Bank of the Future

Dealing with the Unexpected when Calculating Expected Credit Loss – A COVID-19 Use Case

 
May 26, 2020

There is considerable uncertainty on the impact of COVID-19 on the global economy but one thing is for sure – things don’t look rosy. In April 2020, the IMF revised its projections for global economic growth for FY20 at -3.0%, a contraction much worse than that experienced during the global financial crisis (GFC) in 2008-09. During GFC and the ensuing recession, the banking sector suffered huge losses on loan defaults, which added to the liquidity crisis, further deepening the recession. It exposed weaknesses and inadequacies in the credit loss provisioning process and the capitalization level of banks. Even as the impact of COVID-19 on the economic activities is unfolding, it is important to assess whether banks are now suitably equipped to address the ‘too little, too late’ criticism of the earlier incurred loss methodology.

Does it mean banks are already amid a financial crisis?

Not necessarily; Expected Credit Loss (ECL) provisioning is a forward-looking estimate and it needs to reflect the impact of changes in the economic outlook, on the estimated credit losses. The new ECL methodology implemented through the International Financial Reporting Standard 9: Financial Instruments (IFRS 9) and Current Expected Credit Loss - ASC 326 (CECL) aims to remove the inadequacies in credit loss provisioning, but its  effectiveness in the current situation    would largely depend on the efficiency of  banks’ ECL systems in handling such extraordinary and unprecedented events. Banks will need to  review their ECL processes  and controls so that they are  better prepared to tackle the crisis and emerge resilient.

Three major areas that need to be reassessed

  • IFRS 9 stage determination: Customers are being offered loan repayment relief in the form of moratoriums or payment holidays; availing such options need not necessarily indicate a deterioration in credit quality. To determine  whether lifetime ECL applies in such cases, banks may have to refine their processes so as to identify  whether the financial difficulties of their customers indicate just a temporary phase or a more permanent one. This would require analysis of more granular data and qualitative information such as economic outlook for the particular industry, class of borrowers, likely impact of the pandemic situation on the borrowers’ businesses, and so on.  
  • Probability of Default (PD): The PD models may have to be recalibrated to include additional scenarios reflecting the macroeconomic impact of COVID-19 across industries. As it may not be possible to forecast the long-term impact until a later stage, banks will have to identify ways to determine reasonable forecasts – and review and update them  periodically – based on the information available . Shifting to shorter forecast periods would be more appropriate for banks, considering the unpredictability of the situation.
  • Loss Given Default (LGD): Changes in valuation of collateral and its realizability, given the current scenario can considerably impact the LGD models and the same may need to be reconfigured. The impact spans across almost all types of collaterals ranging from real estate to stock market securities.

Sailing through choppy waters

We list three best practices that can help banks tackle the crisis at hand and emerge stronger than ever:

  • Finance and risk data alignment: It is important to have all the required data available at the right place and  time. Having a finance and risk aligned enterprise data, in the required granularity, is an important step in this direction.  It helps banks secure meaningful insights and contributes significantly in proofing the entity from such eventualities in the future.
  • Review ECL systems and processes: ECL processes and the models used will need to be reviewed for their ability to cater to varied scenarios. Inflexibility and non-scalability can severely hamper the agility of the ECL process and may have to be redeveloped. Banks may look at transforming their model landscape and ECL solution entirely to drive efficiency and agility.

Continuous monitoring: The COVID-19 situation has heightened the importance of continuous monitoring of internal processes and controls. As the macroeconomic impact of the pandemic is still unfolding, banks have to ensure their ECL processes factor in the right parameters and assumptions. Corrective measures will need to be taken to ensure that ECL provisioning remains robust and adequate. Intelligent, AI-based tools can be leveraged to monitor the ECL process in real time and validate internal control mechanisms.  
 

While the uncertainty continues, banks may find themselves burdened with additional provisioning requirements, which is likely to pull down their profits drastically. At the same time, it is also widely acknowledged that the ECL methodology is the way to go, especially  in times of uncertainty - both, from financial reporting transparency as well as financial stability and resilience perspectives. It therefore puts the onus on banks to be proactive and agile. A well-aligned ECL ecosystem, with robust processes, accurate data, and effective internal controls and policies, will give banks and financial institutions the extra horsepower they need to battle the COVID storm.

Rekha George is Domain Consultant with TCS BFSI Industry Advisory Group and leads the Finance & Reporting Sub Practice. She is responsible for thought leadership in areas like financial reporting & compliance and finance transformation and anchors consulting engagements for BFSI customers