Methodology for measuring expected credit losses (ECL) according to IFRS 9
Sparebanken Møre has developed an ECL model based on the Group’s IRB parameters and applies a three-stage approach when assessing ECL on loans to customers and financial guarantees in accordance with IFRS 9.
Stage 1: At initial recognition and if there’s no significant increase in credit risk, the commitment is classified in stage 1 with 12-months ECL.
Stage 2: If a significant increase in credit risk since initial recognition is identified, but without evidence of loss, the commitment is transferred to stage 2 with lifetime ECL measurement.
Stage 3: If the credit risk increases further, including evidence of loss, the commitment is transferred to stage 3 with lifetime ECL measurement. The commitment is considered to be credit-impaired. As opposed to stage 1 and 2, effective interest rate in stage 3 is calculated on net impaired commitment (total commitment less expected credit loss) instead of gross commitment.
Staging is performed at account level and implies that two or more accounts held by the same customer can be placed in different stages.
An increase in credit risk reflects both customer-specific circumstances and development in relevant macro factors for the particular customer segment. The assessment of what is considered to be a significant increase in credit risk is based on a combination of quantitative and qualitative indicators, as well as “backstops” (see separate section regarding “backstops”)
A significant increase in credit risk is determined by comparing the PD at the reporting date with PD at initial recognition. If the actual PD is higher than initial PD, an assessment is made of whether the increase is significant.
Significant increase in credit risk since initial recognition is considered to have occurred when either
- PD has increased by 100 per cent or more and the increase in PD is more than 0.5 percentage points, or
- PD has increased by more than 2 percentage points
A 12-months PD is used to determine whether the credit risk has increased significantly.
In addition to the quantitative assessment of a changes in the PD, a qualitative assessment is made to determine whether there has been a significant increase in credit risk, for example, if the commitment is subject to special monitoring.
Credit risk is always considered to have increased significantly if the following events, “backstops”, have occurred:
- the customer’s contractual payments are 30 days past due
- the customer has been granted forbearance measures due to financial distress, though it is not severe enough to be individually assessed in stage 3
Significant reduction in credit risk – recovery
A customer migrates from stage 2 to stage 1 if:
- The criteria for migration from stage 1 to stage 2 is no longer present, and
- This is satisfied for at least one subsequent month (total 2 months)
A customer migrates from stage 3 to stage 1 or stage 2 if the customer no longer meets the conditions for migration to stage 3:
- The customer migrates to stage 2 if more than 30 days in default.
- Otherwise, the customer migrates to stage 1.
Customers who are not subject to the migration rules above are not expected to have significant change in credit risk and retain the stage from previous month.
Definition of default, credit-impaired and forbearance
The definition of default has been amended from 1 January 2021 and has been extended to include breaches of special covenants and agreed payment reliefs (forbearance). The new default definition has not changed the Group’s assessment of credit risk associated with individual exposures, and there is therefore no significant effect on the Group’s losses in the third quarter.
A commitment is defined to be in default and credit-impaired (non-performing) if a claim is more than 90 days overdue and the overdue amount exceeds the highest of 1 per cent of the exposure (loans and undrawn credits) and NOK 1,000 for the retail market and NOK 2,000 for the corporate market. Breaches of covenants can also trigger default.
A commitment is also defined to be credit-impaired (non-performing) if the commitment, as a result of a weakening of the debtor's creditworthiness, has been subject to an individual assessment, resulting in a lifetime ECL in stage 3.
A commitment is defined to be subject to forbearance (payment relief due to payment difficulties) if the bank agrees to changes in the terms and conditions as a result of the debtor having problems meeting payment obligations. Performing forbearance (not in default) is placed in stage 2 whereas non-performing (defaulted) forbearance is placed in stage 3.
As part of the process of granting payment relief, a specific, individual assessment is made of whether the application for payment relief is ‘forbearance’ and whether the loan should thus migrate to stage 2 (performing) or stage 3 (non-performing) in the Group’s ECL model.
Quarterly review meetings evaluate the basis for the accounting of ECL losses. If there are significant events that will affect an estimated loss which the model has not taken into account, relevant factors in the ECL model will be overridden. An assessment is made of the level of long-term PD in stage 2 and stage 3 under different scenarios.
Consequences of Covid-19 and measurement of expected credit loss (ECL) for loans and guarantees
Pursuant to the accounting rules (IAS 34), interim financial reports must provide an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of an entity since the last annual report. The information related to these events and transactions must take into account relevant information presented in the most recent annual report.
The bank’s loss provisions reflect expected credit loss (ECL) pursuant to IFRS 9. When assessing ECL, the relevant conditions at the time of reporting and expected economic developments are taken into account.
Covid-19 has resulted in an extraordinary situation for the bank’s customers. Even though we are back to a normal everyday life (with increased preparedness), there is still considerable uncertainty associated with expected developments both in Norway and in the world economy, and the picture is constantly changing. Some industries have changed fundamentally due to the rapid digitalization that occurred during Covid-19. Further, we will see changes in the economy due to the climate issue and the focus on sustainability. This means that there is greater uncertainty about critical estimates.
In the Group’s calculations of expected credit loss (ECL), the macroeconomic scenarios and the weightings have been impacted by the changes in economic conditions through 2020 and 2021.
During the second half of 2021, the outlook has become more positive and clearer. There are improvements in macroeconomic conditions. There are very few bankruptcies and the level of default is relatively low. Increased compulsory liquidation of companies and an increase in the number of bankruptcies are expected when deferred public debt falls due for payment.
No changes have been made in scenario weighting or other assumptions in the Group’s loss model. The probability of a pessimistic scenario is 20 per cent, the base case scenario is 70 per cent probability and the best case scenario is 10 per cent.