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https://www.nationthailand.com/blogs/business/40017499

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Financial institutions are experiencing highly volatile income statements during the pandemic mainly due to a cushion set aside for defaults from certain type of receivables and financial assets. Now that economies are reopening as infections abate, the question is what are going to happen next?

What is provisioning?

Publicly Accountable Entities, which are the companies that issued outstanding tradable debts or equities, are obliged to follow the requirement of the Thai Financial Reporting Standards (TFRS 9) that state on how entity should classify and measure their financial assets and liabilities. Chief among them is lending institutions which are our focus today.

As they lend money to counterparties, a part of loans is required to be provisioned as a cushion for potential default. This provisioning amount is derived from their own historical data and the incorporation of forward-looking elements that forecast future portfolio conditions based on economic variables, modelled through complex mathematical processes that aim to provide the best estimation on losses reasonably expected to be incurred from that lending, to arrive at the Expected Credit Loss (ECL)  which are also presented in the financial statements to help their user to gauge the overall health of the entity’s lending portfolio. The ECL serves as the best estimation on losses incurred from credit risk exposures of certain financial asset receivables including lending.

Example of factors widely used in the computation of ECL are number of days past due of loan facilities, usually high number of days past due imply higher chance of default thus higher provisioning, but during the pandemic, worldwide authorities were rushed to announce series of debt moratorium to alleviate financial difficulties especially to the hardest hit segments of the society, making the number of customer defaults artificially low in the process, thus giving understated provisioning amount.

Another factors in consideration in money regained by financial institutions from collection and liquidation effort after customer defaults, which was temporarily lower as the seizure and liquidation of collaterals were partially suspended to prevent people displaced and job lost. The market price of some collaterals was fluctuated to the point that financial institutions preferred to warehouse them instead of outright selling.
 

ECL models developed before the pandemic based on information in relatively calm situations were likely not be able to capture escalating credit risks timely. For reasons above provisioning amount from those models suddenly seem to be understated. Statistical models developed during sunny days were suddenly yield no avail.

Worse still, these provisioning models also contained forward-looking elements. Macroeconomic variables such as GDP growth, unemployment ratio, consumer price index (CPI), or energy price with designated level of relationships to the portfolios were incorporated to those models to get the provisioning amount as accurate as possible. This feature suddenly becomes liabilities since variables deviated sharply from reasonable levels. Almost all countries exhibited negative GDP growth, unemployment shot up, crude oil price was in free fall, and the CPI that weighted heavily by commodities were tanked to multi-year lows.

As the world inched towards uncharted territories, financial institutions were hastily racking up provisioning as a cushion against the worst possible scenarios. Financial institution executives developed highly judgmental overlays based on pessimist assumptions to calculate additional provisioning immediately necessary for their institutions, and provisioning amounts including these overlays were reaching exorbitant levels which eventually driven down their profits. 

This prompted central banks around the world to aggressively loosening monetary policies, joining forces with governments in economic stimulation to provide lifeline to businesses and individuals and the business engine once again reignited, so should unwinding provisioning amount now legit?

Woefully, it is not likely that we are seeing provisioning going down any time soon as financial institutions shift their concern to second-order impact from the pandemic and the emergence of geopolitical tension which disrupt supply chains and racks up global inflation. They are reluctant to disentangle overlays set up during the pandemic as uncertainty looms large. Governments are running budget deficit for years are unlikely to continue offering supports, leaving corporate and retail borrowers survived from pandemic fully exposed to unprecedent inflation that in turns affecting their repayment ability.

Some lending institutions are now seeing first-hand impact, as people disbursing their available credit lines while reducing repayments. This is the forward indicator of potential defaults as financial condition at individual levels are deteriorating, shutting possibilities for immediate provisioning release.

There are also ECL model risks that keep financial institutions think that it is still premature to release provisioning and overlays as parameters used in the model development process were mostly frozen during the pandemic and needs to be recalibrated to reflect the most recent situations. Forward-looking elements once again be a cause of ECL model performance deviations. Factors related to inflationary such as CPI or commodities price are expected to remain highly volatile as market participants balance current supply chain situations with potential recession due to cost-pushed inflation thus distorts provisioning results. We are expecting that once normalcy is attained, ECL models would be rectified, and management overlays unwound.

The purpose of provisioning models and overlays is to ensure that financial institutions are setting the right amount of cushion for running business safely while letting financial statement audiences assess the true health of portfolios, therefore it is in everybody’s benefits to keep the precision of these models the top priority, but for the time being, brace for elevated level of provisioning and suppressed level of profit.

By Sarun Boonchalakulkosol
Director I Risk Advisory – Financial Industry Risk & Regulatory
Deloitte Thailand
 

Published : July 08, 2022

By : THE NATION