Payment holidays on loans

Payment holidays on loans under IFRS 9

Governments and banks have introduced payment deferral programs to support borrowers affected by Covid-19. But deferred payments are not forgiven and must be repaid in the future, raising prospective risks to the banking system. Thus, they should be designed to balance near-term economic relief benefits with longer-term financial stability considerations.

The Basel Committee on Banking Supervision (BCBS) and several prudential authorities have issued statements clarifying how payment deferrals should be considered in assessing credit risk under applicable accounting frameworks. These measures aim to encourage banks to continue lending, to avert an even deeper recession.

Prudential authorities are caught “between a rock and a hard place” as they encourage banks – through various relief measures – to provide credit to solvent, but cash-strapped borrowers, while keeping in mind the longer-term implications of these measures for the health of banks and national banking systems.

In navigating these tensions, banks and supervisors face a daunting task as borrowers that may be granted payment holidays have varying risk profiles. Distinguishing between illiquid and insolvent borrowers – amidst an uncertain outlook – should help guide banks’ efforts to support viable borrowers, while preserving the integrity of their reported financial metrics.

What is this all about?

The Covid-19 pandemic has inflicted severe economic hardship on millions of households and businesses. In response, governments have introduced a range of fiscal, monetary and financial measures to support affected individuals and businesses.

These include a temporary suspension of debt obligations owed to banks and other financial institutions. In this context, global standard setters and several prudential authorities have clarified how the various public and private payment deferral programs should be considered by banks and supervisors in assessing the credit quality of such exposures in applicable accounting frameworks.

Statements on the application of accounting standards have been issued by the International Accounting Standards Board (IASB), the BCBS and several prudential authorities that have adopted International Financial Reporting Standards (IFRS). These encourage banks to use the flexibility allowed under IFRS 9 – the standard that deals with how banks estimate provisions for expected credit losses (ECL) for loans held at amortised cost.

These clarifying statements were considered necessary to ensure that banks do not take a pro-cyclical approach in estimating ECL provisions associated with borrowers who might be experiencing temporary cash flow problems due to Covid-19. This is because a sudden and sharp spike in ECL provisions reduces a bank’s reported net income, which could affect the flow of credit to distressed consumers and businesses and hence exacerbate cyclicality.

This narrative investigates how payment deferral programs are structured, outlining the complex trade-offs involved, including how such schemes are reflected in the financial statements of banks and their implications for preserving market trust and in fostering financial stability.

Accounting treatment of payment deferrals

– Overview

An important consideration for banks, supervisors and market participants is how payment holidays that are granted to affected borrowers are reflected in banks’ published financial statements. These decisions are shaped, first, by the prevailing accounting standard used in various jurisdictions; and, second, by any recent official statements on how pandemic-affected exposures should be considered in the applicable accounting frameworks.

The outcomes are consequential, given the close links between a bank’s credit risk profile and its level of ECL provisions, which can materially affect its earnings and reported equity. For the sake of brevity, this section focuses primarily on how payment holidays are treated in jurisdictions that have adopted ECL accounting methodologies under IFRS 9, which in turn drive the reported published financial statements of banks.

Treatment of payment holidays under IFRS 9

– Loan classification and measurement

In jurisdictions that have adopted IFRS 9, banks are required to classify financial instruments into three categories: “performing” (Stage 1), “underperforming” (Stage 2) and “non-performing” (Stage 3). Once a loan has experienced a “significant increase in credit risk” (SICR) since initial credit recognition or is impaired, it should be moved to Stages 2 and 3, respectively.

The three-stage classification process is used not only to signify the credit quality of an exposure but also to determine the method used to calculate ECL provisions, with exposures under Stage 1 subject to provisions based on 12 month ECL, while Stages 2 and 3 require lifetime ECLs. The table ‘IFRS 9 – Classification, measurement and interest income recognition’ below summarises the classification, measurement and interest income recognition (e.g. gross or net) requirements under IFRS 9.

As a general rule, if banks grant payment holidays to a specific borrower facing financial difficulty, it may suggest that, at a minimum, a SICR has occurred, triggering a Stage 2 designation and lifetime ECLs. The standard also includes a rebuttable presumption that any loan that is past due more than 30 days has experienced SICR, while a loan past due 90 days or more is assumed to be in default (Stage 3).

Under the above conditions, the implications of payment deferrals for banks would be threefold: first, they would need to publicly disclose these exposures as Stage 2 or 3, suggesting a deterioration in the credit quality of their loan portfolio; second, their provisions may increase as their estimates will now be based on lifetime rather than 12-month ECLs; and, third, if payment deferrals trigger a reclassification to Stage 3, interest income could fall as the accruals are based on the net carrying value of the loans. These latter two issues could put pressure on banks’ reported net income, and hence their equity.

In addition, if a loan is modified (e.g. via payment deferrals or other changes in terms and conditions), IFRS 9 requires entities to assess if the revised terms will lead to a decline in the expected net proceeds from the loan (e.g. the net present value of the cash flows fall after debt restructuring); and, if so, banks are required to record ECL provisions for the difference.

