Weighting ECL scenarios

How is probability-weighted ECL calculated?

The reported ECL is 29% above the base case, the scenario judged most likely, even though the base case is the most likely outcome. The downside, with only a 30% weight, contributes almost half the total.

Why does scenario weighting matter? Non-linearity

Using the same weights to average the economic variables, unemployment of 5.5% and house prices down 4%, and calculating ECL once from those averages gives 37,260. The probability-weighted ECL of 38,610 is 1,350 higher. The difference arises because PD and LGD both rise in the downside, and their product rises faster than either alone. IFRS 9 requires the probability-weighted amount precisely so that this asymmetry is captured. The Scenarios sheet of the Scenario weighting model (Excel) calculates both figures.

How are scenario weights chosen?

• Statistical approaches: placing each scenario on the distribution of possible outcomes for a key variable, such as GDP growth, and assigning the probability of the range it represents.
• Judgemental approaches: an economics team or committee assesses the likelihood of each narrative, informed by consensus forecasts and the range of external views.
• Consistency: weights should change when the outlook changes, not stay fixed for years; and a higher downside weight during uncertain times should be explained.

Base case weights of 40% to 60% are common, with the remainder split between downside scenarios and an upside.

What happens when the weights change?

If heightened uncertainty leads the committee to move the weights from 60%, 30% and 10% to 50%, 40% and 10%, the reported ECL becomes 0.5 x 30,000 + 0.4 x 62,400 + 0.1 x 18,900 = 41,850, an increase of 3,240 with no change in any scenario. A change in weights is a change in estimate, recognised in profit or loss, and should be explained in the disclosures with the reasons for it.

Who approves the scenario weights?

Usually a committee that includes credit risk, finance and economics, with challenge from the risk function and review by the audit committee for material changes. The minutes should record the scenarios considered, the evidence for the weights, and why any change from the previous period was made.

What is disclosed about weights?

Lenders typically disclose each scenario's main variables, its weight, and often the ECL that would result from each scenario alone. Disclosing the weights lets readers judge how much the allowance depends on the downside.

Does weighting affect staging?

Yes. Many lenders calculate staging under each scenario, so a loan may be in stage 2 in the downside but stage 1 in the base case, and its weighted ECL combines lifetime and 12-month amounts. Others stage once using weighted PDs. The approach should be applied consistently and explained.

Do companies outside banking weight scenarios?

Rarely in full, because short-term receivables respond almost linearly to the economy. But a company with a large customer exposure or long-term loans can apply the same idea simply: estimate the loss if the customer's sector does well, as expected, or badly, weight the outcomes, and compare the result with a single best estimate. If the weighted figure is materially higher, it should be used.

What are common weighting mistakes?

• Weighting the economic inputs and running the model once, which misses the non-linearity.
• Weights that never change, regardless of the outlook.
• Scenarios so mild that the weighting makes little difference, or so extreme that they are not plausible.

See macroeconomic scenarios and ECL sensitivity analysis.

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