Provisioning basics · RiskAtoms Academy

By the end you will be able to

1Contrast incurred-loss and expected-loss provisioning, and say why the change was made.
2Calculate 12-month and lifetime ECL for a loan, with marginal PDs and discounting at the effective interest rate.
3Stage a book with a significant-increase test, the 30 and 90 days past due presumptions and a watchlist.
4Run a first ECL on the corporate book, explain the cliff effect and weight scenarios.

Why it matters

The corporate book's expected loss over the next year is £2.81m. Its IFRS 9 loss allowance is more than twice that, £6.00m, and 89% of it comes from just five loans. Under the old rules the bank might have provided almost nothing, because none of the twelve has defaulted. Provisions are where credit risk meets the profit and loss account, and they move with every downgrade.

Core explanation

From expected loss to a loss allowance

Illustrative dataRiskAtoms Bank plc's credit book

The module's lending book: twelve invented corporate borrowers (exposure at default £587m, expected loss £2.81m), retail mortgages, personal loans and cards, a ten-grade master scale, personal-loan vintages and twenty past workouts. Every firm and figure is made up for teaching, in pounds, at one date; none is real data.

EAD, LGD and today's grades are the book's. Grades at approval, remaining terms, days past due and the watchlist are the extras of L3.3.17: Early warning, watchlists and workout. Each loan's original effective interest rate is an extra: 4.5% plus a margin for its grade at approval (2 points more if subordinated).

L2.7.06: Accounting standards and risk introduced the change of rules. Under IAS 39's incurred loss model a bank provided only once a loss event had happened, so provisions arrived “too little, too late”. IFRS 9 asks for a loss allowance equal to expected credit losses from the day a loan is made, in three stages. This lesson does it on the book.

Stage	When (RiskAtoms Bank's rule)	Allowance	Interest revenue on
1	No significant increase in credit risk since approval	12-month ECL	Gross carrying amount
2	PD × 3 or more since approval, or more than 30 days past due, or on the watchlist	Lifetime ECL	Gross carrying amount
3	Credit-impaired: in default (90+ days past due, or unlikely to pay)	Lifetime ECL	Net amount (after the allowance)

Twelve months or a lifetime

12-month ECL is not the loss expected in the next year from everything; it is the loss from defaults that happen in the next 12 months. With the book's one-year PDs it is close to the expected loss of L3.3.10: Expected loss, discounted for half a year: £2.71m on all twelve loans against an expected loss of £2.81m. Lifetime ECL adds every later year in which the loan could default. With a constant annual PD $p$ , the chance of a first default in year $t$ is $p(1-p)^{t-1}$ ; a real model would use a term structure from rating migration (L3.3.07: Rating migration) and point-in-time PDs (L3.3.06: Probability of default).

Staging in practice

IFRS 9 does not define a significant increase in credit risk with a number. Banks combine a quantitative test (here: today's PD at least 3× the PD at approval, so roughly two grades down on a scale whose PDs double each grade), qualitative tests (the watchlist) and the standard's backstop of more than 30 days past due. The comparison is always with the loan's own starting point: a grade 6 loan approved at grade 6 is stage 1; one approved at grade 4 is stage 2. Five of the twelve loans are in stage 2:

Why is each one in stage 2?

Moving a loan to stage 2 multiplies its allowance: that is the cliff effect. For the five, lifetime ECL is £5.34m against £2.05m at 12 months. Across the book, staging adds £3.29m to what 12-month ECL alone would give. The cliff is why stage 2 is watched so closely, by auditors and supervisors, and why a downgrade can hit profit long before any loss.

The formal version

For a loan with constant annual PD $p$ , LGD $L$ , EAD $E$ , original effective interest rate $r$ and $T$ whole years left, with losses assumed in the middle of the year of default:

\begin{aligned} \text{PD}^{\text{marg}}_t &= p\,(1-p)^{t-1}, \qquad \sum_{t=1}^{T} \text{PD}^{\text{marg}}_t = 1 - (1-p)^T \\ \text{ECL}_{12\text{m}} &= p\,L\,E\,(1+r)^{-0.5} \\ \text{ECL}_{\text{life}} &= \sum_{t=1}^{T} p\,(1-p)^{t-1}\,L\,E\,(1+r)^{-(t-0.5)} \\ \text{ECL}_{\text{stage 3}} &= L\,E \quad (\text{PD} = 1;\ \text{simplified}) \\ \text{ECL} &= \sum_{s} w_s\,\text{ECL}_s \quad (\text{scenarios } s \text{ with weights } w_s) \end{aligned}

Larkhollow Freight Ltd: $p = 0.0226$ , $L = 0.3510$ , $E = \text{£}29\text{m}$ , $r = 7.3\%$ , $T = 3$ :

Year t	Survived to start	Marginal PD	Discount factor	Expected loss
1	100.00%	2.260%	0.9654	£222.1k
2	97.74%	2.209%	0.8997	£202.3k
3	95.53%	2.159%	0.8385	£184.3k

\begin{aligned} \text{ECL}_{12\text{m}} &= 0.0226\times0.3510\times\text{£}29\text{m}\times0.9654 = \text{£}222.1\text{k} \\ \text{ECL}_{\text{life}} &= 222.1 + 202.3 + 184.3 = \text{£}608.7\text{k}, \qquad \text{lifetime PD} = 6.63\% \end{aligned}

Simplifications: constant PD from today's grade, constant EAD and LGD, one scenario unless stated, and no further discounting in stage 3. IFRS 9 itself requires an unbiased, probability-weighted amount, the time value of money, and reasonable and supportable information about the past, the present and forecasts. The detail is in M4.7: Accounting for risk.

