As an update to our last IFRS 9 results blog, 4Q21 results in nine charts, published in April, this post gives a 1Q22 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.

Underlying credit performance continued to be very good with Stage 3 balances as a proportion of total book flat on 4Q19 and banks reporting strong delinquency performance. This continued to be underpinned by a very supportive labour market (job vacancies at a record high, unemployment back under 4%) and robust asset prices (albeit house price inflation may be starting to cool).

In terms of IFRS 9 metrics, there was a small P&L charge in the quarter and cost of risk remained below “normal” levels. Coverage dropped slightly and ECL balances remained broadly flat, indicative of growth in lending portfolios (particularly in mortgages and wholesale, credit card balances fell slightly).

The main theme in 1Q22 is the increase in economic uncertainty.  Although UK banks have little direct exposure to Russia/Ukraine, the wider economic impact of the conflict and the UK’s “cost-of-living” crisis feature in 1Q22 updated economic scenarios. Mitigating this increase in risk, Covid-related risks are viewed to have abated and there has been some upside on UK unemployment and house price inflation.

Looking forward, the main theme for the remainder of 2022 will be how the increased level of economic uncertainty plays out and how (and when) the impact of higher inflation and the “cost of living crisis” start to show up in portfolio performance data. Business confidence has taken a hit and consumer confidence has plummeted to crisis levels which may be an early indicator of the direction of travel.

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

1.    Underlying credit performance continued to be very good

Stage 3 balances as a proportion of total book remained within the range seen since December 2019. The apparent tick-up from 1.7% to 1.9% is partly due to definitional changes with banks moving over to new CRD IV definition of default.  We estimate that, absent this change, Stage 3 would be c. 1.8%.

                  Source: company results announcements, Deloitte analysis

Underlying this there also seemed to be some return to more normal credit behaviour – corporate insolvencies increased to above pre-crisis levels (presumably with an element of catch-up in the data) and personal insolvencies continued their gentle upward trend and are close to their pre-crisis level. 

Source: Insolvency Service statistics, Bank of England quarterly amounts UK resident monetary financial institutions' sterling write-offs of lending to total (in sterling millions) not seasonally adjusted RPQTFHA, Deloitte analysis

2.    There was a small P&L charge in the quarter

There was a small credit risk P&L charge in the quarter after four consecutive quarters of releases. Cost of risk was still suppressed compared to pre-crisis levels.

Source: company results announcements, Deloitte analysis

3.    Coverage dropped slightly and ECL balances remained broadly flat

Coverage dropped slightly and ECL balances remained broadly flat, indicative of growth in customer balances (particularly in mortgages and wholesale, credit card balances fell slightly). The firm-level picture is consistent with the aggregate: small decreases or flat coverage. Beneath the high-level stability there has been change in both economic outlook and the mix of Post Model Adjustments (PMAs).

 Source: company results announcements, Deloitte analysis

While UK lenders have limited direct exposure to the Ukraine/Russia crisis (and therefore limited impact on ECL), its second-order effects have led to changes in economic outlook. Expectations have worsened around inflation, supply chain issues, energy costs, and the wider impact on UK economic growth. The changes in outlook are captured in the chart below which shows downgrades in economic consensus estimates for 4Q22 year-on-year GDP growth and 4Q22 year-on-year CPI.

Source: HMT Forecasts for the UK Economy April 2022

While this feels like a downgrade in outlook, which one might expect to lead to an increase in ECL, there have been some mitigating positives: the risks around Covid have been abating, and house price inflation and unemployment have been more positive than expected.  

As well as the changes to scenarios there has been some change in the mix of PMAs, with some run-down of Covid-related items, and increases related to the “cost-of-living crisis” and economic uncertainty. Wholesale lending sector-related PMAs have been maintained but the rationale is evolving from Covid-related to inflation-related risks.

And looking forward….

The current hot topic is the increased level of economic uncertainty compared to 4Q21 and its manifestation through inflation, which could hit the highest level for 40 years later this year. Currently, the market’s best guess is that inflation might return to more normal levels in 2024.  

The credit risk arising from this is difficult to quantify: most IFRS 9 and IRB models are trained on data from the Great Financial Crisis where interest rate rises and elevated inflation did not feature alongside the credit downturn. To help model this one might look to data from economies that have experienced high inflation in more recent times or to more historic data. However, the relevance of such data to today’s UK lending market is questionable. This leaves firms squarely in the position of relying on management judgement to assess the risk… but at least management processes and governance for this have been strengthened over the Covid crisis period!

The credit risk arising from higher inflation is still latent; as well as being absent from portfolio performance in the big banks, we routinely monitor 30- and 60-day delinquencies for non-conforming RMBS and sub-prime credit cards which also show no uptick to date. The BoE Credit Conditions Survey for March 2022 shows a slightly elevated expectation for increasing default rates but significantly better than the full crisis levels seen in 2008 and at the peak of the Covid crisis.

  Source: Bank of England Credit Conditions Survey, March 2022

Over the coming months credit teams will be looking at portfolio performance in detail to see if/when the impacts of inflation start to impact delinquencies. From an IFRS 9 perspective, the questions will then be about the calibration of Point-in-Time Probability of Default models, default rate forecasting models, and the impact on vulnerable sectors/clients.

In line with the Bank of England’s 2019 Written Auditor Reporting thematic, banks are also seeking, where possible, to move PMAs into their models and reduce their reliance on management judgement (PMAs made up c. 20% of ECL balances at 4Q21). The wind-down of PMAs from unprecedented (and, arguably, unmodellable) Covid risks was a positive move in this regard… but their replacement with another set of unprecedented (and, arguably, unmodellable) risks may hinder progress.

More generally there are some interesting ongoing themes around the timing of model redevelopment (and interactions with CRD IV delivery), the extent to which Covid-period data should be included in model calibrations and rebuilds, and the links between climate impact assessment work and IFRS9 (which is also an increasing feature of the IFRS 9 regulatory agenda).

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.