This is a unique time. Just as organisations were getting to grips with IFRS 9 and its implications, the impact of COVID-19 has created the “perfect storm” for collections as regulators, organisations and customers scramble to understand the economic and financial impact of this pandemic.
Before the Storm Broke…
Before COVID-19, we were looking at how IFRS 9 does not allow any tolerance for those not totally on top of avoidable losses. Whether dealing with true losses or impairments, organisations needed to really push their data science teams to address the customer in the round. Those in collections and recovery needed this forensic-level insight on how customers arriving in collections need to be managed and what the outcomes are likely to be. Anything less and organisations faced the risk of hemorrhaging customers and losses.
The EBA survey published after IFRS 9 went live in 2018 reported that the average impact was around 9% in terms of the loss allowances. However, it highlighted a significant range in the impact depending on interpretation. For example, card clients saw a 10x increase in their provisions on their card portfolios. What was evident was the complexities in modelling were a challenge to implement, particularly with tactical deployments, and it proved difficult to modify them if organisations wanted to change either their models or staging rules. This ability to have agile deployments has become even more significant given the changes brought about in the current climate.
What has Changed in Practice?
For operations, the IFRS 9 accounting standard represents a once-in-a-generation change for collections. In the first-party space, there continues to be a focus on the customer and customer service, as well as increased interest from the offices of the CFO and CRO as to how risk and operations are minimising unnecessary impairments. For example, some major high street banks are looking at operating models completely differently than ever before. Some changes include bringing forward 180-day charge-off for cards to 120 days - or having the accounts on forward flow and debt sale agreements at 120 days that are coming straight off their recovery book from charge off to write-off instantly all in one day. Organisations are having to assess how much impaired debt they can afford to hold and how they manage out that which they need to release, since a substantial proportion of the held impairment will be on paying accounts.
There is a significant change in treatment from the customer perspective. In many organisations, there has been a revised mapping of the customer journey, given they need to collect far more effectively in the early stages, whilst not wanting to look too aggressive on the customer. After all, the customers do not understand what is driving the behaviour of the bank. No customer expects to hear the phrase “glad we have been able to help put a more affordable plan together for you, please be aware in the next few weeks we will assign your debt to an organisation you do not know”!
Meanwhile, in the third-party space, there has been a seismic change in the debt buyer and debt servicing sector, with significant merger and acquisitions activity. Two indicators of first-party creditors needing to offload higher volumes of debt are:
- The percentage of face value purchased debt that is considered performing at the time of purchase. For one of the largest regional debt purchasers, this equated to a 100% increase.
- The increased investment by third-party servicers in performing loan software. This is necessary as loans that are performing at the time of purchase will have a range of terms and conditions that need accommodating, and typically that will take a sophisticated System of Record capability.
The Impact of COVID-19
COVID-19 has had an immediate impact on the marketplace, with organizational challenges becoming enormous both in the immediate and longer term.
Companies are facing immediate, unprecedented demand from customers – literally a month’s worth of calls in a day, aggravated by a 50% staff absence rate and the loss of call centre resources such as those in Manilla and India. The pace of increased unemployment is unprecedented in many mature credit markets, and most informed sources are predicting a multi-year term for economic recovery.
So, the changes brought about by COVID-19 have an immediate impact on the operating model.
There has been some latitude on the mechanistic application of the IFRS 9 Stages and related impairment. The IFRS Foundation has communicated that, in the current climate, organisations would not be expected to apply SICR (Significant Increase in Credit Risk) to customers impacted by COVID-related financial stress. This is mainly because of the uncertainty around both duration of impact and likely recovery to financial good of the customer and the economy. It would not be prudent to consider that every request for a payment holiday would require a lifetime impairment to be carried. This view has been supported by the European Banking Authority, the European Central Bank, the European Securities and Market Authority and the Prudential Regulation Authority.
