IFRS 9 overlays and model improvements for novel risks : identifying best practices for capturing novel risks in loan loss provisions

In recent years, banks have constantly faced new risks that need to be assessed. The COVID-19 pandemic itself revealed that health risks and related restrictions can threaten the solvency of borrowers. After this threat was managed with the help of public support, a stream of other novel risks emerged, like energy supply, geopolitical stability, high interest rates, inflation, and climate change. And since the list of such novel risks is unlikely to be exhaustive, it is only reasonable to expect further surprises. This new risk environment poses a significant challenge to banking supervisors, who draw on a traditional supervisory framework largely reliant on historical data series. But such data series lack scope for dealing with risks looming large on the horizon. For this reason, ECB Banking Supervision places a particular focus on supervisory tools and regulations offering a forward-looking perspective. If properly applied, they allow banks to prepare for and cushion against those risks. One of the areas the ECB is looking into is expected loan loss provisioning under IFRS 9. The accounting requirements are principle-based and require comprehensive consideration of forward-looking information. The resulting provisions impact prudential capital ratios, so adequate accounting provisions for novel risks also act as a prudential safeguard should these risks materialise. While the ECB is not an accounting supervisor, it has been granted a prudential mandate to challenge and influence banks' provisioning practices when there is a particular prudential concern about adequate risk coverage. The topic of IFRS 9 provisioning was also mentioned in the ECB's supervisory priorities for 2022-2024.