Stage 2 lending: what banks watch

A stage 2 example for a loan book

If a weaker economic forecast moves 500 million of loans from stage 1 to stage 2, their coverage rises from 0.3% to 3.5%, because they now carry lifetime ECL, adding 16 million to the allowance, before any borrower misses a payment. That cliff effect is why stage 2 is so closely watched.

What coverage levels are typical?

Coverage rises sharply from stage to stage. For a typical mixed loan book, stage 1 coverage is usually a fraction of a percent, stage 2 a few percent, and stage 3 tens of percent, depending heavily on collateral. Unsecured consumer lending sits at the high end of each range and mortgages at the low end, so the portfolio mix matters as much as the economy.

How does stage 2 move through the economic cycle?

It tends to rise early in a downturn, as forecasts worsen and borrowers' risk increases, peak before defaults do, and then fall as loans either cure or move to stage 3. A bank whose stage 2 balance barely moves in a downturn may have SICR criteria that are too slow.

What drives stage 2 loans at banks?

• Borrower deterioration: rating downgrades, arrears, covenant breaches, forbearance and watchlist status.
• Forecasts: worse economic scenarios raise lifetime PDs across the book, pushing loans over relative thresholds.
• Model and threshold changes: recalibrating PD models or tightening SICR thresholds can move large balances without any change in borrowers.
• Overlays: some banks move whole sectors, such as commercial real estate, into stage 2 as part of an overlay.

How should stage 2 disclosures be read?

Look at the stage transfers in the reconciliation of gross loans and allowance by stage: how much moved into stage 2, how much cured back to stage 1, and how much moved on to stage 3. A rising stage 2 balance with few transfers to stage 3 may reflect cautious forecasts; a rising stage 2 balance followed by rising stage 3 confirms real deterioration. Banks also disclose why loans are in stage 2, for example how much is triggered by the PD test, by days past due, or by watchlist status.

Can stage 2 ratios be compared across banks?

Only with care, and never on the ratio alone. IFRS 9 does not define a significant increase in credit risk, so banks use different thresholds; some include the low credit risk exemption, others do not; and portfolios differ. Supervisors have published reviews showing wide differences in stage 2 ratios for similar exposures, and press banks to make their criteria responsive.

How do banks manage stage 2?

Through early-warning systems that flag deteriorating borrowers, regular watchlist reviews, and monitoring of stage 2 by sector and product. Loans in stage 2 often receive closer credit management, and banks track how long loans stay there and how many cure, reporting both to their risk and audit committees. See significant increase in credit risk, ECL stages explained and bank accounting.

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