• 2. 2. Staging And Default

    IFRS 9 requires banks and finance companies to assess, at each reporting date, whether the credit risk of a financial instrument has increased significantly since its initial recognition. For that purpose, it relies on the concept of Significant Increase in Credit Risk (“SICR”). Clients subject to SICR have their ECL computed over the lifetime of their facility (stage 2) instead of the one-year horizon applicable otherwise (stage 1). SICR is generally driven by several quantitative and qualitative factors, under the discretion of banks and finance companies, and reviewed by external auditors. Amongst others, common drivers of SICR are clients’ number of days-past-due (“DPD”), increase in probability of default (“PD”) and change of rating.

    • 2.1. Repayment Events and Staging Implications

      Over the next few months, banks and finance companies are likely to witness a range of facility repayment events, directly or indirectly, linked to the Covid-19 crisis. These events should not automatically trigger SICR. The nature of such events is set out below, as well as their staging implications.

      Payment deferrals: A large number of clients are expected to be offered payment deferrals by which they will temporarily cease payments of principal and/or interest/profit. Their facilities may be re-scheduled or restructured, and in some cases, additional credit lines may be offered. The TESS scheme issued by the CBUAE intends to facilitate this process by offering zero-cost funding to banks and finance companies. Regulators recognise that some clients will also benefit from payment deferrals outside of the TESS scheme, as banks and finance companies may voluntarily offer payment deferrals to clients outside of this programme. Consequently, the pool of clients benefitting from payment deferrals will comprise both ‘TESS clients’ and ‘non-TESS clients’.
      Staging for TESS clients: The TESS circular amended on 4 April 2020 states under point 9.1. d), that the IFRS 9 staging for TESS clients shall normally remain unchanged for the duration of the scheme. This is based on the presumption that most of these clients will not experience a significant increase in credit risk by virtue of their eligibility for the scheme. In reality, the range of situations will vary and a tailored approach is necessary to align with IFRS principles. Therefore, the aforementioned stage migration principle contained in the TESS needs to be interpreted to allow migrations when needed. Further guidance is given in section 2.2 below.
      SICR Issues: In light of these repayment arrangements and of the government support scheme, the existing mechanisms in place within banks and finance companies to trigger SICR may not be appropriate to address the exceptional circumstances of this crisis. These mechanisms would most likely fail to recognize the scale of various support measures being put in place by government authorities and central banks, both globally and in the UAE. In addition, even certain clients not benefitting from repayment arrangements can be indirectly impacted by the Covid-19 crisis and therefore the SICR triggers currently in place, should be applied cautiously and subject to exercise of judgement.
      Rebuttable Presumption: More specifically, IFRS 9 includes a rebuttable presumption that a facility with more than 30 DPD has undergone a SICR. However, this assumption is likely to be rebutted for clients benefitting from exceptional payment deferrals due to the crisis. For these clients, DPD should no longer be used as a relevant automatic indicator of SICR. Instead it should be frozen at the date of facility rescheduling. DPD can be used again as a relevant indicator when the client leaves the scheme, if the client encounters delays in payment thereafter. Additionally, all other factors usually driving SICR should be carefully evaluated, without automatic triggers, in particular those resulting in the revision of PD and internal/external credit ratings, for the duration of the crisis.

    • 2.2 2.2. Interim Solution: Categorisation

      In light of the points mentioned above, for the purpose of staging updates, banks and finance companies are encouraged to apply judgment and consider clients as explained below - for wholesale and retail clients respectively.

      The Regulators expect that such analysis should start as soon as sufficient, reasonable and supportable information is available. This process is expected to be gradual and iterative as the degree of uncertainty surrounding the Covid-19 crisis reduces through time. Until decided otherwise by bank and finance company management, all clients benefitting from payment deferrals will remain in their current stage, unless movement to a lower stage is motivated by events such as bankruptcy, fraud or skip of owners and senior managers. For consistency and practical purposes, the period of applicability of this interim solution is expected to be in line with that of the TESS scheme because, at this point in time, the TESS duration is a relevant benchmark for the crisis duration.

      • 2.2.1. Wholesale Clients (including SMEs)

        For clients not benefitting from payment deferrals, the SICR mechanisms in place would continue to be applied but with judgmental overrides, when deemed appropriate. This means that stage migrations automatically triggered should be analysed and understood, with the option to be stopped if clients are expected to recover relatively quickly, once the Covid-19 crisis is over. This remains in line with the spirit of IFRS 9, which requires an assessment of the lifetime creditworthiness of a facility.

        For clients benefitting from payment deferrals (all TESS clients and some non-TESS clients) instead of relying on the mechanistic SICR triggers in place, banks and finance companies should separate these clients into two groups based on dedicated analyses, using the following principles:

        Group 1: clients that are temporality and mildly impacted by the Covid-19 crisis.
        o For these clients, the payment deferrals are believed to be effective and thus the economic value of the facilities is not expected to be materially affected. These clients are expected to face liquidity constraints without substantial changes in their creditworthiness.
        o For these clients, banks should hold the view that, despite being subject to payment deferrals, there is insufficient deterioration in credit quality to trigger a stage migration. These clients will remain in their current stage, at least for the duration of the crisis, or their distress, whichever is the shorter. For instance, this would apply to industries that are expected to rapidly return to normal business conditions, once confinement policy decisions are over.
        Group 2: clients that are expected to be significantly impacted by Covid-19 in the long term.
        o These clients are expected to face substantial changes in their creditworthiness beyond liquidity issues. For these clients, there is sufficient deterioration in credit risk to trigger a migration to stage 2, and this migration should take place.
        o Due to the possibility of later economic rebound, these clients are not expected to migrate to IFRS 9 stage 3 based on their financial performance during the period of the crisis. In exceptional circumstances, such stage 3 migration can be triggered by liquidation/ bankruptcy caused by (i) non-financial events (such as fraud) or (ii) significant disruptions threatening the long-term sustainability of the clients’ business model.
        o Consequently, banks and finance companies must continue to monitor the creditworthiness of these clients, particularly indications of potential inability to pay any of their obligations as and when they become due.

