IFRS 9 | 2Q22 results update: what goes down must come up again?

As an update to our last IFRS 9 results blog, 1Q22 results update, published in May, this post gives a 2Q22 update on the loss reserving trends and outlook for UK banks.  Our title refers to the outlook for ECL coverage…having fallen significantly since the peak of the pandemic, is it about to increase again?

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 main feature of this set of results was that almost all key elements were flat on 1Q22…albeit that there have been some changes in shape under the surface. 

Credit fundamentals stayed strong with a robust labour market and asset prices. The obvious (and well-trailed) exception was real pay growth, with the latest data from ONS showing a reduction of 3% in the period from April to June 2022. Banks reported that credit quality remained strong and expectations for year-end cost of risk were reaffirmed at or below through-the-cycle expectations. Although the banks in our sample are prime, high-street lenders, we saw this trend of continued strong credit performance over the full breadth of UK lenders. 

Forward looking economic expectations were flat in the quarter for GDP, unemployment, and asset prices...albeit scenarios included higher base rate and inflation expectations. Against this backdrop it was unsurprising that impairment charges were low, ECL balances and coverage were broadly flat, and Stage 2/3 as a proportion of assets were broadly flat.

Post Model Adjustments (PMAs) reduced slightly in the half as a proportion of total ECL, and also changed shape – with COVID-related items being wound-down and items being spun-up in response to inflation and cost-of-living risks. 

As with COVID-19, these inflation-related items require a significant level of judgement and are literally unprecedented in having no reliable data with which to model the impacts. Banks are typically trying to identify “at-risk” borrowers (whether retail or commercial) and making assumptions about increased defaults/losses to attempt to measure the credit risk. More advanced firms are producing suites of portfolio early warning indicators to track whether assumptions remain valid or need refinement. Similar to the pandemic, the impacts will be spread unevenly across borrowers, and sector risk frameworks will continue to be important. Management judgement will continue to be a critical part of banks’ reserving as these credit risks work through the economy and lenders’ portfolios.

In the two months since the 2Q22 results the economic outlook has darkened and uncertainty has increased. Even with the very significant intervention on energy costs from the new Conservative administration the credit outlook seems skewed to the downside compared to 1H22 which may lead to an increase in coverage at 3Q22.  

However, at this stage, the scale of any coverage change is likely to be muted compared to the 50% increase in ECL cover seen between December 2019 and June 2020, when base case expectations were for peak unemployment to be above 8%. While the credit barometer is pointing toward stormier weather ahead, the current scale of expected deterioration seems likely to be more to a refinement of coverage levels rather than a fundamental re-rating of credit prospects.

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

1. Credit performance stayed strong

Banks reported strong portfolio performance with low entry into delinquency and continued low balances in Stage 3. The slight tick-up in Stage 3 in 1Q22 is partly related to a change in definition, with banks implementing the new regulatory definition of default which has brought some more loans inside the scope of Stage 3.

The proportion of loans in stage 2 was also broadly flat, albeit with some swap-sets between loans previously considered to have deteriorated due to COVID-19, now returning to Stage 1, and loans considered to be negatively impacted by the inflation outlook moving into Stage 2.

Source: Deloitte analysis, company reports

Source: Deloitte analysis, company reports

2. Credit fundamentals stayed supportive with the exception of real pay  

The labour market remained tight and widespread recruitment difficulties persisted. In August 2022 the Bank of England DMP survey reported that 86% of firms reported they were finding it harder to recruit new employees compared with normal. Of those, 63% reported that it was ‘much harder’, 3 percentage points higher than in July.

Asset prices were strong and stable. Housing market data has shown no significant slowing (yet) in response to increased interest rates and other economic pressures; growth in house prices has flattened off but is still at c. 10% and transaction volumes are in-line with pre-pandemic levels. However, the data is backward-looking with some lag and commentary from house-builders and estate agents suggests a slowdown is coming. According to the RICS 2Q22 survey, commercial property showed a weakening outlook with expectations of capital value falls for retail and secondary offices. Used car price growth has come off from the peak seen last winter, although prices are still growing and are up 43% on August 2019 according to Auto Trader. 

Source: Halifax, Nationwide, ONS House price indices

Source: ONS/Land Registry property transaction data

Corporate insolvencies have continued their upward trend and now above 2019 levels, with personal insolvencies edging up in-line with 2019 levels.  Some of the rise in corporate insolvencies is likely to be “catch-up” from the very low levels seen over the COVID-19 period and it is hard to tell the extent to which current cost and operating pressures are driving the increase.  Interestingly these increases in insolvency rates do not seem to be translating into increases in Stage 3 asset volumes or bank write-offs (yet), with the latter very subdued compared to pre-crisis levels.

Source: Insolvency service, BoE RPQTFHA

3. Banks’ view of forward-looking economic scenarios was broadly flat in the quarter 

Against that background, banks’ outlook for GDP, house price inflation, and unemployment was broadly stable in the quarter. However, scenarios did factor in higher base rate and inflation assumptions.  It is difficult to summarise banks’ views of forward-looking scenarios in one chart but we attempt to do this below by showing weighted unemployment expectations – both the average and range from our sample.

Source: Deloitte analysis, company reports

This is consistent with signals in the BoE Credit Conditions Survey for 2Q22, which showed that banks’ outlook for credit risk had not changed much in the period, staying elevated but not at crisis levels.

