IFRS 9 | 4Q23 results update: improving outlook / where are all the defaults?

Following on from our last IFRS 9 results blog on the 3Q23 results, this post gives a 4Q23 update on the loss reserving trends and outlook for UK banks.

Overall, the fourth quarter showed an improvement in the economic outlook, and a consequent small reduction in cost of risk and ECL cover. The proportion of ECL attributable to post model adjustments also decreased slightly. While overall credit performance stayed strong there were some signs of stress in mortgage portfolios with an increase in mortgage arrears (unsurprisingly).

The resilience of loan portfolios has been surprising given the very significant shocks that businesses and personal borrowers have been exposed to and a question we often hear is “where are all the defaults?”. We have seen that credit teams tend to sit in one of two broad camps: the first being “the letter is in the post” (i.e. there will be a credit response to the turbulence of recent years, we are just waiting for the lags to run through) and the second being that loan books and borrowers are more resilient than anybody expected and there will be no significant credit response. The outcome over the first half of 2024 will give us a sign of which view is more likely to be right and there is a limit to the length of time the “lags” view can play out for.

Either way, we seem to have passed the point of maximum peril. From the banks’ base case outlook at 4Q23, economic conditions are becoming more supportive, despite the UK economy slipping into a technical recession towards the end of 2023: the labour market is expected to stay strong, GDP to remain positive and borrowing costs are reducing. Absent another major shock it is difficult to see banks going above their long-run cost of risk targets, or for there to be a sudden credit event. It seems more likely that any post-Covid, post-inflation, post-rate change “normalisation” will flow through gradually.

1) Credit performance stayed strong
 

The proportion of loans in Stage 3 stayed flat at Group level for our sample of banks (figure 1). At UK-level there was an (expected) increase in mortgage arrears at Stage 3, a small increase in consumer lending Stage 3 and a reduction for commercial lending (figure 2).

Figure 1: Group: Stage 3 as a % of loans and advances

Figure 2: UK portfolios: Stage 3 % of loans and advances 4Q23 v’s 4Q22

For UK portfolios the proportion of loans subject to forbearance was up slightly over the year for mortgages (50bp->60bp of total balances) and down for consumer lending and commercial lending.

The credit performance of mortgage portfolios has understandably seen a lot of focus given the volume of fix-to-fix remortgages and the payment shock that customers have been experiencing. The increase in mortgage arrears has been noteworthy albeit the absolute level of arears is still low in a historic context (figure 3).

Figure 3: MLAR % of mortgages >1.5% in arrears inc. repossessions

2) The economic outlook has improved
 

The economic outlook is a critical driver of IFRS 9 ECL. Banks’ forward-looking view of the economy showed a slight improvement over the fourth quarter. Figure 4 shows a view of the aggregated base case outlook for our sample of banks. While expectations for peak unemployment have remained broadly stable, the prospects for GDP, HPI and base rates have improved over the year, with the latter two showing a particular improvement over the fourth quarter.

The improvement in the rates outlook (figure 5) and improving consumer confidence seem to have helped pull the housing market out of the deep freeze with monthly mortgage approvals ticking up (figure 6) and falls in house prices easing. And the rental market remains extremely tight, with sustained (although reducing) new rent inflation and demand for properties still strong.

On the corporate side, profit warnings are at levels seen from 2011 through to 2019, and the elevated level of corporate insolvencies has been mainly attributed to micro-businesses with limited-to-no bank lending, explaining why the link between this metric and lenders’ default flows seems to be broken. This is consistent with the conversations we have been having with clients where, although credit teams are often being cautious, there has been little adverse movement with watchlist flows and other early warning indicators.

For consumer lending, personal insolvencies are running c. 20% below their 2019 level, consistent with benign observed credit performance, albeit slightly at odds with the elevated level of “breathing space” applications.

Figure 4: Change in economics base case 4Q22 -> 4Q23 (min, max, mean)

Figure 5: Forward-looking interest rate expectations

Figure 6: Monthly mortgage approvals in Thousands (K)

3) Cost of risk and ECL cover improved in the fourth quarter
 

Consistent with the continued benign credit performance and improved economic outlook, cost of risk and ECL cover showed small improvements in the fourth quarter (figures 7 and 8). Interestingly, this did not lead to an improvement in the proportion of loans in Stage 2 which stayed broadly flat on 3Q23 (normally we would expect Stage 2, which is predominantly driven by future default expectations, to move in-line with changes in economic outlook).

Zooming in to UK-level, ECL cover on mortgage was flat over the year and slightly down for consumer and commercial lending (figure 9). Given the improvement in outlook for house prices we were a little surprised there wasn’t a small decrease in cover.

Figure 7: Group: annualised cost of risk

Figure 8: Group: ECL cover

Figure 9: UK portfolios: ECL cover 4Q23 v’s 4Q22

4) Cost of living / cost of borrowing / sector risks
 

A big part of any conversation on credit risk reserving over the last year has been around concerns arising from “cost of living”/high inflation, changes to cost of borrowing/debt service capacity and sector risk for corporates.

