Expected credit losses – a brave new world?

The world economy is shifting to a new phase with higher inflation and interest rates than at any time since the global financial crisis of 2008.

The UK is affected more than most, with major impacts on the daily lives of consumers and the prospects of businesses across the economy.

Against this background, the past few weeks have seen a localised financial shock in the UK. This followed the now-former chancellor’s mini-budget (without associated Office for Budget Responsibility (OBR) forecasts or offsetting spending decreases), which had the effect of undermining markets’ confidence in the UK economy and its public finances. Following intervention in the gilt markets by the Bank of England (BoE) and subsequent policy U-turns, much of the slump in 30-year gilt prices has since been reversed. The impacts of the resignation of the prime minister and forthcoming fiscal statements on market sentiment are, at the time of writing, yet to be seen.

The uncertainty and volatility that come with the shift are likely with us for the foreseeable future. It has already necessitated action from the BoE in the UK government bond market and will, in the near future, around interest rates. Market expectations around base rates have increased from an expected peak of 4 – 4.5 per cent next year to close to six per cent, before falling slightly to about five per cent. This has already affected mortgages, through rate rises and the withdrawal of mortgages by many lenders. It will impact corporate lending and unsecured consumer borrowing.

Current expected credit loss (ECL) models are not equipped for the new normal

The new environment fundamentally affects the risks faced by lenders from their existing loan portfolios and from new lending.

More than ever, as set out in the BoE’s recent Dear CFO letter, firms should be reviewing their Expected Credit Loss (ECL) processes. They should be engaging with experts so that they are able to reflect and manage an increasingly challenging lending market. Models in use currently all too often do not contain within them any direct ability to determine the impact of inflation and substantial interest rate rises on the likelihood of their customers defaulting, and subsequently on ECLs. This is a consequence of historical interest rates and inflation having no easily quantifiable link to fluctuations in default rates – they simply haven’t been a deterministic issue in the recent past.

This gives rise to a two-track issue, depending on businesses’ year end:

  1. Businesses which have time until their next financial reporting year end, should already be engaging with experts to expand on their modelling so that these hugely significant factors are taken into account.
  2. Businesses planning to report over the next few months, should already be developing robust and well thought through quantitative overlays to their models. These may leverage customer data on affordability or exogenous data on affordability shocks but should be quantitatively devised so that they can be substantiated.

For businesses with near term financial reporting requirements, the imperative for action is self-evident.