As an update to our last IFRS 9 results blog, 3Q21 results update: always look on the bright side of life, published in November, this post gives a 4Q21 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.

There was a small P&L credit in the quarter. This was driven by the prevailing trends over 2021, with a further improvement in economic expectations and a benign credit environment with a small drop in Stage 3 balances and supportive credit fundamentals (supportive asset prices, strong labour market, economic rebound as covid restrictions were eased).

Balance sheets continued to grow, increasing 2.1% over the year, powered by mortgages, while consumer lending balances remained subdued after the de-leveraging seen in 2Q20. This has led to a small mix change in asset class with mortgages now accounting for 51% of customer loans and advances (49% at 4Q19), consumer lending 10% (9% at 4Q19), and wholesale lending 39% (41% at 4Q19).

In line with the P&L movements, ECL balances continued to fall, by 8% in the quarter and 31% over the year. ECL reserves are now just £2bn above the 4Q19 level with coverage of 1.1% equal to the 4Q19 level. However, the underlying picture is a little more nuanced. When adjusting for change in asset mix, reported coverage is higher than 4Q19 but 19% of ECL balances now are attributable to COVID-related management judgement, with the models giving a lower output than at 4Q19. 

In their 4Q21 disclosure, banks predicted that cost of risk will trend back to “through-the cycle” levels over the next one-to-two years. 

The uncertainties and threats of Omicron, which was the main concern at 4Q21, now seem a distant memory. While some risks and uncertainties from 4Q21 remain, principally the development of the COVID-19 pandemic and the impact of the “cost of living crisis”, it seems likely that the improvement in economic outlook and narrowing of the range of expectations seen over 2021 will go into reverse in 2022.

The range of credit risks and the extent to which they interact will be hard (if not impossible) to model because of lack of precedent data and management judgement will continue to be an essential tool for mitigating the limitations of models in dealing with economic circumstances outside the living memory of many modellers!

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

1) Banks reported a small P&L credit in the quarter.

The credit P&L has, largely, been driven by changes in economic expectations against a background of stable and benign credit performance. The release in 4Q21 was the smallest over the year. Overall the cost of risk for the year was -18bp compared to 90bp in 2020.

Source: company reports, Deloitte analysis

2) Economic expectations continued to improve.

It is difficult to capture one metric to sum up banks’ forward-looking economic views, but we try to do this by looking at weighted peak unemployment, which improved again over the quarter.

Source: company reports, Deloitte analysis

3) The credit environment remained benign.

Stage 3 exposures were marginally down, indicative of the benign environment seen over 2021. Stage 2 exposures continued their downward trend in line with the improvement in economics (as more benign forward-looking expectations flow through the models fewer accounts that are currently “good” are expected to experience a significant deterioration in credit risk in the future).

Source: company reports, Deloitte analysis

Source: company reports, Deloitte analysis

4) Credit fundamentals stayed supportive.

Credit fundamentals remained supportive over the year with strong asset prices, a strong labour market, and an economic rebound as Covid restrictions were eased. Personal insolvencies/bankruptcies remained low but there were signs of some normalisation in corporate insolvencies with levels returning above the 2019 average.

Source: 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

5) Balance sheets continued to grow.

Customer loans and advances grew 2.1% over the year, and 0.7% in the quarter. The growth has been powered by mortgages with consumer lending remaining subdued compared to 4Q19 levels and, while UK wholesale lending has grown since 4Q19 (in part because of the government sponsored schemes), when taking international exposures into account the position is broadly flat.

This has led to a small mix change in asset class with mortgages now accounting for c. 51% of customer loans and advances (49% at 4Q19), consumer lending 10% (9% at 4Q19), and wholesale lending 39% (41% at 4Q19).

Card usage (both debit and credit) has been subdued over the crisis, reflecting the restrictions on spending opportunities. As conditions normalise banks expect card activity (and borrowing levels) to trend back to pre-COVID levels.

Source: company reports, Deloitte analysis

Source: 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

6) ECL balances continued to fall and coverage hit the 4Q19 level.

In line with the P&L movements, ECL balances continued to fall, by 8% in the quarter and 31% over the year. ECL reserves are now just £2bn above the 4Q19 level with coverage of 1.1% equal to the 4Q19 level.

However, the underlying picture is a little more nuanced than credit risk having reverted to pre-crisis levels. The change in asset mix has an impact on coverage, when adjusting for this (i.e. looking at 2019 coverage levels on the basis of 2021 asset mix) the pre-crisis comparable drops from 105bp to 99bp, which is below 2021 cover of 109bp, suggesting risk levels are still perceived as higher than the pre-COVID level.

Additionally, at 4Q21, c. 19% of ECL balance was not attributable to the models but rather to COVID-related management judgement (i.e. judgements relating to economic uncertainty, default suppression etc. rather than to other non-COVID items such as cladding risk). When this is stripped out, we see that the underlying coverage is 88bp, less than the pre-COVID level. This highlights two important issues that banks have been grappling with and where management judgement has been used to mitigate model weaknesses: benign credit performance giving answers that management judge are “too low” when data is pushed through the model, and concerns that the models are not able to sufficiently capture the significant level of uncertainty in the economic outlook.

Source: company reports, Deloitte analysis

Source: company reports, Deloitte analysis

And looking forward….

The uncertainties and threats of Omicron, which was the main concern at 4Q21, now seem a distant memory. While some risks and uncertainties from 4Q21 remain, principally the future development of the COVID-19 pandemic and the impact of the “cost of living crisis”, it now seems likely that the improvement in economic outlook and narrowing of the range of expectations seen over 2021 will go into reverse in 2022.

The range of credit risks and the extent to which they interact will be hard (if not impossible) to model because of lack of precedent data: supply chain disruption, medium-term impact of Brexit in the UK, inflationary pressures and their persistence (and the associated monetary policy response), and geopolitical events. Management judgement will continue to be an essential tool in banks mitigating the limitations of models in dealing with economic circumstances outside the living memory of many modellers!

The management of models and ECL will 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. In 2021 we released a blog with our thoughts on seven things banks should consider for 2021 year-end which set out our thinking on topics including model monitoring and calibration, sectoral risk, model adjustments, “uncertainty”, and Stage 2 triggers if the credit environment deteriorates.

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. Approaches to the interaction of climate risk and IFRS 9 are also likely to evolve over 2022 with the regulator showing some interest in this area.

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.