As an update to our 1Q21 IFRS 9 results blog, IFRS 9 | 1Q21 results update: the beginning of the end?, this post gives a 2Q21 view on the loan loss reserving trends and outlook for UK banks. As before, we have analysed the aggregate position of Barclays, HSBC, Lloyds, NatWest and Santander UK as a proxy for the wider UK banking sector. The blog looks at the following six areas:
- Changes to loans and advances
- The credit environment
- The economic outlook
- ECL releases in 2Q21
- The extent and use of model adjustments
- The overall longer-term outlook for ECL
This quarter saw a slightly bolder unwind of ECL reserves – a 12% reduction in ECL in the quarter versus 7% in 1Q21. This comes from a significant improvement in banks’ economic outlook and another very benign quarter for underlying credit performance with delinquencies and defaults remaining very low.
The banks are signalling that 2021 will be a benign year for the credit P&L with impairment charges well below through-the-cycle levels and possibly net releases for the year at some institutions.
However, the more positive outlook is heavily caveated: the releases to date have been cautious and there is still a significant level of uncertainty in the credit risk outcome of the crisis – from the unknown and unprecedented effects of the wind-down of state support to the unpredictable evolution of the virus and its impact on the economy and society more generally.
1) Loans and advances showed marginal growth in the quarter (c. 1%), mainly driven by the mortgage market.
Consumer lending and credit card drawn balances are still much reduced compared to pre-COVID levels. It’s also worth noting that the growth in corporate and business lending since 1Q20 is heavily influenced by the government’s lending schemes – Private Non-Financial Corporation (PNFC) and Unincorporated net lending growth since Dec 19 is c. £38bn compared to gross lending on the government schemes (CLBILS, CBILS and BBLS) of c. £79bn.
2) The credit environment has remained benign: insolvencies and write-offs are still below trend, the labour market has been stable, and Stage 3 credit impaired loans have reduced in balance and as a % of book.
Banking sector write-offs, personal insolvencies/bankruptcies and corporate insolvencies are all still running below 2019 trends. The chart below shows the quarterly level of each of these measures compared to the quarterly average for 2019 (i.e. quarterly average for 2019 = 100). The latest data points for each measure suggest an increasing trend but the data are volatile. The aggregate sum of “missed” write-offs (i.e. below the 2019 average) currently stands at c. £1.6bn.
The labour market has been relatively stable so far in 2021. After the spike in redundancies and unemployment in 4Q20, the unemployment rate has trickled down to under 5%, still low by historic standards. However, at the end of May, there were still 2.4m people on furlough (4.4% of the available workforce) which, as it starts to be phased out, presents a significant uncertainty and potential credit risk: how many of those people furloughed will return to work?
Compared to the latest unemployment data point (4.8%), taking the latest consensus estimate for 4Q21 unemployment (5.6%) and banks’ weighted average peak unemployment expectation (6.5%) implies an expectation that a high proportion (c. 75%-90%) of those on furlough will return to work.
Stage 3 credit impaired assets have fallen in both absolute terms and as a proportion of the book to levels below those seen prior to the COVID-19 crisis. Consistent with this, banks are also reporting benign book performance for emergence of delinquencies.
3) In addition to strong credit fundamentals there has been a significant improvement in economic outlook.
The banks have reported an improvement in their assessment of the economic outlook. The chart below shows the weighted average peak unemployment expectation – mean and range – for the banks in the sample (where the data are available) as a simple way to represent economic expectations. The improvement since June 2020 is marked, with average weighted expectation for peak unemployment now 6.5% in 4Q21 versus 9.4% this time last year. The same trend is also reflected in the other economic variables.
As well as the improvement in forward-looking credit expectations, recent strength in house and used car prices has also been supportive.
4) The improved inputs led to a further release in ECL at 2Q21, with banks reporting slightly larger decreases in ECL and coverage than at 1Q21.
P&L charge as a % of drawn assets (often termed “cost of risk”) has been negative for a second quarter with banks releasing some of the ECL reserves they have built as a result of their improved credit risk outlook.
