Looming Shadows Of COVID-19

Looming Shadows Of COVID-19 On IFRS 9 Provision In GCC

With the advent of global financial crisis, it has been criticized that incurrent loss model under International Accounting Standards - IAS 39 contributed to delay in recognition of credit losses (“Too Little, too Late”). Based on learnings from this crisis, International Financial Reporting Standards (IFRS) published new guidelines of IFRS 9 which are forward looking in principle. IFRS 9 provides a framework for determining the Expected Credit Loss (ECL).

According to this framework, lifetime ECL must be recognized whenever there is a significant increase in credit risk on a financial instrument. Furthermore, the standards require the entities’ judgement in adjusting the methodology to compute ECL whenever necessary.

According to this framework, lifetime ECL must be recognized whenever there is a significant increase in credit risk on a financial instrument. Furthermore, the standards require the entities’ judgement in adjusting the methodology to compute ECL whenever necessary.

What Has Changed: The Numbers are alarming to say the least

At the on-set of March 2020, most economies across the world were grappling with the unprecedented novel COVID -19 virus and as a precaution large-scale lockdown were implemented to sustain its spread. This lockdown resulted in huge economic losses due to restricted trade and commerce across the globe; something that was last seen only during World War II. This situation has resulted in the outlook for banks taking a sharp downturn.

Banking institutions across the world are facing a negative momentum due to the pandemic. The impending crisis has resulted in sudden oil shocks, severe market volatility, and an overall slowdown in trade and tourism. Global GDP growth has been hampered significantly; in fact, the GDP forecasts remain negative for the year 2020-21 with analysts even predicting a recovery to pre-COVID levels only from the second quarter of 2022.

The decreasing oil price and the COVID-19 pandemic has resulted in the Gulf Cooperation Council (GCC) facing a liquidity crunch. A detailed study of the top 10 banks in this region, indicated a major reduction of 31% in their net incomes.

Banks and financial institutions are still working on comprehensive risk mitigation strategies to tackle this stressed scenario. On March 27, 2020, the International Accounting Standards Board (IASB) issued a document to support the consistent application of requirements as per IFRS standards in light of the uncertainty due to the COVID-19 pandemic.

In the last few months, governments and authorities have taken measures to control the spread of virus and support economies by designing and implementing fiscal stimulus packages to revive growth. Several governments have announced moratoriums or payment holidays for all borrowers however, these should not automatically be considered as complete credit relief for borrowers as they have to pay back the principal with the accrued interest.

These should not automatically be considered as triggers indicating significant increase in the credit risk. Moreover, some assumptions were constructed by financial entities that calculating ECL would not be applicable in the current scenario of faltering economic indicators.

Three Stage Model

IFRS 9 requires a ‘Three Stage Model’ for measurement of ECL. The stages are decided based on indicators for significant increase in credit risk. Changes in payment behaviour is usually an indicator of increase in credit risk. The board has advised entities to not implement their ECL models mechanically, but instead adjust their assumptions and methodology according to current market scenario. For example, the extension of payment holidays/moratorium to all borrower-classes of financial instruments, should not automatically lead to those instruments being considered to have suffered a significant increase in credit risk. Entities are required to develop estimates based on best available information about past events, current situation and forecasted economic conditions. While assessing forecasted economic conditions, entities should consider the effects of COVID-19 and government induced support measures.

They may choose to incorporate forward-looking factors that reflect the forecasted scenario in the model.

If the effects of COVID-19 cannot be reflected in the model, post-model adjustments or overlays reflecting the economy should be considered. In response to the pandemic, the guidelines set by regulators and the IASB, banks have been focusing on continuous calibration of stress testing scenarios to current market scenarios. As expected, a considerable shift in the ECL numbers has been observed. The top 10 banks in the GCC region have observed a 11% increase in their stage 2 exposures and as a result, the provisions have gone up by - 14%.

Stage 3 exposures in these banks have jumped to a whopping 21%, hence resulting in a 13% increase in provisions.

These huge spikes in stage 2 and stage 3 exposures along with the downward pressure on net incomes due to deteriorating operating conditions and low oil prices suggest the downgrade of credit rating of the banks in this region. To absorb the shock of these deteriorations in credit quality, ECL numbers have increased significantly.

Act Now

Entities are not sticking to the same level of provisions which were calculated at the start of the year. In these times of uncertainty, banks are advised to heavily invest their time and energies into scenario and sensitivity analysis to capture the effects of this pandemic and analyse the impact of these adjustments on the ECL models. These models should be recalibrated when new information on possible scenarios are available. Banks are also advised to re-assess provisions and their impact on capital while considering the possibility of a second wave of the novel coronavirus.

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