On March 20, 2020, the European Central Bank (ECB) announced further measures to ensure that its directly supervised banks can continue to “fulfil their role to fund households and corporations amid the coronavirus-related economic shock to the global economy”. As part of these measures, the ECB encouraged banks to “avoid excessive procyclical effects when applying the IFRS 9 international accounting standard”.
IFRS 9 requires banks to increase provision levels when there is a credit deterioration of a loan. Required provisions will also increase when the economic outlook is expected to deteriorate in the future. As the current economic outlook is rapidly deteriorating, IFRS 9 would result in provisions increasing drastically. Within its prudential remit, the ECB recommends that all banks “avoid procyclical assumptions in their models to determine provisions” and that those banks that have not done this so far should “opt for the IFRS 9 transitional rules”.
On March 25, the European Banking Authority (EBA) issued a statement to clarify that “there is no automatic classification in default, forborne, or IFRS9 status”. Like the ECB, the EBA wants to prevent banks’ provisions growing rapidly, hindering the much-needed financing to the market. The EBA highlighted that “when applying the IFRS 9 international accounting standard, institutions are expected to use a certain degree of judgement and distinguish between borrowers whose credit standing would not be significantly affected by the current situation in the long term, and those who would be unlikely to restore their creditworthiness”. In other words, the EBA seems to take the stance that the increase in provisioning should only be applied if the credit deterioration is not linked to the outbreak of the coronavirus.
To follow-up on its earlier statement, the EBA published detailed guidelines, on April 2, on legislative and non-legislative moratoria on loan repayments applied in the light of the coronavirus crisis. The EBA sees the payment moratoria (which is a delay in the payment of debts or obligations) as effective tools to address short-term liquidity difficulties caused by the limited or suspended operation of many businesses and individuals resulting from the impact of the coronavirus. Many businesses and private individuals affected by the crisis may face liquidity shortages and difficulties in timely payment of their financial and other commitments. This could in turn have an impact on credit institutions, as delays in the repayment of credit obligations lead to a larger number of defaults and increased own funds requirements for credit institutions.
The guidelines clarify that payment moratoria do not trigger classification as forbearance or distressed restructuring if the measures taken are based on the applicable national law or on an industry or sector-wide private initiative agreed and applied broadly by the relevant credit institutions. These guidelines clarify which legislative and non-legislative moratoria do not to trigger forbearance classification, while in all other cases the assessment must be done on a case-by case basis. The guidelines apply from the date of translation of the guidelines into all EU languages.
"The EBA seems to take the stance that the increase in provisioning should only be applied if the credit deterioration is not linked to the outbreak of the coronavirus."
Furthermore, local regulators have also commented on the application of IFRS 9 in the context of the coronavirus. The Prudential Regulation Authority (PRA), together with other UK authorities, provided guidance to UK banks, building societies and PRA-designated investment firms regarding the applications of IFRS 9. This includes the extent to which missed payments should constitute an event of default or should otherwise attract a lifetime expected loss provision. The PRA takes a similar stance as the EBA by expecting lenders “to treat covenant breaches that relate to the coronavirus differently compared to uncertainties that arise because of borrower-specific issues”.
It remains to be seen to what extent banks can exploit the room that the ECB and other regulators are trying to provide, as (a changed) application of the accounting rules needs to be approved with each bank’s auditor. This is not part of the responsibilities of the ECB and EBA.
Want to know more about the impact of Covid on credit risk? Read our study on rating downgrades across sectors here.