        The above grouping decisions should take into consideration the specific circumstances of clients in the context of the Covid-19 outbreak. Banks and finance companies should perform analyses by incorporating at least the following principles:

        a) Grouping decisions should rely on a mixture of quantitative analysis and a judgmental approach based on the views of clearly identified subject matter experts within banks.
        b) Grouping decisions should be in line with the spirit of IFRS 9 stages; relying on the assessment of credit risk over the lifetime of facilities. Hence the necessary distinction between clients that are impacted over the short term vs. long term.
        c) It is expected that clients will face a range of impact intensity and duration. Therefore, grouping will be achieved by establishing cut-offs based on expert judgment. Industries and sectors could be used as a commonly accepted starting point for segmentation.
        d) For clients to which banks and finance companies have a material exposure, analyses are expected to be performed on a case-by-case basis. For clients with less material exposures, analyses should be performed on a portfolio basis and be based on credit risk drivers, typically industry, tenor and rating. It may be useful to set appropriate materiality thresholds for the purpose of client segregation. For example, in this context, a client could be considered material if it belongs to the top 50 clients ranked by the size of exposure at default (“EAD”) or contributes to the cumulative top 30% of the total wholesale portfolio EAD. Banks and finance companies with less than 50 clients would therefore treat their entire portfolio on a case-by-case basis, for the purpose of this exercise.
        e) For the purpose of establishing priorities in this grouping exercise, banks and finance companies are expected to organize their portfolio by materiality and susceptibility to the crisis, and start with the most material/susceptible segments. It is expected that the assessment will be more reliable at an individual account/obligor level rather than at a portfolio level.
        f) Ultimately, banks and finance companies should assess if their clients have put in place appropriate measures to cope with the crisis, in particular, decisions related to the management of their cash position, inventories, fixed costs and financial costs.
        g) Considerations related to parent/government guarantee and collateral should also be included in the grouping decision, as such decision should consider potential credit enhancement.

        Return to stage 1: For wholesale clients classified in Group 2 during the crisis, banks and finance companies may consider migrating them back to stage 1 once there is clear evidence that customers are no longer impacted by the Covid-19 crisis. The analysis of staging upgrade must be performed at least at the same granularity employed for staging downgrade. For those clients that migrated to stage 2, a return back to stage 1 needs to be supported by three consecutive monthly payments or one payment if the payment intervals are longer than two months (typically quarterly), provided that there is reasonable evidence supporting an improvement in creditworthiness. For TESS clients in particular, such payments qualify only when clients are no longer supported by the TESS scheme.

      • 2.2.2. Retail Clients

        For clients not benefitting from payment deferrals, the SICR mechanisms in place would continue to be applied. As judgmental overrides are practically challenging to implement for retail portfolios, other solutions should be envisaged to manage the unwarranted consequences of an automatic stage migration as follows:

        • Banks and finance companies are encouraged to take pre-emptive initiatives towards clients to help them anticipate financial difficulties and potentially avoid deterioration of credit risk and consequential trigger of stage migrations. For instance, this can be achieved by clear communication to clients about payment deferral schemes (as part of TESS or not) and a process for them to report difficulties.
        • Banks and finance companies are also encouraged to undertake regular analysis by segments in order to identify spikes in migrations, which can subsequently be used to inform necessary updates of accounting policy.

        For clients benefitting from payment deferrals (all TESS clients and some non-TESS clients), instead of relying on the mechanistic SICR triggers in place, banks and finance companies should separate these clients into two groups based on dedicated analyses.

        • Group 1: clients that are temporarily and mildly impacted by Covid-19. These clients will remain in their current stage; and
        • Group 2: clients that are expected to be significantly impacted by Covid-19 in the long term. These clients will migrate to stage 2. Migration to stage 3 will normally not occur for the duration of the program, unless motivated by specific circumstances.

        The grouping decisions should take into consideration the specific circumstances of clients in the context of the Covid-19 outbreak, including at least the following principles:

        a) Case-by-case analyses may be practically challenging for retail clients. Instead, portfolio and/or product analyses might be more appropriate.
        b) Grouping decisions should rely on a mixture of quantitative analysis and a judgment-based approach based on the views of clearly identified subject matter experts within banks and finance companies.
        c) When possible, banks and finance companies should assess whether clients’ employment and financial situations are likely to be impacted temporarily or over the longer term. More specifically, banks and finance companies should consider at least (i) the severity of the impact on the sources of income, typically, whether clients are subject to temporary salary reduction or employment loss, (ii) clients’ financial leverage and (iii) residency status.
        d) If possible, the industry/sector associated with retail clients’ employment should be taken into consideration in the grouping analysis. The treatment of industries for retail clients should be consistent with that of wholesale clients.
        e) For the purpose of segregation, it might be necessary to systematically collect additional information from clients entering the TESS scheme and other payment deferral initiatives that banks and finance companies wish to put in place outside TESS.

        Return to stage 1: For retail clients classified in Group 2 during the crisis, banks and finance companies may consider migrating them back to stage 1 once there is clear evidence that customers are no longer impacted by the Covid-19 crisis. The analysis of staging upgrade must be performed at least at the same granularity employed for staging downgrade. For clients benefitting from deferrals during the crisis, that migrated to stage 2, a return back to stage 1 can occur after 6 months of performing payments. For TESS clients in particular, such payments qualify only when clients are no longer supported by the TESS scheme.