6. Office of National Statistics - UK HPI; Halifax HPI; Nationwide HPI
7. Bank of England Interactive Database - RPQB69D (PNFC); RPQB78D (Unincorporated); RPQB73D (Mortgages); RPQB74D (Credit Card); RPQB75D (Other Consumer)
8. Company reports, Deloitte Analysis
9. Company reports, Deloitte Analysis
10. Company reports, Deloitte Analysis
11. Company reports, Deloitte Analysis
12. Bank of England Interactive Database – IUMTLMV (Revert-to-rate); IUMBV42 (Refinance rate – 2Y); IUMBV34 (Refinance rate – 5Y)
13. Bank of England - Credit Conditions Survey
14. Bank of England - Credit Conditions Survey
15. Bank of England Interactive Database - RPQB8YP; RPQB8YQ; RPQTFHA; RPQTFHJ
16. Unemployment - Office for National Statistics
17. Bank of England Financial Stability Report, July 2023