As an update to our last IFRS 9 results blog, 2Q21 results update: the unwind continues, published in August, this post gives a 3Q21 update on the 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 credit environment remained benign in the quarter with strong fundamentals and banks reporting robust credit performance.  At firms that refreshed their economic scenarios the economic outlook showed a modest improvement.  This led to a small P&L credit in the quarter and continuation of the glide path toward pre-COVID reserving levels: ECL balances were down £2bn in the quarter to £26bn and coverage fell 0.1pp to 1.2%, only just above the 4Q19 level of 1.1%.

Changes in the shape of banks’ balance sheets are suppressing loss rates and this effect is likely to persist for a while.  In combination with gradually improving economic outlook and the supportive effects of the tail end of state support, lenders are expecting net P&L releases for 2021 and/or continued low impairment run rate.  

Although it seems unlikely that material credit issues will emerge before year-end, uncertainty persists.  Lenders will also have to consider continued COVID-related risks (e.g. to unemployment from furlough unwind), new affordability risks (via interest rate rises, inflation, and higher energy costs), and potentially start thinking through risks from climate change at year end. 

A significant level of management judgement may continue to be used to deal with risks outside of the models or to compensate for the models operating outside of their original design, although the shape of this will likely change as COVID-related risks subside and new risks emerge.

We look at these topics in more detail (and, as usual, with a lot of charts) below…

The credit environment remained benign in the quarter with firms reporting robust credit performance

The proportion of balances in Stage 3 stayed broadly flat at 1.8% of drawn loans and advances.  The proportion of balances in Stage 2 has continued to fall, dropping from 13% to 12% of drawn loans and advances in the quarter, with loans migrating back to Stage 1 because of the more positive economic outlook.  Stage 2 is still 50% above its pre-COVID level of 8% but significantly down on its peak of 18%.

Credit fundamentals stayed strong

Unemployment improved during the quarter, trending down to 4.5%, back to mid-2020 levels.  The CJRS (furlough) scheme continued to unwind with 1.6m people reported as being furloughed at end Jul 21 compared to 9m at its peak.  The redundancy rate was very low through 2Q and 3Q21.

Personal and corporate insolvencies were still running below 2019 levels (taken as a comparison for a more “normal” credit environment) but there was an uptick in corporate insolvencies in 3Q21 (although not driven by any particular sector).  This can be seen in the chart below where insolvency and write-off levels are compared to the average for 2019 (at 100), with the data trend mostly bumping around below that level.

House price inflation remained strong, although lower than the peak in Jun 21 which was driven by the increase in stamp-duty at the end of that month. Used car prices have also been strong, increasing for six consecutive months, rising 20% over that time net of depreciation [source Cap-HPI].

There was a small P&L credit in the quarter and continuation of the glide path to return to pre-COVID reserving levels

3Q21 saw a £0.8bn credit to the P&L and small negative cost of risk (i.e. annualised P&L charge divided by drawn assets), more modest than in 2Q21 but in-line with 1Q21. 

ECL balances and coverage continued their glide path back to pre-COVID levels.  ECL balances decreased another £2bn in the quarter to £26bn and are now £4bn above 4Q19 levels (peak £36bn).  Coverage (total ECL divided by drawn loans and advances) decreased by 0.1pp in the quarter to 1.2%, just above the 4Q19 level of 1.1% (peak 1.6%). 

There is still a significant level of management judgement being used to compensate for uncertainty in the outlook, other COVID-related risks, and/or model issues, with the aggregate balance of adjustments remaining broadly stable.  There were early signs of some COVID-related adjustments being wound down.

Changes in the shape of banks’ balance sheets are suppressing loss rates

Loan books saw modest growth in the quarter (0.3%) with strong mortgage activity being offset by some reductions in lending to businesses and consumer lending balances remaining subdued compared to pre-COVID levels.

Particularly with respect to credit cards, Bank of England data showed that, at 3Q21, credit card balances were £13bn (23%) below Dec 19 levels but had returned to modest growth in 2Q and 3Q21 after five quarters of reduction.  Card transaction volumes and values are trending back to pre-crisis levels as the economy reopens [Source: UK Finance] with demand expected to continue (seasonal spending will help) and some signs of competition in the market with lenders expecting spreads to tighten and some lengthening of interest-free periods [Source: BoE Credit Conditions Survey].

This balance sheet dynamic is suppressing loan loss rates and will likely continue for a while.  This is driven by three effects: firstly, the spike in business lending in 1H20 was largely guaranteed by the government (so low loss).  Secondly, massive consumer lending deleveraging, which troughed at end 1Q21 with balances 18% below 4Q19 and very modest net growth in 2Q and 3Q21, means that the normal vintage/maturity dynamics are absent for this higher coverage asset class.  Thirdly, growth has been focussed on mortgages (i.e. low coverage with a longer maturity dynamic), underwritten with tighter lending criteria.  In addition to the individual asset class effects, for some lenders the change in asset class mix with a greater part of the balance sheet in mortgages or guaranteed business lending and less in consumer lending is also pushing total coverage down. 

