Impact Of COVID-19 On IFRS 9 Methodology: Miscalculations And The Lessons Of Icarus

Icarus flew too close to the sun; his estimation of when his wax wings would melt in the sunlight was flawed. Transposing this analogy from ancient Greece to today, IFRS 9 attempts to avoid a similar folly. The IFRS 9 methodology intends to more accurately estimate the price of loans using point-in-time (PIT) estimates to ‘right size’ return on risk capital based on credit extended to counterparties. Icarus’s miscalculation led him to melt his aerial transport. In a similar vein, it could be argued that current PIT models for IFRS 9 are dated — given the unexpected impact of COVID-19 and difficulties regarding how to adjust models in crisis mode.

Are We Also Flying Too Close To The Sun?

All of humanity is currently trying to guess when the COVID-19 pandemic will be over and what its lasting effects on the global economy will be. Historically, financial institutions have developed probability of default scales using the through-the-cycle (TTC) methodology for assessing return-on-risk capital and expected losses. IFRS 9 methodology, on the other hand, uses a PIT probability of default to mark a loan to market. This approach is based on the impact of current macroeconomic factors, rather than a look through over time that normalizes economic peaks and troughs. Given the black swan nature of the event, COVID-19 has clearly upended this entire thought process. And although marking loans to market has not yet fallen into the Mediterranean Sea with wings aflame, unless the current pandemic is adequately incorporated in modeling scenarios, it will come close.

Excluding Downturns, Including Complexity

Logically, the first step should be to recalibrate the PIT models used by financial institutions in the age of COVID-19 and beyond. However, this is an onerous task and involves a significant commitment of time and resources. One must also bear in mind that most models are hybrid in nature and may not be able to accurately incorporate the impact of the deepest possible downturns — thus excluding important information.

In addition, the balancing factor of economic stimulus packages and related measures adds an additional layer of complexity: it could affect default probability due to factors such as payment holidays, forbearance, and covenant breach leniency, not to mention loss instance and its severity.

Super Engineered Wax Wings
So, how about an alternative?

A contrasting approach would use an approved methodology that incorporates simulations and algorithms based on a slew of historical business cycles, current macroeconomic factors, and high frequency data, thereby helping to benchmark existing model outputs. Effectively, it would take the hybrid model outputs and decompose them into their pure PIT and TTC components. Any excess (deficit) over current Expected Credit Loss (ECL) calculations could be adjusted as a ‘management buffer’ — a more efficient solution than having to recalibrate a plethora of models. Questions remain about the shape of the recovery after the current crisis. Therefore, any adjustments to ECL / IFRS 9 models must be properly thought through.

The advantages of this approach are clear. The Monte Carlo or scenario-based simulations can help create forward-looking PD term structures to more accurately reflect the aggravated downturn as well as the counterbalancing of factors at play, in the near term and in the future. The result will reduce profit and loss volatility by right sizing the ECL calculations. An additional benefit is access to a purer TTC component, which would allow regulatory capital to be smoother over time.

If Icarus had only had better engineered wings!

Tracing Changes And Returning To Normality

Like tracking COVID-19 cases to estimate contagion, the above ideas require the ability to consistently ‘trace’ the ECL to the granular components within credit portfolios. Electronic records of traceability provide a period-on-period record of how counterparties are affected in the ECL calculation process. Any calculation adjustments can then be made seamlessly on an as needed basis. Keep in mind, not only is the impact of the downturn idiosyncratic per specific industries, but the counterbalancing measures are as well!

As humanity develops and administers a vaccine for COVID-19, there will be a gradual return to normalcy. However, it should be borne in mind that this is likely to be a ‘new normal’. Hence it behooves financial institutions to take a strategic approach at the current juncture. A holistic and strategic course of action should not only include more accurate calculations, but also a flexible architecture that enables: improved meta data tracing, transparent tracking of changes, version control capabilities, and effective model risk management.

In short, financial institutions have a unique opportunity to rethink and re-engineer their IFRS 9 methodology to meet the current challenges and prepare for a new normal.

AxiomSL: Engineering The Wings Of Change

In a time of COVID-19 disruptions and rapid regulatory change, it is even more important than ever for financial institutions to have complete transparency into their data and calculations, and be prepared to manage change.

Implementing AxiomSL’s flexible data dictionary architecture, seamless calculation updates, full drilldown to data and processes, transparency into model calculations, and complete, dynamic data lineage strengthen an institution’s regulatory reporting processes, end-to-end. Being able — at any time — to easily examine a complete regulatory-reporting data flow zeroing in on any step in the journey, and also being able to trace a single financial transaction’s data journey from source to reports and vice-versa enables regulatory compliance processes to run smoothly. With AxiomSL’s proven technology, organizations can also satisfy requirements and deliver the data integrity and auditability that regulators demand within the IFRS 9 methodology. Furthermore, by future-proofing their risk and regulatory calculations and reporting, organizations strengthen their resilience in times of crisis, and ultimately, enhance their decision making to drive business growth — now and as they fly ahead on an uncertain path.

Icarus may have fallen from the sky and been lost at sea, but there is no reason financial institutions cannot successfully navigate the impact of COVID-19.

We invite you to have a conversation about IFRS 9 methodology and how best to engineer future-proofed wings, contact us.

The following topical pieces about risk and regulatory reporting in the age of COVID-19 may be of interest, including our IFRS9 solution:

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