Source: Bank of England Credit Conditions Survey

4. Impairment charge was low and coverage was flat, driven by flat inputs 

Annualised cost of risk stayed below pre-crisis levels at c. 10bp with banks reporting a robust outlook for impairment charge for the year. And ECL balance and coverage were broadly flat too.

Source: company reports, Deloitte analysis

Source: company reports, Deloitte analysis

5. The prevalence and shape of PMAs changed to reflect the wind-down of COVID-19 risks and the recognition of increasing inflation risks

Banks’ disclosed PMAs reduced slightly as a proportion of ECL at the half-year. Underneath this headline movement there was a change in shape: COVID-19 related PMAs were wound-down and adjustments relating to the inflation/cost-of-living crisis spun-up to replace them.  (Note that the chart below shows an average for four of the five banks in our sample, for the fifth it was not possible to clearly separate-out COVID-19 related PMAs.)

Source: company reports, Deloitte analysis

The issues with quantifying cost-of-living/inflation risk are similar to those posed by payment holidays in 2020: there is no reliable historic data on which to model the risk, and the impacts are likely to be unevenly spread between borrowers (with a likely income/indebtedness-related skew for retail and sector-related for commercial). 

Banks are typically using one or more of three strategies to quantify the risk: firstly, identification of “marginal” customers (often through indebtedness and/or income/disposable income and/or credit worthiness) and making assumptions about increased defaults/losses; secondly, adapting COVID-19 style sector/watchlist frameworks to identify specific “hot spots” of risk; and thirdly, adapting models to use real rather than nominal inputs.  More advanced firms are then producing suites of portfolio early warning indicators to track whether assumptions remain valid or need refinement.

Entering the 1Q22 and 2Q22 reporting seasons it was the prevailing view of mainstream lenders that, for personal customers at least, the cost-of-living crisis and increases in credit costs would not impact their “average” customer but rather would affect those more marginal customers with lower disposable income and higher indebtedness (assuming continuation of a supportive labour market), and the rationale was similar for corporate borrowing.

This view was supported in the BoE July 2022 Financial Stability Report (section 1.4) which looked at the likely impact of the rise in inflation and debt servicing costs on households and corporate borrowers from a financial stability perspective. The BoE found that the proportion of households with high debt service ratios has been significantly below pre-global financial crisis levels over the past few years and would “…increase above its historical average in 2023… but it would remain significantly below the peaks seen ahead of the global financial crisis” and that the lower-income households that will be most affected hold a smaller share of consumer credit and mortgage debt.  For corporates, the BoE concluded that the impacts of inflation, higher debt service costs, weaker economic growth and supply chain disruption will “not fall evenly across businesses. Sectors with large exposures to energy or fuel prices (manufacturing and transport in particular) could face significant cost pressures. And the fall in household real incomes could reduce demand significantly in sectors such as non-essential household goods and services. While these pressures are likely to lead to some business failures, it would take large increases in borrowing costs or severe earnings shocks to impair businesses’ debt-servicing ability in aggregate.”

As with COVID-19 for commercial lending, a view of sectoral risk is important and the charts below taken from the ONS Business Insights and Conditions survey grabbed our interest.   The first shows the proportion of firms reporting an increase in both prices bought and sold by industry and the potential disparity in ability to pass on costs by sector.  The second shows the survey’s view of sectoral insolvency risk.

6. The economic outlook has deteriorated and ECL coverage may be set to increase at 3Q22

As risk professionals, we could be accused of having a perpetually gloomy outlook… but, since the 30 June, the economic outlook has deteriorated and is significantly more uncertain (again!) with predictions of recession in 4Q22. Expectations for inflation and GDP have worsened but the labour market is expected to stay robust in the near-term (HMT consensus in August has unemployment at 4.0% at end 2022 and 4.2% at end 2023) but worsen thereafter as inflationary pressures subside.  It’s worth noting that in the August 22 Monetary Policy Report, the BoE projected that inflation would rise to 13% in December 2022, higher than suggested by the consensus figures.

In line with this, the Bank of England Decision Maker Panel survey data for 3m to August 2022 showed that the level of overall business uncertainty had edged up.  63% of respondents reported that uncertainty for their business was ‘high’ or ‘very high’ at the moment, 1 percentage point higher than in July 2022.

Some press articles have focussed on strong recent year-on-year growth in credit card balances, suggesting that this may be the “canary in the coal mine” and that households may be starting to borrow to survive.  However, our reading of the data is that this is more about the prior year comparative, with monthly new lending flows showing no particular spikes.  Additionally, the volume of debt respite scheme “breathing space” applications has been broadly flat and this data is widely acknowledged as a good leading indicator of personal insolvencies.

Even with the very significant intervention on energy costs from the new Conservative administration the credit outlook seems skewed to the downside compared to 1H22, which may lead to an increase in coverage at 3Q22.   As expectations worsen, the expected credit impact may spread from the most marginal population of borrowers to affect a greater proportion of lenders’ portfolios, prompting lenders to raise ECL coverage.

However, at this stage, the scale of any change in coverage is likely to be muted compared to the 50% increase seen between December 2019 and June 2020, when base case expectations were for peak unemployment to be above 8%.  While the credit barometer is pointing toward stormier weather ahead, the current scale of expected deterioration suggests more of a refinement of coverage levels rather than a fundamental re-rating of credit prospects.

Time will tell.