4. Macroeconomic Overlay
As per the IFRS 9 accounting rules, ECL should incorporate forward looking information in the form of a macroeconomic overlay. The purpose of this overlay is to adjust the estimation of PD, LGD and EAD, in order to incorporate not only backward looking statistical data, but also forward-looking assessment. This is especially important if future economic developments are expected to be significantly different from past experience. The macroeconomic scenario inputs are expected to impact all clients.
Under the IFRS 9 framework, banks and finance companies are expected to update the macroeconomic forecasts, in order to reflect the likely change in the economic environments (in both the UAE and abroad). However, the Regulators recognize the high degree of uncertainty surrounding the economic consequences of the Covid-19 crisis and therefore the challenges of constructing meaningful and accurate economic forecasts at this point in time. In addition, the UAE economy is materially dependent on the performance of the global economy, therefore the evolution of Covid-19 related government policies implemented throughout the world will also impact the UAE economic forecasts.
Consequently, and in order to avoid excessive disparity amongst banks and finance companies’ macroeconomic forecasts, banks and financial companies are not expected to incorporate the updated forecasts into ECL until September 1, 2020. Subsequent to this date, banks and finance companies should follow their existing process for the production of economic scenario forecasts. Furthermore, in light of the exceptional circumstances, banks and finance companies are required to establish dedicated crisis-focused governance, in order to (i) undertake benchmark analyses using relevant sources, (ii) seek the view of economists and subject matter experts, (iii) ensure that key macro factors driving ECL are still relevant for the present circumstances and (iv) adjust the economic forecasts iteratively, as new information becomes available.
When banks and finance companies are in a position to use economic forecasts to generate PDs and LGDs, they need to be mindful of lags currently employed in their macro models. The modelled lags are likely to be longer than observed in reality during this specific crisis.
Finally, banks and finance companies also have the option to employ add-ons at portfolio or product level in order to holistically reflect changes in the economic environment, provided that the decision-making process and results are fully documented and disclosed.