Banks are predicting net releases for 2021 and/or continued low impairment run rate

Uncertainty in the outlook has reduced through 2021 but is still elevated compared to the pre-COVID era.  Although news flow on job vacancies is positive, with the highest recorded number of vacancies in Sep 21 (1.1m), and the number of furloughed employees is falling (1.6m at end Jul 21 compared to a peak of almost 9m), the sectoral spread of this is uneven and risk to unemployment remains.  For example, there are more people on furlough in the accommodation and food services sector than there are vacancies, with the opposite being true for health and social work.

At this point it seems unlikely that material credit issues will emerge before year-end.  Indeed, it may take until 2H22 or longer for “normal service” to resume and the underlying credit position of portfolios to become clear as the economy (we hope) continues to recover and the distorting effects of the accumulation of cash on some corporate and personal balance sheets, personal deleveraging, and the withdrawal of state support wash through.

There is likely to continue to be a disconnect between the level of coverage management teams deem acceptable and the answers coming from the models.  At the heart of this issue observed credit performance continues to be better than 2019, itself a benign year from a credit perspective, with risk teams widely considering this a false starting position for their models and requiring adjustments to compensate to get credible output.

A significant level of management judgement may continue to be used to deal with risks outside of the models or to compensate for the models operating outside of their original design.  Some COVID/economic uncertainty-related Post Model Adjustments will likely reduce at year-end compared to 4Q20 and 2Q21 as some of those risks subside and uncertainty reduces.

However, the prospects of rate rises and inflation eroding debt servicing capability is an emerging dynamic that is likely to feature in lenders’ economic outlook at year-end and may play through into observed credit issues in 2022.  Unhelpfully there are limited data to model these effects and judgement will be critical.

Regulators are starting to probe lenders and auditors about their approach to the inclusion of climate risk considerations in balance sheet valuations. The PRA highlighted this in their 29 Sep 2021 “Dear CEO” letter, saying that, for Cat 1 banks within the scope of Written Auditor Reporting:

“As part of next year’s round of written auditor reporting, we have asked for your auditor’s views on how robust your firm’s risk assessments are regarding the impact of climate change on balance sheets, and the quality of the underlying data, models, and processes to support these assessments.”

ESMA also raised this as an area of focus in their recent enforcement priorities for 2021 annual financial reports:

“ESMA expects credit institutions to disclose whether material climate-related and environmental risks are taken into account in credit risk management, including information about the related significant judgements and estimation uncertainties. More specifically, to meet the objectives of paragraph 35B of IFRS 7, credit institutions should provide explanations, where applicable, on how these risks are incorporated in the calculation of ECL, on any credit risk concentrations related to environmental risks and how those risks affect the amounts recognised in the financial statements.”  

Undoubtedly this area will gather pace in 2022.

And further forward….

While some firms are redeveloping models these changes are largely dealing with legacy issues, consistency issues, and addressing the points raised by the PRA in their 2020 letter regarding flexibility, agility, and ability to run scenarios.  Outcome data from the crisis will take several years to emerge, with action not possible for some time, and current model changes tend to exclude COVID-impacted data. There are also significant pressures on credit modelling teams with a hefty regulatory capital change agenda and further climate risk/stress testing development over the coming few years.

The management of models and ECL will likely become more challenging if the credit 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 if the credit environment deteriorates.

Firms have already started thinking about how to respond to the latest PRA “Dear CEO” letter published on 29 Sep 2021 which, in addition to monitoring progress on issues raised in prior letters (noting some progress in key areas but with more work to be done), added eight new areas where action is required.

Sector and the ability to differentiate loss expectations with appropriate granularity continues to be a theme.  Incumbent model frameworks were, generally, not built with sophisticated sectoral risk distinctions but the nature of COVID impacts and climate risk considerations are likely to push a move for more granularity.

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 any of the topics covered.

Source data for charts:

  • Chart 1: Company reports, Deloitte analysis
  • Chart 2:  Company reports, Deloitte analysis
  • Chart 3:  Monthly insolvency statistics, September 2012, The Insolvency Service; Bank of England RPQFTHA Quarterly amounts UK resident monetary financial institutions' sterling write-offs of lending to total (in sterling millions) not seasonally adjusted
  • Chart 4:  Company reports, Deloitte analysis
  • Chart 5:  Company reports, Deloitte analysis
  • Chart 6:  Company reports, Deloitte analysis
  • Chart 7:  Bank of England RPQB68D, RPQB69D, RPQB78D, RPQB73D, RPQB74D, RPQB75D - Quarterly amounts outstanding UK resident banks and building societies sterling and all foreign currency Loans including CDs, CP and bills, but not reverse repos (for write-off aggregates) (in sterling millions) not seasonally adjusted
  • Chart 8:  HMRC CJRS statistics 9 Sep 2021, table 10; ONS A01 labour market statistics summary data tables, table 21