Significant Increase in Credit Risk: a Worked Example

When a bank prices a loan, the margin is meant to pay for the risk it can see that day. If the risk later rises well above that level, the margin no longer pays for it, and the accounts should stop implying that it does. Expected credit loss accounting deals with this by changing the horizon. A loan whose risk has not moved much carries twelve months of expected loss. A loan whose risk has moved a long way carries the loss expected over all its remaining years.

The standard is IFRS 9, issued as NZ IFRS 9 in New Zealand and AASB 9 in Australia, and applied in the UK by lenders reporting under UK-adopted international standards. It is not universal. A smaller UK lender reporting under FRS 102 may have chosen that standard's own impairment rules, which wait for objective evidence of loss and have no stage 2.

Three features surprise people. First, the test looks at the risk of default, not the size of the expected loss, so strong security does not keep a loan in stage 1. It lowers the allowance once the loan has moved, but it does not stop the move. Second, the comparison is relative: the same rise in default risk counts for more on a loan that began safe than on one that began risky. Third, the standard sets no figure for "significant". Each bank writes its own staging policy, usually a measured change in lifetime default probability or internal rating, alongside judgement on indicators the standard lists, such as a fall in operating results, a deteriorating sector or an expected covenant waiver.

There is one backstop. A loan more than 30 days past due is presumed to have moved, unless the bank has reasonable and supportable information to the contrary. Where a bank has forward-looking information it cannot rely on arrears alone, so 30 days is the last point of the test and not the working one. The assessment can also be made collectively, which is how a whole sector can move on a change in outlook with no event at any one borrower. The standard also offers a shortcut: a lender may assume no significant increase where an instrument has low credit risk at the reporting date, and its guidance gives an investment-grade rating as an example.

A maker of conveyor belts for quarries, constructed for this page like every figure in it, borrows US$8m for five years, interest only. At the start the bank puts the chance of default in the next twelve months at 1.0% and its loss given default at 35%. Two years on, the two largest customers have stopped ordering, though every payment has been on time. The bank now puts default over the three years left at 12.0%; when the loan was made, it expected 3.6% for those same three years. Its twelve-month figure is now 4.5%. This bank's policy treats a doubling of lifetime default risk as significant, which belongs to the example and is not a market norm. The standard requires expected losses to be probability-weighted across a range of outcomes and discounted; both steps are left out here so the arithmetic shows.

About two-thirds of the charge comes from the longer horizon and one-third from the worse risk. Change one fact and the staging changes. If the same loan had been made to a riskier business, with 9.0% expected for those three years, today's 12.0% would be 1.3 times its starting point and it would stay in stage 1, with an allowance of US$126,000. Two loans with the same risk today carry allowances US$210,000 apart, because of where each began.

Stage 2 and stage 3 both carry lifetime loss, but they describe different loans. A stage 3 loan is credit-impaired: something has already happened, the probability of default has in effect reached certainty, and interest income is calculated on the balance net of the allowance. A stage 2 loan is still performing and interest is still earned on the gross balance. Stage 2 is not the same as non-performing, which is a separate classification used in regulatory reporting and bank results.

The watch list is the bank's own management tool. It overlaps with stage 2 and many banks treat a watch-list entry as an indicator, but one is a decision about attention and the other a measurement for the accounts. Forbearance is a third thing: a concession to a borrower in difficulty. A loan whose terms are modified without being derecognised is assessed by comparing the risk now, on the new terms, with the risk at the start, on the old ones, so a kinder schedule does not by itself restore stage 1.

DEFINED IN ONE PARAGRAPH → · STAGE 3, WORKED → · ONE LOAN, PROVISION TO WRITE-OFF →

A move to stage 2 is normally an internal event. It is not usually notified to the borrower, and most facility letters contain nothing that turns on it. Its effect arrives by another road. The charge lands in a portfolio's results, so the relationship team is asked to explain it; the file tends to receive closer monitoring; and any request for more money or more time is read against a loan already carrying its full remaining loss. A longer tenor at renewal also lengthens the period over which a lifetime allowance is measured.

It runs both ways. If the risk falls back so that it is no longer significantly higher than at the start, the allowance returns to twelve months and the difference is released to profit. For a reader of bank accounts, the stage 2 balance is often the earliest place a book's weakening shows, because arrears and non-performing loans come later. That is why it is read with provision coverage and the expected loss behind it, and against the same bank a year before.

PROVISION COVERAGE, WORKED → · HOW TO READ BANK RESULTS →