PRA guidance on applying IFRS 9, Financial Instruments, during the COVID-19 outbreak
To facilitate consistent and robust application of IFRS 9 accounting during this period of global uncertainty, the Prudential Regulation Authority (PRA) has issued guidance in the form of a letter, dated 26 March 2020, to the Chief Executive Officers of UK Banks.
The introduction of International Financial Reporting Standard (IFRS) 9, Financial Instruments, effectively represented the response by the International Accounting Standards Board (IASB) to the global financial crisis and subsequent criticisms about the way that financial assets and liabilities had been measured and reported by financial institutions.
Applicable for accounting periods commencing on or after 1 January 2018, IFRS 9 introduced new reporting requirements, the most significant of which was to adopt a forward-looking approach to the estimation of expected credit losses (ECL).
We now find ourselves in the midst of a new global crisis which could never have been predicted when IFRS 9 was being created. The need, under IFRS 9, to consider forward-looking information when determining ECL could not have anticipated such a period of global and economic uncertainty. In these unprecedented circumstances, the extent and availability of such forward-looking information is likely to be limited as global economies have never before experienced a crisis of this magnitude and uncertainty.
In order to facilitate consistent and robust application of IFRS 9 accounting during this period of global uncertainty, the Prudential Regulation Authority (PRA) issued guidance in the form of a letter, dated 26 March 2020, to the Chief Executive Officers of UK Banks.
Calculation of ECL during COVID-19
The letter stresses that while we are experiencing short-term market volatility, it is anticipated that markets will rebound when the imposed social-distancing measures have been lifted, although, at the moment, the extent and timescale of any recovery is still very much unknown. Furthermore, the PRA discourages any significant overstatement of ECL which might result in the imposition of tighter credit conditions.
Consequently, the PRA encourages the calculation of ECL based on the most reasonable, robust and supportable assumptions and information available in the current climate. These calculations should balance the level of uncertainty about the potential impact of COVID-19 against the substantial support measures introduced by the various governments and central banks.
In addition, the Basel Committee on Banking Supervision has agreed some amendments to the existing transitional arrangements for the regulatory capital treatments of ECLs.
The PRA guidance discusses how to approach the issues of payment holidays and covenant breaches in the current climate when applying IFRS 9.
The PRA does not envisage that the use of payment holidays offered during the COVID-19 crisis should automatically trigger, other things being equal, a move to stage 2 or stage 3 for the calculation of ECL. Nor should it automatically trigger, other things being equal, a default under the EU Capital Requirements Regulation (CRR).
Under IFRS 9, loans are only required to be moved from stage 1 to stage 2 if they have been the subject of a significant increase in credit risk (SICR). A SICR occurs when there has been a significant increase in the risk of a default occurring over the expected life of a financial instrument.
Up to this point, payment holidays offered as a result of financial difficulty have been broadly regarded as reliable proxies for identifying whether a SICR has occurred. However, the position in the current environment is different and the PRA does not consider that borrowers who use government-endorsed payment holidays (and similar schemes) should be automatically deemed to have suffered a SICR. In many situations, the request for a payment holiday may be more indicative of short-term liquidity or cash-flow problems. In fact, payment holidays were already a standard feature of many borrowing facilities which provided borrowers with some flexibility to manage their short-term cash flow needs.
Nonetheless, in some situations, the request for a payment holiday may be an indication that an entity is experiencing severe financial difficulties. Whether this is indicative of a SICR will depend upon the entity’s individual circumstances. The PRA acknowledges that it may be necessary for lenders to establish new policies relating to SICRs and will continue to discuss this matter with firms to establish a consistent approach.
While asset values have been in sharp decline, and we have witnessed significant market falls, governments and central banks have intervened by introducing a series of unprecedented measures to minimise the risk of individuals and corporates defaulting on their financial obligations. What is not clear at this stage is the effect, if any, that these measures will have on the rate and extent of default.
The PRA has therefore stressed that it is important to distinguish between covenant breaches under normal circumstances and those that arise as a result of COVID-19, which may only be temporary or directly related to some of the social distancing measures introduced. The PRA has proposed that lenders should consider waiving those covenant breaches directly related to COVID-19. Nor should a breach, or a waiver of a covenant breach relating to a modification in the auditor’s report, other things being equal, either result in the related loan automatically being moved to stage 2 or stage 3 (both of which require lifetime recognition of the ECL), or deemed to be a trigger of default under CRR.
In the past, a delay in the issue of the financial statements, a modification to the auditor’s opinion or material uncertainties around going concern would have been regarded as potential indicators of an increased credit risk. As a result, they would generally have been reliable proxies for determining whether a SICR or default had occurred.
In the current climate, the PRA believes that such delays, modifications and material uncertainties related to going concern will be much more commonplace. As a result, they recommend that such instances be considered on a case-by-case basis to fully understand the underlying reasons behind them as they may not necessarily indicate solvency or liquidity difficulties on the part of the borrower.
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