Macroeconomic scenarios for ECL

What does a set of macroeconomic scenarios look like?

Each scenario tells a coherent, written story: in the downside, a recession raises unemployment to 7.0% and house prices fall 15%; in the upside, stronger growth lowers unemployment to 4.0% and house prices rise 5%. The variables move together as they would in a real economy, not independently of each other.

What do the scenarios do to ECL?

The downside more than doubles ECL, while the upside reduces it by only about a third: losses are non-linear. With weights of 60%, 30% and 10%, the reported ECL is 38,610; see scenario weighting. The Scenario weighting model (Excel) lets you change every assumption.

How are scenarios designed?

• Base case: the most likely outcome, usually close to consensus or the lender's planning forecast.
• Downside: a plausible recession, severe enough to capture the risk of non-linear losses but not an extreme stress test. Many banks also add a severe downside with a small weight.
• Upside: a plausible stronger economy.
• Paths: each scenario covers several years, after which the variables revert to long-run averages.

How is a scenario narrative written?

Each scenario starts with a story: what happens, why, and how the economy responds. A downside might describe a sharp rise in energy prices that pushes inflation up, leads the central bank to raise rates, and tips the economy into a two-quarter recession, with unemployment peaking a year later. The variable paths follow from the story. A clear narrative makes the scenario easier to challenge, explain to the board and disclose.

How did scenarios cope with recent shocks?

The pandemic showed the limits of models built on past recessions: unemployment forecasts implied large losses that government support prevented. The later rise in inflation and interest rates raised a different risk, affordability for borrowers with variable-rate debt, which many models did not capture through unemployment alone. In both cases lenders added scenarios with new variables, widened their downside cases and used overlays while models caught up.

How many scenarios are needed?

Enough to capture the non-linearity in the portfolio. For a portfolio where losses respond almost linearly to the economy, one well-chosen forecast may give nearly the same answer as several. For most loan books, three scenarios are the minimum, and many banks use four or five, especially when uncertainty is high.

Why must scenarios be consistent with other forecasts?

Auditors and regulators compare ECL scenarios with the forecasts used for budgets, capital planning, goodwill impairment and going concern. A bank whose budget assumes rising unemployment but whose ECL base case does not would struggle to explain the difference.

Do companies outside banking need several scenarios?

For short-term trade receivables, losses usually respond close to linearly to the economy over a few months, so a single forward-looking adjustment is often acceptable, provided the company has considered whether a downside would change the answer materially. Companies with long-term loans, such as to joint ventures or customers on extended credit, may need scenarios.

What are common scenario mistakes?

Downside scenarios that are too mild to matter; variables that move inconsistently, such as falling unemployment in a recession; scenarios left unchanged for several reporting dates while the outlook moves; and base cases that differ from the forecasts used in the budget without explanation.

How often are scenarios updated?

At least at every reporting date, and more often when conditions change quickly. During periods of rapid change, the time between finalising scenarios and the reporting date matters; significant late developments may need a management overlay. See management overlays and forward-looking information.

This guide is general information. It is not tax or legal advice for your situation.