Understanding sensitivity disclosures on expected credit losses | Deloitte UK has been saved
Since its introduction IFRS 9 has caused considerable interest, especially with respect to the potential volatility that it may cause. How a firm’s ECL may change under different economic scenarios is important in understanding whether its estimates are “unbiased” (including whether an appropriate level of both upside and downside credit risk has been incorporated) and in understanding potential earnings (and capital) outcomes in different economic environments.
The interaction of the standard’s objective to “bring forward” future loan losses to today’s P&L with the non-linear1 impact a distressed economy can have on loan losses increases volatility compared to IAS39, where losses were booked only when loans went bad. This means that if a firm’s view of the future economy deteriorates, and their expectation of future credit losses increases, a material P&L charge could be incurred today despite no cash losses having materialised.
Information touching on these areas is presented as part of “estimation uncertainty” disclosures in firms’ accounts under IFRS and also via regulatory stress testing disclosures.
Firms’ sensitivity disclosures are evolving and each set of disclosures, both accounting and regulatory, has its own limitations for understanding economic sensitivity. Because of these limitations, sensitivity disclosures should not be used as a proxy for forecasting banks’ performance under different economic conditions while stress test results are an imperfect worst-case representation of volatility under stress.
Insight into sensitivity is obscured for some firms that are currently using large post model adjustments to reflect downside risk not currently being captured through their models or economic scenarios. Comparison between firms is difficult because of differences in disclosure, differences in credit fundamentals (i.e. loan portfolio mix, credit management and recovery practices) and differences in models (i.e. modelling choices and the performance of those models).
Sensitivity disclosures are in the spotlight of analysts and regulators at the moment. We would expect a greater degree of consistency to emerge over time and expect the impending second DECL report to support that.
What sensitivity disclosure is required?
The requirements are set out in IAS 1 Presentation of Financial Statements:
An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
Estimation uncertainty is not a defined term, but the standard explains how it can be disclosed:
The assumptions and other sources of estimation uncertainty […] relate to the estimates that require management's most difficult, subjective or complex judgements. […]
Examples of the types of disclosures an entity makes are:
(a) the nature of the assumption or other estimation uncertainty;
(b) the sensitivity of carrying amounts to the methods, assumptions and estimates underlying their calculation, including the reasons for the sensitivity….
Further recommendations on how these disclosures can be presented were included in the initial report published by DECL, a disclosure taskforce group set up by UK regulators and including members representing the major UK banks, investors and analysts, whose initial recommendations were published in November 2018 with a follow-up released later this year. The key additional recommendations were that:
Multi-factor sensitivity analysis should usually be primarily based on the same economic scenarios that are modelled for the purposes of estimating ECL... if single-factor disclosures are provided, usually they would be provided in addition to multi-factor sensitivity analysis and they should be accompanied by an explanation of their disclosure explaining the limitations of any sensitivity/uncertainty disclosures.
Note that the report included other recommendations as well, but in this blog we will focus specifically on multi- and single-factor sensitivities.
What has been published? Multi-factor sensitivities
All major UK banks (other than those using monte carlo approaches) published a form of scenario-based sensitivity analysis. These disclosures present ECL at the reporting date under the assumption that 100% probability is assigned to a particular macroeconomic scenario. Below is how this disclosure was presented in the Barclays accounts:
