This post continues our occasional series of investigations into what the future might hold for UK credit risk, and the implications for banks accounting estimates for Lifetime Expected Credit Losses (LECL).

In our initial analysis of the subject we presented a benchmark model and assumptions whose output suggested that, as of 31 March 2020, LECL values were likely to have increased by a significant multiple with respect to year-end 2019.

In subsequent months, our modelled assumptions suggested reductions in LECL in response to some combination of improvements risk factor values, the policy- and strategic response to the economic impacts of the COVID-19 pandemic; and the fact that the model's in-sample goodness-of-fit deteriorates under tail events.

As at 30 June, our LECL estimates have increased with respect to 31st May, by around 25% in secured lending and up to 10% in unsecured lending. The principal driver behind the increases is that the underlying credit cycle index (CCI) trend towards neutral conditions has reversed.  The 30 June market-implied default risk for our basket of UK companies is around 3% higher than at 31 May. (By contrast, April and May had seen ~20% month-on-month improvements).

Being market-implied, the CCI should reflect increased certainty about the nature, duration and impact of fiscal and monetary responses, as well as the wider strategic response, agent behaviour and network-effects among economic agents. However, the observed increase in credit risk suggests that these are currently outweighed by greater certainty about the limitations of the overall response, be it governments' ability to stimulate demand or longer-term structural changes in agent behaviour and/or consumer spending patterns. In pure Merton model terms, asset volatility is likely to have reduced, but expected asset returns have fallen further.

Our model, therefore, assigns a lower probability to a clean V-shaped CCI path, and the probability of a W-shaped CCI paths increases. In addition, recent downwards movements in House Price Index are reflected.

Results at 30 June 2020

The LECL uplifts with respect to the 31 December base case are presented below. These should be interpreted in the context, that they are conditional on the model's assumptions. Those assumptions tend to deteriorate under extreme or tail conditions.

Benchmark Secured Portfolio

The table below summarises LECL uplifts with respect to the 31 December 2020 base case, for secured lending:                                

Maturity (months)BaseDownUp
62.3x3.5x1.5x
122.3x3.9x1.4x
242.2x4.6x1.1x
362.1x5.3x1.0x
482.0x6.1x0.8x
602.0x6.9x0.8x
721.9x7.8x0.7x
841.9x8.9x0.6x
961.8x10.1x0.6x
1081.8x11.6x0.6x
1201.8x13.2x0.5x


Benchmark Unsecured Portfolio

The table below summarises LECL uplifts with respect to the 31 December 2020 base case, for unsecured  lending:                                                        

Maturity (months)BaseDownUp
62.0x2.8x1.4x
121.8x2.9x1.2x
241.7x2.9x0.9x
361.6x2.8x0.8x
481.5x2.8x0.8x
601.4x2.7x0.7x
721.4x2.7x0.7x
841.3x2.6x0.6x
961.3x2.5x0.6x
1081.3x2.5x0.6x
1201.3x2.5x0.6x