Incorporating macroeconomic scenarios into ECL
IFRS 9 requires ECL measurements to reflect "reasonable and supportable information" about past events, current conditions, and forecasts of future economic conditions. This is a fundamental shift from the IAS 39 incurred loss model.
"An entity shall measure expected credit losses... in a way that reflects... reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions."
IFRS 9 requires an unbiased, probability-weighted estimate of ECL. This is typically achieved using multiple macroeconomic scenarios.
| Variable | Optimistic | Base | Pessimistic |
|---|---|---|---|
| GDP Growth (Year 1) | +3.5% | +2.0% | -1.5% |
| GDP Growth (Year 2) | +3.0% | +2.2% | +0.5% |
| Unemployment Rate | 3.5% | 4.5% | 7.0% |
| House Price Change | +8% | +3% | -15% |
| Interest Rates | 4.0% | 5.0% | 3.0% |
| Scenario Probability | 15% | 55% | 30% |
The final ECL is calculated as the probability-weighted average of ECL under each scenario:
| Scenario | ECL | Probability | Weighted ECL |
|---|---|---|---|
| Optimistic | $800 | 15% | $120 |
| Base | $1,200 | 55% | $660 |
| Pessimistic | $2,500 | 30% | $750 |
| Final Probability-Weighted ECL | $1,530 | ||
Note that the probability-weighted ECL ($1,530) is higher than the base case ECL ($1,200). This reflects the non-linear relationship between economic conditions and credit losses - downside risks typically impact ECL more than upside benefits reduce it.
Macro models translate economic forecasts into risk parameters (PD, LGD).
Convert through-the-cycle PD to point-in-time using:
Model default rates directly as function of macro variables:
| Portfolio | Primary Driver | Secondary Drivers |
|---|---|---|
| Residential Mortgages | House Price Index | Unemployment, Interest Rates |
| Consumer Credit | Unemployment | Real Income, Inflation |
| Corporate Loans | GDP Growth | Corporate Profits, Credit Spreads |
| Commercial Real Estate | CRE Price Index | Vacancy Rates, GDP |
Management overlays are adjustments to modeled ECL to capture information not reflected in the models.
Overlays should be temporary adjustments with clear sunset provisions. Over time, the underlying models should be enhanced to incorporate the factors that necessitated the overlay.