PRA letter on impairment of loans to borrowers affected by Covid-19
The PRA published a letter from Sam Woods, Deputy Governor and CEO of the PRA, to PRA-regulated firms in relation to the prudential treatment of loans to borrowers affected by Covid-19.
The letter focusses on impairment of assets for the purposes of IFRS9 and the application of the definition of “default” in CRR to affected assets. The apparent purpose of the letter is to encourage PRA-regulated firms not to over-provision for COVID 19, including where certain covenant breaches and waivers have occurred or loan repayments are subject to a payment holiday. The letter provides useful guidance (see details below), although it is not binding and therefore ultimately the decision still rests with the relevant firm. The PRA encourages firms to discuss their thinking with their supervisor as it evolves.
As a general matter, the PRA would expect lenders to consider the need to treat covenant breaches that arise from Covid-19 related matters that are of a general nature or are firm-specific but unrelated to the solvency or liquidity of the borrower differently compared to uncertainties that arise because of borrower-specific issues and in doing so consider waiving the resultant covenant breach. The PRA would expect firms to do so in good faith and not to impose new charges or restrictions on customers following a covenant breach that are unrelated to the facts and circumstances that led to that breach.
IFRS9 and Covid-19
IFRS9 changed the way firms recognise impairment of assets and moved from an accounting system focused on incurred losses to expected credit losses (“ECL”). Firms must allocate all credit exposures to one of three “credit stages”, which determine how impairment is calculated:
PRA guidance in relation to Covid-19
IFRS9 generally requires firms to use forward-looking information in ECL estimates which is reasonable and supportable. The PRA (consistent with its earlier statements and the EBA’s views) recognises that there is limited information relating to losses from Covid-19 at this stage. The PRA notes that firms should not take into account the market impact of Covid-19 on borrowers in isolation but also take into account all the public support measures and guidance by governments and central banks.
As immediate implications for firms’ financial reporting, the PRA recognises that:
- firms may need to make adjustments (overlays) to their ECL estimates for the period ending at end-March to take into account government and public support interventions and such overlays should be subject to high quality governance; and
- that there may also be a need for model adjustments.
More generally, the PRA notes that it is essential for firms to:
- reflect that the economic shock from Covid-19 will be temporary although its duration is uncertain (which means that many borrowers will only suffer a short term deterioration of credit quality);
- recognise that although there are clear signs that the economic conditions are worsening, to some extent this is counterbalanced by significant economic measures of support introduced by domestic and international fiscal and monetary authorities; and
- avoid double-counting between adjustments for Covid-19 and existing adjustments for uncertainties such as Brexit.
Crucially, the PRA clarifies that payment holidays and similar schemes and breaches of covenants due to Covid-19 (not “normal” covenant breaches) should not automatically trigger loans being moved into Stage 2 or Stage 3 for the purposes of calculating ECL.
Definition of Default and Covid-19
Generally, under CRR, a loan which meets the definition of default must be classified under a separate asset class and receive a punitive capital treatment of 150% risk weighting.
Broadly, the definition of "default" under Article 178 CRR has two triggers:
- the unlikeliness to pay criterion, where the institution considers that the obligor is unlikely to pay its credit obligations to the institution, its parent or subsidiaries in full without any actions taken by the institution such as enforcement of security; and
- the days past due criterion where the obligor is past due more than 90 days on any material credit obligation to the institution, its parent or any of its subsidiaries. National authorities are given discretion to replace the 90-day test with 180 days for exposures secured by residential or SME commercial real estate in the retail exposure class and exposures to public sector entities.
The PRA published PS7/19 where it took a strict approach to the definition of default and introduced amendments including removing the 180 days past due option.
PRA guidance in relation to Covid-19
The PRA in a statement last week delayed all non-essential regulatory changes that would increase banks’ regulatory capital including the changes to the definition of default made under PS7/19. In addition, in today’s letter, Sam Woods clarified that:
- payment holidays and similar schemes should not, by themselves, automatically trigger the days past due criterion or generate arrears under CRR and a borrower should not necessarily be considered unlikely to pay under the first limb of the definition of default; and
- breaches of covenants due to Covid-19 (not “normal” covenant breaches) may be a possible indication of unlikeliness to pay under the first limb of the definition. However, a covenant breach by itself should not automatically trigger a default. Rather, firms have scope to assess covenant breaches on a case-by-case basis and determine whether they are unlikely to pay.
At the EU level, the EBA published a statement yesterday making very similar statements to those of the PRA in relation to assets in default, forbearance and IFRS9 in the light of Covid-19. Therefore, EU banks will have similar capital relief to UK banks in relation to provisioning of affected loans. Also, one of the first measures announced on 12 March by the ECB/EBA was that they encourage national authorities to take a flexible approach to applying the NPL guidelines to exposures affected by Covid-19. For more detail see our dedicated webpage here. This is particularly important because the definition of non-performing exposure in CRR has been recently amended by the NPL Regulation to be much broader than just exposures in default and would capture exposures at earlier stages of impairment.