Try it

Pick Bramwick Stores plc, approved at grade 5. Move its grade from 6 to 7 and watch the provision jump as the loan crosses into stage 2. Then put it back and raise the days past due past 30, and past 90. Finally try Graybeck Plastics Ltd: already in stage 2, its allowance almost quadruples if it defaults.

Try itStage a loan

Borrower

Grade today6 (PD 1.13%)

Days past due0

On the watchlist?

Stage 1No significant increaseProvision £374k

12-month ECL

£374k

Lifetime ECL (3 years)

£1.04m

Credit-impaired: LGD × EAD

£34.20m

PD at approval → today0.57% → 1.13%

Ratio (stage 2 at 3× or more)2.0×

EAD, LGD£76.0m, 45.0%

Original effective rate6.6%

Worked example

A first ECL on the corporate book

From stages to a loss allowance

Step 1 of 5

1
Stage every loan
Apply the rule in order: stage 3 if in default; stage 2 if PD has risen 3× or more, or more than 30 days past due, or on the watchlist; otherwise stage 1. Result: 7 loans (£438.5m) in stage 1, 5 (£148.5m) in stage 2, none in stage 3.

What the finance and risk teams agree

Corporate book ECL £6.00m (1.02% of EAD): stage 1 £0.65m, stage 2 £5.34m. Sensitivity: if the 7 stage 1 loans all moved to stage 2, the allowance would rise by £1.48m. Review whether an overlay is needed for the retail and real estate sectors.

Regulatory lens

IFRS 9 (issued July 2014, effective 1 January 2018) sets the rules used above: 12-month ECL in stage 1 and lifetime ECL once credit risk has increased significantly (paragraphs 5.5.5 and 5.5.3); a rebuttable presumption of a significant increase when payments are more than 30 days past due (5.5.11); a rebuttable presumption that default happens no later than 90 days past due (B5.5.37); discounting at the original effective interest rate (B5.5.44); and an unbiased, probability-weighted estimate using reasonable and supportable information (5.5.17). For credit-impaired loans interest revenue is calculated on the amortised cost after the allowance (5.4.1). The US uses CECL instead, with lifetime losses from day one. The Basel Committee recommends that the accounting definition of default, which sends a loan to stage 3, be guided by the regulatory one (L3.3.17: Early warning, watchlists and workout). How provisions interact with capital, the expected-loss shortfall and transitional relief are in M4.7: Accounting for risk and M4.2: Credit risk capital.

Spark Atoms

Spark AtomSpain looked ahead first

In 2000 the Banco de España introduced a “statistical” (often called dynamic) provision: banks built up a fund in good years, based on the losses their lending would produce over a cycle, and drew on it in bad ones. It was an early attempt at forward-looking provisioning, nearly two decades before IFRS 9.

Spark AtomNot mechanically

On 27 March 2020, as governments granted payment holidays in the pandemic, the IASB published a note on IFRS 9 and covid-19. It told banks they “should not continue to apply their existing ECL methodology mechanically”, and that a payment deferral for a whole class of borrowers should not automatically mean each loan had a significant increase in credit risk.

Key takeaways

IFRS 9 provides for expected losses from day one; IAS 39 waited for a loss event (too little, too late).
Stage 1: 12-month ECL. Stage 2 (significant increase): lifetime ECL. Stage 3 (credit-impaired): lifetime ECL and interest on the net amount.
Lifetime ECL = Σ p(1 − p)^(t−1) × LGD × EAD × discount factor at the original EIR; staging the book adds £3.29m to 12-month ECL alone.
Staging compares today's risk with the loan's own starting point; 30 days past due and 90 days past due are rebuttable backstops.
ECL is probability-weighted across scenarios, so downside scenarios raise it; the corporate book's allowance is £6.00m against £2.81m of one-year EL.

Reaction

Check what stuck

Glossary

Loss allowance: Loss allowance: the amount set aside in the accounts against expected credit losses on loans. Increases are charged to profit.
12-month ECL: 12-month ECL: the lifetime losses that would result from defaults in the next 12 months, weighted by the probability of those defaults.
Lifetime ECL: Lifetime ECL: expected losses from defaults at any time over the remaining life of the loan.
Significant increase in credit risk (SICR): Significant increase in credit risk since the loan was first recognised. It moves a loan from stage 1 to stage 2.
Credit-impaired: Credit-impaired: one or more events with a detrimental effect on the loan's expected cash flows have happened, such as default or a distressed restructuring. Stage 3.
30 and 90 days past due presumptions: IFRS 9's rebuttable presumptions: credit risk has increased significantly by 30 days past due, and default has happened by 90 days past due.
Effective interest rate: Effective interest rate: the rate that discounts a loan's expected cash flows to its initial carrying amount. ECL is discounted at the original EIR.
Cliff effect: The jump in a loan's provision when it moves from 12-month to lifetime ECL.
Management overlay: A management adjustment to modelled ECL for risks the models do not capture yet.
Coverage ratio: Loss allowance divided by gross exposure: the share of the book already provided for.

Deep Dives & Origins

Deep Dives

Basel Committee on Banking Supervision, Guidance on credit risk and accounting for expected credit losses, BIS, December 2015. Intermediate.
S. Fernández de Lis, J. Martínez Pagés and J. Saurina, “Credit growth, problem loans and credit risk provisioning in Spain”, Banco de España Working Paper 0018, 2000. Advanced.

Origins

IASB, IFRS 9 Financial Instruments, July 2014, paragraphs 5.4.1, 5.5.3, 5.5.5, 5.5.11, 5.5.17, B5.5.37 and B5.5.44.
IFRS Foundation, “IFRS 9 and covid-19”, 27 March 2020.
FASB, Accounting Standards Update 2016-13, Financial Instruments—Credit Losses (Topic 326), June 2016.

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