31 May 2023

SSM's McCaul/Walter: Overlays and in-model adjustments: identifying best practices for capturing novel risks

It’s a fact of life for supervisors that they constantly face new risks that need to be assessed. While the gloomy outlook of the pandemic is receding, a stream of emerging risks has arisen.

Energy supply, geopolitical risks and inflation come to mind. 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. This blog post focuses on one area within our supervisory priorities for 2022 to 2024: IFRS 9 provisioning frameworks of our supervised banks. This matters to us because it has a direct effect on prudential capital ratios, profitability and, ultimately, bank resilience.

Against 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. The information we have gathered from the review is helping us target our supervisory actions and establish credible and consistent provisioning practices.

How are banks coping with emerging risks in provisioning?

We asked almost half of the banks under our supervision how their IFRS 9 provisioning framework captures emerging risks. We selected the sample on the basis of our benchmarking framework for assessing the quality of banks’ internal provisioning practices.

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. All five have something in common: they lack the necessary historical data on which classical expected loss provisioning models depend. That’s why banks need alternative approaches to quantify and cover these risks reliably. Spoiler alert: some challenges remain.

First, though, some good news: banks acknowledge that there are indeed novel risks and try to capture them. As we expected, most respondents said they use “overlays”^[1] to assess novel risks. But we also identified some credible alternative approaches. 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. While these solutions do not yield client-specific provisions, they provide for collective allowances at a sectoral level. With a top-down view, banks can steer and monitor novel risks actively, and set aside sufficient capital to cover them.

When banks use in-model solutions, provisions incorporate novel risks automatically. In contrast, when banks quantify emerging risks outside the existing models, they record overlays. Overlays became prevalent during the pandemic, and are now widely used for different novel risks not easily captured by models. To be clear, using overlays that are grounded in sound analysis with strong governance and transparency is welcomed...

 more at SSM

© ECB - European Central Bank