Does ECL measurement appropriately reflect the impact of economic uncertainty?

24 February 2022 (updated 31 October 2023)

Global IFRS Institute | Uncertain times

Measurement of ECLs

IFRS 9 Financial Instruments requires expected credit losses (ECLs) to be measured as an unbiased, probability-weighted amount, using reasonable and supportable information that is available without undue cost or effort at the reporting date. This includes information about past events, current conditions and forecasts of future economic conditions. [IFRS 9.5.5.17]

Evaluating ECLs requires companies to consider a range of possible outcomes and their respective probabilities, and to apply judgement when determining what constitutes reasonable and supportable forward-looking information. [IFRS 9.B5.5.42]

Companies may find this particularly difficult for emerging issues:

• that have not previously been included in a company’s planning and forecasting process; and
• whose future economic consequences are particularly challenging to determine.

However, a company cannot assert that reasonable and supportable information about a matter is unavailable simply because modelling its effects appears difficult or because it would involve a wider than usual range of possible results. [Insights 7.8.238]

In periods of increased economic uncertainty the challenge for companies is to incorporate into their measurement of ECLs the forward-looking information that is available without undue cost or effort at the reporting date.

Economic uncertainty caused by external events – e.g. geopolitical unrest, natural disasters, climate effects or inflationary pressures – can cause severe impacts across many jurisdictions. Governments, central banks and economists may revise their economic forecasts to try to incorporate the likely impacts. However, the economic outlook may change quickly.

Companies are required to update the economic forecasts that they use to measure ECLs at each reporting date by incorporating the reasonable and supportable information available at that time. The effort and sophistication required will depend on the company’s exposures. ECLs are usually material for banks and other financial institutions: these companies are likely to continue to face the greatest challenges and will need to put the most resources into updating ECLs to reflect changing conditions. [IFRS 9.5.5.17]

The following factors may be particularly relevant when measuring ECLs.

• Uncertainty about potential future economic scenarios and their impact on credit losses may require companies to explicitly consider additional economic scenarios when measuring ECLs. [IFRS 9.B5.5.42]
• Existing ECL models use historical experience to derive links between ECL parameters (e.g. loss rates, probabilities of default and loss given default) and changes in economic conditions and customer behaviour. However, these historical relationships are unlikely to remain stable in times of economic uncertainty. Therefore, adjustments to model results, based on expert credit judgement and the most recent economic data, could be necessary to reflect the information available at the reporting date appropriately.
• Certain types of customers, industries or regions may be affected by economic uncertainty more than others. Companies with exposure to these customers, industries or regions will need to consider whether this exposure is captured appropriately in their ECL measurements.
• There may be impacts from government and central bank measures to mitigate the adverse impact of economic uncertainty on banks and borrowers.
• Many borrowers may draw down credit lines or hold on to cash to obtain additional liquidity to help them weather the economic storms. This will be relevant for estimating exposures from loan commitments and prepayable or extendable loans.
• The expected cash flows used in measuring ECLs may also be affected by any actions planned or taken by the company – e.g. modification, forbearance, limit extensions. [IFRS 9.5.5.12, Insights 7.8.260.20]
• Also, limit increases for credit cards may impact the period of exposures assessed under paragraph 5.5.20 of IFRS 9.

Disclosures

A company is required to disclose the nature and extent of risks arising from financial instruments and how it manages those risks. Therefore, a company will need to explain the significant impacts of economic uncertainty on the risks arising from financial instruments and how it is managing those risks. It will need to use judgement to determine the specific disclosures that are relevant to its business and necessary to meet these disclosure objectives. [IFRS 7.31]

Examples of specific disclosures include the following.

• Information about a company’s credit risk management practices and how they relate to the recognition and measurement of ECLs. A company may have changed its risk management practices in response to the impact of increased economic uncertainty – e.g. by extending debt relief to borrowers or by following specific guidance issued by governments or regulators. [IFRS 7.35F]
• The methods, assumptions and information used to measure ECLs – e.g. a company may need to explain how it has incorporated updated forward-looking information into measuring ECLs; in particular:
  • how it has dealt with the challenge of ECL models that were not designed for the economic shocks; and
  • how it has calculated overlays and adjustments to these models.
• Quantitative and qualitative information that allows evaluation of the amounts arising from ECLs; the types of analysis disclosed previously may need to be adjusted or supplemented to clearly convey the evolving impacts arising from the economic uncertainty. [IFRS 7.35H–L]
• Information on the assumptions that the company has made about the future and other major sources of estimation uncertainty at the reporting date that have a significant risk of resulting in material adjustment within the next financial year. [IAS 1.125]

Consider the following when measuring ECLs:

• whether additional economic scenarios are needed;
• whether adjustments to model results, based on expert credit judgement, are necessary;
• whether the measurement appropriately captures the types of customers/issuers or regions that are particularly impacted by the effects of economic uncertainty;
• changes in customer behaviour such as drawing more extensively on credit lines and holding on to cash;
• the impact of any assistance to borrowers from a government or regulator; and
• the impact of any actions planned or taken by the company (e.g. modification, forbearance, limit increases) on the expected cash flows.