So, the latitude on SICR and IFRS 9 will be gratefully received as organisations grapple with home-based workers returning to on-prem business operations safely and meeting customer needs. But many have also started to consider what information they will need and when to substantiate what they are going to report as a Significant Increase in Credit Risk. To get close to a defendable position on this challenge, organisations are going to need strong:
- Customer situational, financial and credit related data (See also Debt Collection & COVID-19 What Past Crisis Can Teach Us)
- Macro and micro economic data
- Industry sector data
And they will need agile scenario modelling tools to assess both how to treat the customers from a risk, strategy and operational execution perspective and also from an impairment and SICR perspective.
Regulator Help and Expectations
Regulators are there to help to drive the right outcomes. They are looking to relax some of the rules - for example, not classifying some of the payment holidays as a restructure that would then flag as defaults at Stage 2. Sme are looking at extending the 90 days past due definitions.
Organisations will still need proper and reliable forecasts, which is difficult, given the fluid situation on the economy and regulations. Regulators have issued advice to help and the Bank of England has issued a note cancelling stress tests if results will be distorted due to COVID-related payment holidays and repayment periods – even if client defaults do not move on to Stage 2.
For the mid-term, everything about IFRS9 will be kept, and regulators will expect to see all changes reflected in the models - so tracking every decision is vital, as organisations can rebuild the numbers they had and validate what they did during the pandemic. Organisations are being permitted to use their capital buffer to help in the current situation.
Organisations need to be agile to incorporate the changes and they will need to revisit their models to rate the real risk.
Immediate Modelling Considerations with COVID-19
Organisations need to track the impact of COVID-19 and be agile about incorporating changes.
Don’t rush to include the shock in your economic forecasts. Evidence for IFRS 9 needs to be reasonable and supportable. As this situation is unparalleled, there is no supportable evidence to show what impact this will have – so give more weight to your long-run stable estimates created prior to COVID-19.
Mid-term considerations: keep an eye on macro-economic factors for future calculations – e.g. unemployment rate, consumer confidence – and make sure your loss estimates are not overestimated due to these short-term shocks.
Recording changes, why the changes were made and what the conditions due to COVID-19 were will be integral to recalibrating your future models.
Keeping the Spirit of IFRS 9: Practical Steps
The key to keeping the spirit of IFRS 9 is to take a wide-angle view and remember all your operational efforts, decisions, challenges and actions are connected.
Management are reminded that the current very fluid situation is hindering reliable forecasts. At present it is less about an accurate forecast and more important that you are running a range of viable scenarios. Exercise flexibility over any guidance and consider relief measure changes as they occur.
The success to forecasting in a fluid environment is to create different scenarios as everything is changing. Consider where the main focus was and then how it has shifted at each stage. Keep a continuous track of portfolio deterioration, whilst preparing to rebuild the liquidity coverage ratio.
Understand the impacts of the decisions you have taken, e.g., what this portfolio was impacted by, and track data changes, operational efforts and challenges and their impacts.
Immediate Considerations
What are your immediate considerations? Consider:
- A change of staging rules to meet regulatory relief and incorporating economic support in the forward look.
- Don’t rush to include the ‘shock’ in the forecast - be reasonable as the current situation is unparalleled.
- Place greater emphasis on preventing 31 days past due (DPD) or “significant increase in credit risk”.
- Consider a change to the 90 DPD default definition so payments between 90 and 180 DPD are not effectively treated as “recoveries”.
- Consider discounting at an effective interest rate - delaying loss helps and timing matters.
- Use credit card impairment based on total line, not just drawn balance.
- Keep an eye on quarterly or annual macro-economic factors – ensure loss estimates aren’t overestimating because of short-term shock.
- Record changes so they can be identified in data. Be able to identify your COVID-related impairments from your steady-state delinquency. This is critical for balance sheet validation. Track every adjustment you make to operating practice, customer treatment policy, data capture and models.
- Consider model alignment when the COVID bow wave reduces.
Finally, when you have breathing space, create a future desired operating model that meets steady state and allow this desired operating model to be shared with finance and risk colleagues. This will help them understand not only how you are managing a book that has to be reported on under IFRS 9, but also understand how that differs from the business continuity you are challenged with today.
I discussed this topic in greater detail with a team of FICO experts in analytics, regulation and risk management in a recent webinar, What Have Been the IFRS 9 Learning on Models and Operations? Watch the webinar for more information.
