On the 26th of August 2020 the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) released updated guidance detailing UK regulatory expectations of how lenders should approach COVID-19 related mortgage payment holidays. This was the latest in a series of regulatory statements, with previous communications on the 26th March and 4th June 2020.
From a financial and impairment recognition perspective, payment holidays have been a significant source of uncertainty for banks trying to estimate IFRS 9 Expected Credit Losses (ECL) since the end of the first quarter 2020. Firms have put a lot of effort into deciding how to stage borrowers/facilities benefitting from a payment holiday and quantify the associated credit risk. With some lenders seeing up to half of certain portfolios with a COVID-19 payment holiday, there have been some serious cases of Stage fright across the industry!
The emergency response: keep calm
The first wave of COVID-19 payment holidays (typically lasting three months) were made widely available to borrowers without reference to their individual circumstances. The concern was, during the initial lockdown, many borrowers had suffered temporary liquidity issues beyond their control (rather than a conventional credit event) and a short payment holiday would tide them over until the world (and its’ cash flows) were un-paused. The PRA (consistent with the EBA) guided firms to consider that such deferrals were “not necessarily good indicators of a Significant Increase in Credit Risk (SICR), impairment or default” and should not automatically be classed as Stage 2 or Stage 3/defaulted (our emphasis).
Typically, firms adopted an “innocent-until-proven-guilty” principle, leaving borrowers in Stage 1 unless there was observable evidence that borrowers taking up a COVID-19 payment holiday were in financial difficulty and should be moved to Stage 2 (e.g. borrowers with arrears in periods prior to the onset of the crisis or exposure to sectors significantly impacted by the crisis).
Managing the crisis
In early June, as the first wave of payment deferrals started to mature, the guidance was updated to address exits from the initial wave of payment deferrals with the FCA guiding that:
- Firms should distinguish between customers who are able to resume full payments immediately, who are currently unable to resume full payments due to circumstances arising out of coronavirus, and who had a payment shortfall prior to 20 March 2020.
- Where a customer indicates they cannot immediately resume full payments, firms should offer them a further full or partial payment deferral for 3 monthly payments.
With respect to IFRS 9, the PRA guided that:
- The PRA would not expect the immediate resumption of full payments at the end of a COVID-19 related payment deferral to be regarded as an indicator of SICR or credit impaired for ECL purposes or default for CRR purposes – even if a revised schedule of repayments is agreed to smooth the cash-flow effect of the deferred amount. However, if any payments on the revised schedule are missed, normal processes for identification of SICR, credit impairment and default would apply.
- Further payment deferrals do not automatically mean a SICR or credit impairment; nor should the assumption be that all the loans involved remain in stage 1. Although it would not be appropriate for firms to assume all loans subject to or eligible for payment deferrals have necessarily suffered a SICR or are credit impaired, it is unlikely to be the case that none of those loans have been so affected; some should be in stage 2 or 3.
This latter point left firms in a similar place to 1Q20, with customers “innocent until proven guilty” from a staging perspective. This approach was supported by the framework published by the PRA in their 4th June statement that proposed four elements for firms to consider when making staging decisions:
- economic conditions;
- historical information held about borrowers;
- information gathered from customers using payment deferrals; and
- expert judgment.
The PRA also made the point that the more the customer offering is based on the individual financial circumstances of the borrower, the more potential it has to be an indicator of SICR or impairment.
As a result, when firms reported at 30th June 2020, the credit risk on lenders’ balance sheets was in part unobservable, with government support schemes sustaining both retail and wholesale borrowers impacted by the crisis. Reported unemployment and corporate insolvencies were still low, supported by government intervention, and Stage 3 credit impaired loan balances were broadly stable compared to pre-crisis levels (other than a few single name issues at some lenders).
However, Stage 2 balances increased significantly at the half-year reflecting a material downgrade in forward-looking credit risk expectations (i.e. forward-looking probability of default exceeded thresholds to trigger a Stage 2 event) and also those observed cases with payment holidays where firms judged the borrowers had suffered a Significant Deterioration In Credit risk. The borrowers taking up COVID-19 payment holidays were at the worse end of the Stage 1 credit risk spectrum and were pushed into Stage 2 as a result of the economic forward-look, making the staging quandary for these facilities a moot point.
Returning to “normal”?
On 26th of August the guidance was further updated with the FCA calling an end to new COVID-19 payment holidays from the 31st October 2020 (i.e. the last COVID-19 payment holidays will expire on the 31st January 2021).
The guidance detailed how firms should treat customers who cannot resume full payments where they have already benefitted from two COVID-19 payment deferrals or an initial deferral that expires after 31st October. In short, it sets out a return to normal forbearance and reporting processes, including in relation to the Credit Reference Agencies, and the normal resumption of repossession proceedings.
The PRA issued a simultaneous statement that called for a return to the normal recognition of forbearance in credit risk measurement, stating that non-COVID-19 forbearance arrangements “are likely to be as good an indicator of SICR, credit impairments or defaults as forbearance was prior to the pandemic”.
This means that the staging issue around COVID-19 payment deferrals will largely have passed by 31st December 2020, with only a small number of arrangements likely to remain at year-end. Firms will return to their usual pre-COVID-19 practices for forbearance which, in many cases, class forbearance treatments as Stage 2 or 3 based on underlying analysis of their credit risk.
In the interim, pending the wind-down of COVID-19 payment holidays, if customers take subsequent payment holidays at this point in the crisis, auditors may take a sceptical view of firms placing these borrowers in Stage 1 unless there is strong evidence that their lifetime credit risk is unaffected. The full availability of state support since April, the potential worsening in the credit environment as it is withdrawn, and the likely extended duration of the crisis (it is no longer viewed as a short, sharp event with a quick return to “normal” as it was in March) mean that continued allocation of borrowers to Stage 1 on the basis of temporary liquidity difficulty needs to be justified.
Overcoming Stage fright
The return to “normal” brings with it some challenges that are not new, but stakes are higher on a stressed reporting date than under benign economic conditions.
Firms should consider whether they are recognising problem and/or deteriorated loans in a timely way in addition to how their FINREP, regulatory (especially in the context of the new definition of default practices in the EU e.g. EBA GL/2017/07 and related documents) and accounting views of “bad” loans align… or don’t.
Additionally, given the likely wave of forbearance and restructuring, firms will need to consider how to align their accounting, regulatory and operation views of loan quality. For example, when a facility is significantly restructured and “modified” from an accounting point of view, it can be de-recognised and re-recognised as a new asset, with the implication in IFRS 9 being it could be put in Stage 1. However, from a risk and regulatory perspective, the facility could be considered a distressed restructure and, in likelihood, a forborne Non-Performing Exposure.
These questions were interesting at half-year 2020 but will likely be much more important at year-end and throughout 2021. Auditors are going to pay close attention to staging rules and processes, firms should continue to harmonise their definitions and activities, review forbearance practices and look to understand the additional risks of recidivism in the current environment. Stage fright is a common phenomenon… but can be overcome through thorough preparation and anticipating what might happen!