Forward-looking information in ECL

How is forward-looking information built into ECL?

What does IFRS 9 require?

ECL must reflect an unbiased, probability-weighted amount, the time value of money, and reasonable and supportable information available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. A company does not need to search exhaustively for information, but it cannot ignore information it has, such as the forecasts in its own budget.

Which macroeconomic variables are used?

• Unemployment: the main driver for consumer lending, mortgages and credit cards.
• GDP growth: for corporate lending and, at many companies, trade receivables.
• Residential and commercial property prices: mainly through LGD on secured lending.
• Interest rates and inflation: affordability for borrowers with variable rates or squeezed incomes.
• Industry indicators: commodity prices, freight rates or sector output for concentrated portfolios.

Variables are chosen because they have explained losses in the past, not because they are available or because other lenders use them. Each model typically uses two or three of them.

An example: from a forecast to a PD

A lender's base case PD is 3.75% at unemployment of 5.0%, and its history shows PDs rise by about 30% for each extra percentage point of unemployment. If the forecast for next year is 7.0%, the PD becomes 3.75% x 1.6 = 6.0%. If house prices are forecast to fall 15%, and LGD rises 0.8 points for each 1% fall, LGD rises from 40% to 52%. Both feed into ECL. The Scenarios sheet of the Scenario weighting model (Excel) shows the calculation.

How far ahead should forecasts go?

As far as the lender can make reasonable and supportable forecasts, typically two to five years. For later periods, IFRS 9 allows the lender to extrapolate, usually by reverting to long-run average conditions, either immediately or gradually. The length of the period and the reversion method are judgements that should be documented and applied consistently.

Where do forecasts come from?

Banks usually have an in-house economics team or buy forecasts from specialist external providers, and compare them with central bank and consensus forecasts. Companies outside banking often use published forecasts from central banks, governments or international organisations, and their own budget assumptions. Whatever the source, the forecasts used in ECL should be consistent with those used for budgeting, goodwill impairment and going concern, and dated close to the reporting date.

What does "without undue cost or effort" mean?

It sets the limit of the search for information, not an excuse to ignore what is available. Information the company already uses, such as budgets, internal credit reports and published economic forecasts, is available without undue cost or effort. A small company does not need to build an econometric model, but it should use the forecasts it already has.

What are common mistakes with forward-looking information?

Using forecasts that are older than the reporting date; choosing variables because data is available rather than because they explain losses; and ignoring significant information that arrives between finalising the forecasts and approving the accounts.

How do companies outside banking apply this?

Usually in a simpler way than banks: through a forward-looking adjustment to their provision matrix, linking loss rates to GDP, unemployment or an industry indicator; see forward-looking adjustments to a provision matrix. One forecast is often enough for short-term receivables, although scenarios are needed when losses respond non-linearly; see macroeconomic scenarios, scenario weighting and sensitivity analysis.

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