IFRS 9 | PRA IFRS 9 Thematic Feedback 2022-23

Each year the statutory auditor for each of the UK’s “Category 1” banks is required to respond to a range of questions from the PRA relating to various accounting practices, usually with a focus on IFRS 9 loan loss reserving. This is under SS1/16, Written reports by external auditors to the PRA, which has just been reaffirmed and refined after a recent evaluation. The PRA collates and considers the auditors’ reports and then issues thematic feedback highlighting the key priorities for firms over the following year and into the medium-term where they expect improvement in lenders’ practices. While not directly applicable to other firms, the letters, along with the Taskforce on Disclosures about ECL (DECL) publications, are an excellent guide to best practice in IFRS 9 loan loss reserving and disclosure.

The main ECL-related themes have been broadly consistent over time, albeit with some slight variation year-on-year reflecting prevailing market circumstances at the time. For example, the definition of “lifetime” has not featured since 2019-20, while climate considerations related to IFRS 9 have been a standing feature since 2021-22. The PRA has also signalled that multiple economic scenarios and significant increase in credit risk (SICR) are unlikely to feature in the 2023-24 round, mainly owing to work done by the largest banks on these topics in the BoE-sponsored ECL Consistency Working Group (referenced in paras 32 and 35 of the document). Table 1 below shows how different themes have ebbed and flowed through the document in recent years.

Table 1: Main areas of concern over recent years

Main themes of the 2022-23 report

The letter covers five main themes with regards to IFRS 9: model risk; recovery strategies; economic scenarios; SICR; and climate.

1. Model risk: in the PRA’s view, model risk remains elevated in an environment of high inflation and high interest rates. Both pose significant challenges to models’ suitability at a time when firms are also facing challenges in the identification of vulnerable sectors and borrowers. The PRA is focused on the completeness of PMAs to ensure provision cover reflects actual expectations of credit losses. They encourage firms to move to more granular, well-supported PMAs and to continue to address long-standing model limitations. These areas of focus also align with the expectations outlined in SS1/23 on model risk management for banks.

2. Recovery strategies: like model risk, the PRA notes that the recent credit environment is unusual, and that recent default experience is limited. Given higher inflation and interest rates, they note that past recovery outcomes may not necessarily be a good predictor of future recovery rates and that firms should be challenging realism in the recovery assumptions that drive loss given default (LGD).

3. Economic scenarios: the PRA recognises that the impact of high inflation and interest rates will be different across different sectors and segments. They consider economic scenarios to be an effective tool to explore the vulnerabilities in specific areas and are encouraging firms to consider additional, more “severe but plausible” scenarios that account for shocks in such “hot spots”.

4. SICR: the PRA also notes that firms continue to consider SICR differently and are looking for larger banks to continue to bring greater consistency to their SICR approaches and controls. Additionally, they see opportunities for firms to improve the linkages between the application of PMAs and collective SICR assessments to ensure that the risk factors driving the use of PMAs are also considered for staging.

5. Climate and ECL: the PRA notes the improvements made by lenders, but describes wide variations in practice. They see scope for firms to consider a broader range of climate-related risk drivers relevant to their portfolios, with a need for continued follow-on work around data quality and consideration for the impact of refinancing risk.

With regard to climate, this piece covers the aspects that relate to loan loss reserving, but the PRA also considers other elements, including governance and financial reporting risk assessments, controls to support the use of a higher volume of forward-looking climate-related data in financial reporting and capabilities to quantify the impact of climate risks on balance sheets and financial performance. There is also a short annex on mark-to-model fair values.

These themes have been key talking points over the last few quarters, and the macro outlook, as well as the PRA’s feedback here, both reaffirm their importance.

PRA areas of focus for 2024 and the medium-term

The key areas of focus for firms over 2024 and new areas of focus for the medium-term are listed below. Those for 2024 highlight practices that the PRA view to be a priority.

Conclusion

As we approach the 2024 year-end, credit portfolios continue to weather the inflation and interest rate storm. Amongst all the uncertainty there are two elements that are likely to persist: an increasing focus on model risk and the use of PMAs to mitigate model weaknesses to capture all risks posed by the current macroeconomic outlook.

The points raised in the PRA’s letter require action from “Category 1” banks and, in combination with prior years’ letters are a great guide to high-quality practices for the management of ECL for all other lenders.

The team at Deloitte are available to help you take action to strengthen practices to meet the regulator’s expectations as set out in this and previous years’ thematic feedback letters. We would invite you to read our previous blogs on the topic and to contact any of the authors or co-authors listed below if you would like to discuss any of the themes discussed here.