PRA thematic feedback on 2021/22 written auditor reporting

Each year the PRA receives a written report from the auditors of regulated firms responding to questions of particular supervisory interest. The key themes of the reports are then shared with the Chief Financial Officers (CFOs) of the largest UK banks. 

This year's Dear CFO letter, for the 2021/2022 round of written auditor reporting, focused on the PRA's thematic findings relating to IFRS 9 Financial Instruments expected credit losses (ECL), accounting for climate risks, disclosures and benchmark reform. 

The letter is of relevance to all banks, building societies and similar financial institutions (firms) with a material ECL balance on their balance sheet, even if they have an indirect exposure. The key findings relating to ECL and accounting for climate risks are summarised below. 

While the PRA found it encouraging that firms have made “significant efforts” to apply lessons learned from the pandemic to current economic challenges, it notes that, as last year, further progress is still required to embed high quality practices. The PRA's observations focus on three core areas: model risk, economic scenarios and recovery strategies.

1. Model risk

Model performance has continued to be impaired due to challenges in capturing the uncertain economic outlook and long-standing limitations in firms' approaches. The PRA is prioritising effective oversight of model risk and advises firms to engage with the consultation on proposed model risk management principles for banks. 

Given the impacts of global inflationary pressures on borrowers, the PRA encourages firms to consider whether their ECL estimates accurately reflect the vulnerabilities of specific sectors or segments. This may require the use of a broader set of data to identify borrowers experiencing affordability issues, and the enhancement of capabilities to quantify the associated risks, including analytical tools to capture expectations for future deterioration in affordability. 

Firms should make appropriate use of post model adjustments (PMAs), based on expert judgement, to ensure that provisions reflect actual credit risk expectations. PMAs should be subject to high-quality governance and firms should ensure that they are not released before the underlying issues have been addressed. 

2. Economic scenarios

There are limitations in firms' abilities to respond to events shortly before the end of the reporting period, and to develop scenarios that explore vulnerabilities in specific sectors or segments. In addition, there is a lack of internal challenge on downside scenarios capturing non-linearity. 

The PRA expects firms to develop capabilities to perform more comprehensive economic sensitivity analysis more quickly, and to improve their use of timely, granular and comparable peer benchmarking data to support robust governance.

3. Recovery strategies

Firms made extensive use of simplified ways to incorporate economic forecasts into loss given default (LGD), however there was limited use of LGD adjustments to reflect elevated risks that past experience may not be a good indicator of future recovery rates. Thresholds used to determine when multiple recovery outcomes are used to calculate LGD should be reassessed regularly to ensure that they are sensitive to sectoral risks and updated for changes in high risk sectors.

For the next round of written auditor reporting, the PRA will ask for auditors' views on firms' progress on these key plan elements in order to establish a baseline for future monitoring.

Implications for firms

The PRA's letter is likely to result in:

• Continued scrutiny of the internal ECL model, especially the extent to which it captures the impacts of current economic situations (e.g. high inflation, interest rate uncertainty and the cost of living crisis  - including its impact on affordability)
• More frequent challenges on how firms are using PMAs and whether they accurately reflect credit risk expectations
• Continuing focus on and evolving expectations for firms' climate risk management capabilities and their consideration of climate risk in financial reporting 

Uncertain economic conditions make high quality practices even more important. Firms are encouraged to carry out their own analysis on the extent to which they are applying high quality practices and make it available as part of the year-end audit. In 2023, the PRA plans to discuss firms' plans to make changes to their ECL approach that would improve consistency. The PRA will also work to identify standard industry metrics around the effectiveness of different approaches to significant increases in credit risk (SICR).

Firms have taken steps to enhance their climate-related governance, data and risk assessments and auditors did not identify any specific risks of material misstatement. However, firms are at different stages of preparation, particularly in relation to the capture of climate risk in ECL. Auditors found that there was a lack of reasonable and supportable data made available to management on their exposure to climate risk and consequently to auditors on potential impacts on the balance sheet. Where data was available, quality control around new data sources and proxies was immature. Some firms were more advanced in identifying data and modelling requirements and assessing how economic scenarios could be adapted to reflect the impact of climate risks. 

The PRA expects firms to have detailed plans for developing their capabilities to capture the impact of climate risks on balance sheets to ensure that accounting practices evolve at the same pace as improvements in risk monitoring. “Key plan elements” are consistent with the expectations in the PRA's Supervisory Statement 3/19 and the findings of the 2021 Climate Biennial Exploratory Scenario (CBES) exercise and include: 

• Embedding governance and allocating responsibilities within the financial reporting functions to ensure the timely capture of climate risks
• Increasing and embedding the use of quantitative analysis in climate risk assessments to support decision making
• Developing management information to oversee plans to enhance data and models needed to factor climate risk into balance sheet valuations long — and to track the significance and implications of their limitations
• Developing centralised processes to manage relevant data, improving controls around data and monitoring data quality
• Identifying climate-related risk drivers that could influence ECL for loan portfolios that have the highest sensitivity to climate risk and enhancing review and monitoring by second line risk teams 
• Increasing use of quantitative analysis of the potential impact of climate risk on balance sheet valuations to support robust valuation processes. Enhancing monitoring and controls over these processes and ensuring that climate risk is sufficiently considered in accounting policies for new and existing products, including tracking exposure to instruments with climate-linked terms

For the next round of written auditor reporting, the PRA will ask for auditors' views on firms' progress on these key plan elements in order to establish a baseline for future monitoring.

The PRA's letter is likely to result in:

• Continued scrutiny of the internal ECL model, especially the extent to which it captures the impacts of current economic situations (e.g. high inflation, interest rate uncertainty and the cost of living crisis  - including its impact on affordability)
• More frequent challenges on how firms are using PMAs and whether they accurately reflect credit risk expectations
• Continuing focus on and evolving expectations for firms' climate risk management capabilities and their consideration of climate risk in financial reporting