And among those that do, not all quantify them robustly. Where do we see cause for concern? Unfortunately, a significant minority of banks are not yet capturing novel risks. We recommend that others follow the good example set by banks using such in-model adjustments or overlays for the effects of higher interest rates on commercial real estate client debt capacity or for modelling environmental risk-driven default. For example, some re-rate all their clients assuming higher levies on carbon emissions, or higher costs to consume natural resources like water, and thus model environmental risk-driven defaults. A small portion of pioneer banks even include concrete model solutions to add environmental risk to their IFRS 9 provisioning framework (12% using overlays and 4% using in-model adjustments). Think of an in-model adjustment capturing the effects of higher interest rates by increasing the default probability for clients active in the development of commercial real estate, or an overlay that leverages on households’ payment history to simulate how an increase in the cost of living would strain their debt service capacity. In-model adjustments and overlays exist in many forms and configurations. We are pleased to see that many banks have already started to use in-model adjustments or evidence-based overlays to try to quantify how inflation, geopolitical risk, supply chain shortages and energy prices have affected their clients’ creditworthiness. To be clear, using overlays that are grounded in sound analysis with strong governance and transparency is welcomed. Overlays became prevalent during the pandemic, and are now widely used for different novel risks not easily captured by models.

In contrast, when banks quantify emerging risks outside the existing models, they record overlays. When banks use in-model solutions, provisions incorporate novel risks automatically.

With a top-down view, banks can steer and monitor novel risks actively, and set aside sufficient capital to cover them. While these solutions do not yield client-specific provisions, they provide for collective allowances at a sectoral level.

These include using complementary model solutions (“in-model adjustments”) and additional models relying on a different modelling logic, like simulations, scenario analysis or client sampling techniques. But we also identified some credible alternative approaches. As we expected, most respondents said they use “overlays” to assess novel risks. Spoiler alert: some challenges remain.įirst, though, some good news: banks acknowledge that there are indeed novel risks and try to capture them. That’s why banks need alternative approaches to quantify and cover these risks reliably. All five have something in common: they lack the necessary historical data on which classical expected loss provisioning models depend. We asked banks about five novel risks likely to have a prominent impact on default rates identified in our previous surveys: supply of energy, supply chains in general, environmental risks, inflation and geopolitical risks. We selected the sample on the basis of our benchmarking framework for assessing the quality of banks’ internal provisioning practices. We asked almost half of the banks under our supervision how their IFRS 9 provisioning framework captures emerging risks. How are banks coping with emerging risks in provisioning? The information we have gathered from the review is helping us target our supervisory actions and establish credible and consistent provisioning practices. This matters to us because it has a direct effect on prudential capital ratios, profitability and, ultimately, bank resilience.Īgainst this background, in November 2022 we launched a targeted review of IFRS 9 provisions to better understand whether and how banks already cover novel risks with loan loss provisions. This blog post focuses on one area within our supervisory priorities for 2022 to 2024: IFRS 9 provisioning frameworks of our supervised banks. That’s why this is a good moment to reflect on how prepared the European banking system is to identify and cover novel credit risks in a timely manner. Energy supply, geopolitical risks and inflation come to mind. While the gloomy outlook of the pandemic is receding, a stream of emerging risks has arisen. It’s a fact of life for supervisors that they constantly face new risks that need to be assessed. Blog post by Elizabeth McCaul, Member of the Supervisory Board of the ECB, and Stefan Walter, Director General of Horizontal Line Supervision

Seeing stars overlay