IFRS 9 | PRA IFRS 9 Thematic Feedback 2023-24

This blog summarises the Prudential Regulation Authority's (PRA) annual thematic feedback on accounting for IFRS 9 Expected Credit Loss (ECL), including the impact of climate risk on ECL. The PRA’s feedback is based on a review of external auditor responses to a set of questions posed by the PRA relating to 2023 results for the major UK banks and building societies. It follows our previous summary for 2022-23.

In the feedback the PRA highlights key areas of concern for both the near- and medium-term to help firms prioritise their efforts to improve ECL practices. Near-term priorities centre around the timely recognition of credit risk and challenging the recovery assumptions that drive LGD. Regarding climate risk, the focus is on enhancing firms' capabilities to identify and quantify its impact on ECL. These areas of concern are consistent with previous editions of the feedback.

Table 1: Main areas of concern over recent years

The IFRS 9 PRA Consistency Working Group has been considering the consistency of practices across the UK’s largest banks for multiple economic scenarios and Significant Increase in Credit Risk (SICR) and so they have been removed from the scope of the feedback.

PRA key areas of concern for IFRS 9 Expected Credit Losses (ECL):
 

The PRA has the following as their key areas of concern for ECL:

Elevated model risk and risk capture: while firms are making progress in redeveloping IFRS 9 models, model risk remains elevated. It is crucial that firms challenge the completeness of PMAs to ensure that provisions reflect actual expectations of credit losses, particularly in capturing risks associated with affordability in the higher interest rate environment and capturing vulnerabilities of specific sectors.

Recovery strategies and limited default experience: limited recent default experience requires firms to challenge the realism of recovery assumptions driving Loss Given Default (LGD) calculations, especially given the emergence of complex recovery paths and changing strategies.

Key themes on climate risk:
 

The PRA has the following as their key areas of concern for climate risk:

Evolving Practices: Firms are at various stages of developing capabilities to assess climate-related risk drivers with further scope to expand risk assessments across portfolios.

Data Challenges: Data availability and quality remain pervasive challenges in assessing climate-related credit risks with further scope to enhance data and processes to challenge overlays and embed climate risk in credit risk assessment.

Emerging Approaches: Firms are exploring different approaches to incorporate climate risk drivers into their ECL calculations with further scope to consider a broader range of climate scenarios and indicators to identify sectors and borrowers exposed to climate risk.

PRA areas of focus for 2025 and the medium-term
 

The PRA has outlined specific areas for firms to prioritise, both in the near- and the medium-term, across model risk, recovery strategies, and climate risk:

Model risk

Near team priorities:

• Firms should challenge whether models capture risks associated with the impact of higher interest rate environment for vulnerable retail and corporate borrowers. There is scope to enhance assessments to consider longer projection periods to better capture payment shocks for those expected to refinance on higher rates. 
• The PRA continues to see scope to continue to enhance quantification of PMAs to capture affordability and refinancing risks. 
• Firms should ensure their model redevelopment plans address identified model limitations, enhance risk capture and are subject to effective oversight. End-state governance and controls for new models should be considered from the outset to align with Supervisory Statement (SS) 1/23 - Model Risk Management Principles for Banks.
• Models should have clearly defined operating boundaries, as defined in SS1/23, to facilitate timely identification of performance issues and inform the use of PMAs.
• Model segmentation remains a focus and firms should continue to assess how model segmentation aligns to those high-risk segments and sectors monitored for risk management purposes. 

Medium term focus areas:

• Firms should enhance model monitoring and validation, ensuring coverage extends to key components of ECL and  model testing is sufficiently granular to identify any model performance issues.
  
• As model redevelopment programs progress and more recent loss data becomes available, firms should increase the frequency and detail of model back-testing across a broader set of models and segments.
• Firms should establish a clear framework for deciding whether to include or exclude data and inform future enhancements to modelling capabilities.
• Firms should enhance the documentation and testing of key model limitations, including the use of sensitivity analysis as part of ongoing model validation. This will help reassess the impact of using different modelling assumptions and challenge the completeness of PMAs

Recovery strategies

Near team priorities:

• Firms should closely monitor the assumptions underpinning forward-looking recovery strategies to ensure foreseeable changes are detected early and incorporated into ECL calculations.
• As more recent loss experience becomes available, firms should formalise periodic validation and monitoring of LGD models, particularly for portfolios where historical loss experience is insufficient.
• Internal reporting should be enhanced to provide greater insights into loans or segments most sensitive to changes in recovery strategy. This information should be used to inform the targeted use of PMAs.

Medium term focus areas:

• Firms should identify limitations in capturing the impact of recovery strategy failure in modelled LGD and challenge whether the impact is fully captured by economic scenarios and historical loss data or in individual assessments.

Climate risks

Near team priorities:

Risk Identification:

• Challenge the completeness of climate-related risk drivers used to identify potential ECL impacts.
• Consider refinancing risk for higher-risk portfolios.
• Expand the coverage of portfolios with formal climate risk assessments

Quantitative Analysis:

• Enhance analytical tools to ensure conclusions on PMAs are supported by robust, data-driven analysis.
• Increase focus on granular portfolio-level assessments considering the impact on PD, LGD, and EAD.

Integration with Existing Processes:

• Further embed the impact of climate risks into business-as-usual credit risk assessments for corporate exposures.
• Consider a broader range of downside climate scenarios and climate-related variables in economic scenarios used for ECL calculations

Medium term focus areas:

Data and Model Development:

• Identify the data and model requirements for factoring climate-related risk drivers into loan-level ECL estimates.
• Continue developing and implementing more climate-aware models.

Oversight and Review:

• Enhance review and monitoring by second-line risk teams of how models and scenarios used to calculate ECL incorporate climate-related risk drivers.
• Identify limitations in capturing the impact of recovery strategy failure in modelled LGD and challenge whether the impact is fully captured by economic scenarios and historical loss data.

Next steps

The PRA stated that the next round of written auditor reporting will contain auditors’ views on the progress made in each of the areas of focus. It is also encouraged to perform self-assessments against these areas of focus.

As many firms approach their year-ends, we are here to discuss any of these topics in further detail with you.