ECL balances and coverage are heading back down to more normal levels with ECL falling 12% in the quarter versus 7% in 1Q21. ECL balances are now sitting at £28bn, c. £6bn above pre-crisis levels and c. £8bn down from the peak, and coverage (ECL / drawn balances) at 1.3%, c. 25bp above normal levels and down from a peak of 1.6%. Taking into account the c. £1.6bn of below trend write-offs, this implies an expectation of c. £4-5bn of losses (c. 20bp of book) attributable to the economic fallout of the crisis, a far cry from the (albeit prudent) £80bn potential credit losses estimated by the Bank of England based on the May 2020 Monetary Policy Report.
Stage 2 is shrinking as the improved forward-looking expectations push fewer accounts over the Significant Increase in Credit Risk (SICR) Probability of Default thresholds (i.e. banks think that fewer loans will get into difficulty in the future). Stage 2 is now half-way back to “normal” levels as a proportion of assets. ECL on Stage 2 now accounts for 39% of ECL stock, down from 43% at the peak but still significantly above the c. 30% level seen pre-crisis.
5) Banks are still making extensive use of model adjustments with disclosed adjustments now 23% of ECL versus 15% at 4Q20.
The ECL impact of disclosed model adjustments has increased from c. £5.1bn at 4Q20 to c. £6.5bn at 2Q20 (i.e. acting to increase ECL). Model adjustments are an important part of managing model risk in this unprecedented environment and we expect the level of adjustments to remain material for some time.
There is some commonality in the COVID-related model risks that have been addressed by banks: general uncertainty over the wide range of potential economic/credit outcomes and model sensitivity to them; risk from the withdrawal of state support for particularly vulnerable sectors/customers; mitigation of artificially favourable observed credit performance (viewed as being flattered by government support); and managing the credit risk consequences of operational issues such as the suspension of house repossessions / car repossessions / tenant evictions and emerging issues like cladding on high-rise apartment blocks.
Given that the prevailing change in IFRS 9 inputs is to reduce ECL (i.e. the much-improved economic outlook and the risk from payment holidays has gone away), lenders have used judgement to put the brakes on inappropriate releases of provision. Without the adjustments, coverage would be c. 1.2%, only c. 20bp above pre-crisis levels.
6) The outlook is much more positive than at 4Q20… but is heavily caveated given the uncertainty and unpredictability in the evolution of the crisis.
Consistent with the theme from our previous posts, that banks raised all the provision they needed at the peak of the crisis and are now releasing reserves as the outlook improves; expectations are for credit risk P&L charges to be well below through-the-cycle norms with the potential to see net releases at some institutions.
However, there are a few big credit risk unknowns lurking in the shadows: uncertainty over what will happen to unemployment as the furlough scheme unwinds, the prospects for businesses who made use of government lending schemes as payments become due, the extent to which some sectors may see permanent change impacting their viability, and, of course, the unpredictability of the evolution of the virus and potential impacts on the economy. In the background there is also the underlying impact of adjusting to post EU-exit trading arrangements.
The economic trough is expected around the end of 2021 with deterioration in credit performance towards the end of the year and through 2022.
A lot depends on what happens over the autumn as the uncertainties start to crystallise but it seems likely that the credit risk consequences of the crisis will start to emerge in 4Q21 with defaults and write-offs being incurred as the real world catches up with accounting expectations.
Given the reduction in ECL cover to 1.3%, c. 25bp above pre-crisis levels, and the level of uncertainty over how events will unfold over the coming quarters, it feels like there isn’t much more room for further meaningful releases until the outlook resolves and banks have much more confidence about the size of the write-offs that are coming.
The management of models and ECL will likely become more challenging as the environment deteriorates: banks will have to keep updating models to keep pace with observed events and refresh their judgements about the extent to which defaults and losses will emerge.
We recently released a blog with our thoughts on seven things banks should consider for 2021 year-end which sets out our thinking on topics including model monitoring and calibration, sectoral risk, model adjustments, “uncertainty”, and Stage 2 triggers as the credit environment deteriorates.
Please look out for our follow-up blogs in coming quarters as we see how the credit and loss reserving situation evolves. You can also check out our previous blogs or contact one of the team who would be happy to discuss.