To date there has been little credit response to the economic stresses and strains suffered by businesses and individuals over the last few years other than in some parts of mortgage portfolios (typically focussed on older, variable rate loans).

While many lenders introduced post model adjustments to help reserve for these potential risks (because of their models’ understandable inability to completely fully consider the economic environment we were living through), some have now started to unwind these adjustments. This is because either model improvements have led to more of the risk being considered in the model or because banks consider that the risks are abating (e.g. because portfolio management information does not show a meaningful response to inflation and real incomes are in recovery or from taking a view that risks for specific sectors are no longer elevated). Other lenders are adopting a more cautious approach, preferring to see more outcome data to avoid potentially releasing reserves prematurely.

Either way, the point of maximum credit stress seems to have passed. The yield curve is flat-to-down, implying reduced debt servicing costs going forwards, and real incomes have been growing again since the summer (figure 10). Latest forecasts from the OBR indicate that real household disposable income is expected to recover to its pre-pandemic peak by 2025-26, two years earlier than the previous forecast.

Figure 11 shows the rate shock that a mortgage customer would suffer when refixing from a fixed rate deal to another fixed rate deal on a particular date. Payment shock has already improved by c. 2pp since its peak in the summer of 2023 and seems set to fall further given recent comments from the Bank of England on the rate outlook. This means that the cohorts that remortgaged in 2H23 are likely to have seen the worst affordability shock and their credit outcome will be important to monitor through 2024 to understand the level of refinance risk still remaining in mortgage portfolios.

Figure 10: YoY pay growth

Figure 11: Payment shock on remortgage for product switches in each month

5) Our observations from year-end and areas for focus in 2024
 

Our main themes from year-end 2023 and likely areas of focus for 2024 are listed below.

• SICR: while the industry has seen a gradual year-on-year improvement in practices relating to the setting and monitoring of SICR criteria this is still an area with significant variation. Firms need to make sure that they have robust quantitative frameworks in place for setting and then monitoring the efficacy of quantitative PD thresholds and that these decisions are put through appropriate governance.
• Model calibrations: in an increasing delinquency environment firms need to consider the pattern of default emergence during the calibration outcome window and also early delinquency emergence after the outcome window and before the balance sheet reporting date to make sure that PD models are adequately calibrated. Firms should have a clearly stated policy about the in/exclusion of Covid-era data in their models.
• Recovery expectations: for consumer lending LGD there has been a change in the debt sale environment with pricing levels shifting because of the change in the rate environment. Lenders need to make sure that forward-looking assumptions on debt sale pricing are appropriate.
• Non-linearity and ranking of scenarios: like SICR,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.
• Quality of assessment of model limitations and weaknesses… and mitigation (if) required: the economic environment is very different to 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 the models or data, and consideration for mitigation is critical.
• 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 judgement required to assess future risks. High quality governance, documentation, controls, and reporting are essential.

The Bank of England’s Written Auditor Reporting thematic outcomes will also be published at the start of the autumn which may bring new themes to light. The EBA recently released a very thorough report on the monitoring of implementation of IFRS 9 by EU institutions which also makes relevant reading for UK lenders.

6) Outlook/where are all the defaults?
 

The economy has been through a significant shock: a large fall in commercial property prices, a significant increase in mortgage and commercial credit costs and a small fall in house prices. The paradigm change in the rate environment may take some years to fully flush through the system. The question is: where are all the defaults? As mentioned above, we have found that the risk community broadly bifurcates into the two groups which we characterise below:

Glass half-empty: “Business and personal borrowers are gradually eating through the liquidity they hoarded over Covid and government-backed loans are still running off. There’s a lag in defaults and we just need to wait – every time we’ve seen a 20% drop in CRE prices and a level shift in the rate environment there’s been a big credit impact in the past. There are some early signs of credit deterioration including mortgage arrears, “breathing space” applications and corporate insolvencies and it’ll take a long time for the change in the rate environment to fully filter through. And this is all against a fragile recovery where the outlook is uncertain with risks to the downside.”

Glass half-full: “Lending portfolios and borrowers are more resilient than we expected: lower indebtedness through borrower de-leveraging, affordability testing, and risk appetite discipline (which has been even tighter since 1Q 2020) have all played a part. Added to which state support over Covid and for energy price increases took the sting out of pain that would have flowed through in previous economic stresses. There are no pervasive signs of credit issues from inflation/”cost-of-living”/supply chain problems or debt refinance, just some “normalisation” after Covid lows. The general economy has been more resilient than we expected, the outlook is improving, and while not spectacular, holds nothing that looks like it might cause a sudden credit shock.”

As we have said before, time will tell and 2024 will be an interesting year (although hopefully less eventful from a credit perspective than 2020-2023!).

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

• IFRS 9 | 3Q23 results update: holding steady for year-end?
• IFRS 9 | 2Q23 results update: the end of boom and bust?
• IFRS 9 | PRA IFRS 9 Thematic Feedback 2022-23
• IFRS 9 | The Mortgage Charter, SICR and default
• IFRS 9 | 1Q23 results update and “cost-of-living” focus
• IFRS 9 | 4Q22 results update
• Monetary Policy Report - February 2024 | Bank of England