Management overlays in ECL

Why are management overlays needed?

ECL models are built on historical relationships between economic variables and defaults. When something happens that history does not contain, those relationships break. During the COVID-19 pandemic, unemployment forecasts implied surges in defaults, while government support schemes kept borrowers paying; models could not reflect either effect properly, so lenders adjusted the results. Overlays fill the gap between what the model produces and the best estimate IFRS 9 requires.

What are the common types of management overlays?

• Economic events outside the model's data: pandemics, energy price shocks, rapid inflation and interest rate rises affecting borrowers' ability to repay.
• Sector or segment risks: stress in commercial real estate, agriculture after a drought, or an industry facing new regulation, where segment-level models are not granular enough.
• Model limitations: known weaknesses waiting to be fixed in the next model update, such as an LGD model that does not yet reflect falling property values.
• Data issues: missing or late data, such as overdue financial statements from corporate borrowers.

An example: from modelled ECL to reported ECL

Each adjustment has a specific cause, a calculation and an owner. An overlay described only as "economic uncertainty" with a round number would be challenged by auditors.

How are overlays sized?

By rerunning parts of the model with adjusted inputs, by stress testing the affected segment, by analysing recent arrears or defaults that the model has not yet absorbed, or by benchmarking against comparable past events. The method should be documented and repeatable, so the overlay can be updated at each reporting date rather than reset by judgement alone.

Can overlays reduce ECL?

Yes. If a model overstates losses, for example because it reacts to an economic variable distorted by an unusual event, a downward adjustment may be appropriate. Downward overlays receive particular scrutiny, because they reduce the allowance and increase profit.

Do companies outside banking use overlays?

Yes, though they rarely call them that. A company whose provision matrix is based on calm years may add to its loss rates for a customer segment hit by a downturn, or for a large customer known to be struggling. The adjustment should be explained and quantified in the same way, so that it is clearly part of the estimate rather than a general reserve.

What are common mistakes with overlays?

Round-number adjustments with no calculation; overlays that double count risks the model already captures, for example adding a downturn overlay on top of scenario weights that already reflect the downturn; overlays carried forward for years with no release plan; and using overlays to smooth profit between periods, which IFRS 9 does not allow.

What must be disclosed?

IFRS 7 requires information about the inputs, assumptions and techniques used to measure ECL. Lenders typically disclose the amount of each material overlay, its purpose and how it was estimated, and how overlays have changed during the year. See post-model adjustments: governance and release and how to calculate ECL.

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