IFRS 9 – Classification, measurement and interest income recognition

	Stage 1 (performing loans)	Stage 2 (under-performing loans)	Stage 3 (non-performing loans) Any one or more of the following events suggest evidence of credit impairment
Classifi- cation (credit quality)	Performing loan & no SICR since credit origination	SICR since credit origination SICR not defined but various qualitative factors listed as information that may be relevant to assess SICR Loans past due more than 30 days assumed to have experienced SICR (rebuttable)	Significant financial difficulty of borrower A breach of contract such as default or past-due event (presumed that loans 90 days past due more have defaulted – can be rebutted) The lender has granted the borrower a concession due to the borrower’s financial difficulty It is probable that the borrower will enter bankruptcy The disappearance of an active market for that financial asset because of financial difficulties The purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses
Loss allowance (Provisioning)	12-month ECL	Lifetime ECL
Interest income (Recording)	Based on gross loan amount (e.g. without deducting the applicable provisions)		Based on net loan amount (gross loans minus the lifetime ECL provisions)

Authorities’ public statements on Covid-19 related payment deferrals

With respect to pandemic-related payment moratoria, the IASB, BCBS and several prudential authorities have clarified that the utilisation of a payment deferral programme should not, by itself, result in an automatic trigger for SICR and would not necessarily require a migration of all such loans from Stage 1 to Stages 2 or 3, thus avoiding the need for lifetime ECL provisions.

Authorities have argued that Covid-related debt moratoria are not borrower-specific and target a wide range of borrowers, many of whom might only be experiencing temporary cash flow difficulties. In general, their stance seeks to differentiate measures that have a preventative nature and aim to sustain economic activity in relation to borrower-specific payment holidays that are carried out under normal circumstances.

Moreover, only a few authorities have specifically issued statements with respect to whether pandemic-related payment deferrals should be considered “debt modifications” under applicable accounting standards; and if so, how they should be treated.

This is mainly because payment deferrals are not forgiven and must be repaid in future periods without any (principal) haircuts, resulting in little or no decline in the net present value of the loan after modification, particularly if the length of the deferral period is relatively short-term in nature.

Disclosure

Public disclosures are essential if stakeholders are to understand the actual and potential effects of payment moratoriums on banks’ financial soundness. Accordingly, authorities have issued statements supporting the disclosure of quantitative and qualitative information relevant to the evaluation of the ECL recorded and the understanding of the assumptions and judgments made in their estimate.

This includes, for example, disclosure of information on judgments made on how payment deferrals have been factored into the assessment of SICR and ECL, as well as the use of forward-looking information.

Practical considerations

– Overview

Payment deferrals increase future risks to both borrowers and banks, as the missed payments are not forgiven and must be repaid. This can lead to a situation where the missed interest payments are added to the loan balance, resulting in a higher debt repayment burden for borrowers, once the payment holiday period ends.

At the same time, IFRS 9 allows banks to recognise interest income on these missed payments, raising prospective risks if borrowers are ultimately unable to repay. In addition, if the payment moratorium is lengthy, the deferred interest payments that are added to a borrower’s loan balance and the corresponding amount that are recognised in banks’ interest income accounts will increase, accentuating medium-term risks for borrowers and banks.

The extent to which these risks materialise, and how they affect the accounting classification and measurement of loans, depends on two factors: first, the borrowers’ ability to repay the debt once the deferral period ends; and, second, the availability of collateral support, including the existence of public guarantees that back the underlying exposures.

In this context – and for illustrative purposes – it might be helpful to take stock of three groups of borrowers who may be affected by the pandemic, as depicted below:

Solvent and insolvent borrowers

At one end of the spectrum are borrowers whose loans were performing as agreed before the pandemic hit and are not yet significantly affected. For these debtors, the loan classification and measurement of ECL provisions are relatively straightforward.

At the other extreme are borrowers who may already have been struggling to meet their financial obligations and, consequently, were classified in the Stage 2 or 3 category before the onset of Covid-19.

In these cases, while the probability of default may still increase even if the loan classification remains unchanged, the main challenge is, arguably, the measurement of ECLs, which will likely be driven by the value of collateral. This is because it may be difficult to arrive at reasonable collateral valuations, particularly for distressed borrowers amidst an uncertain economic outlook.

The space between solvency and insolvency

An even more complex issue is the treatment of the middle group of solvent but illiquid borrowers, since this encompasses a large number of borrowers with varying risk profiles. This group of debtors may have been paying as agreed before the pandemic (eg classified as Stage 1), but have been impacted by the crisis.

In this regard, banks need to differentiate between borrowers whose cash flow difficulties are considered temporary in nature and other debtors with more chronic problems. For borrowers who are judged to be solvent but temporarily illiquid, payment deferral measures may be effective and the impact on classification and ECL measurement may be minimal.

Other debtors within this middle group, however, may experience more chronic problems and might not be able to repay their loans even after the payment deferral period is over. Such circumstances may result in a classification downgrade (to Stage 2/3) and an increase in ECL provisions. In these situations, there may be a need to explore whether negotiating principal haircuts, rather than relying solely on payment deferrals, might put borrowers on a more sustainable footing.

While this approach may result in the recognition of higher short-term losses, it could enhance banks’ longer-term resilience as it may help them to recoup the revised principal loan balance. Lastly, the longer it takes for the global economy to rebound, the greater the likelihood that some debtors who were initially perceived as having only temporary liquidity problems will migrate to the group with more permanent financial difficulties.

These overall credit risk assessments – which are within the spirit of various authorities’ recent statements that there should not be an automatic assumption that borrowers granted payment holidays have experienced credit deterioration (which is a SICR in accounting language) – should help guide the accounting classification and measurement of such loans.

Distinguishing between these sets of borrowers will be critical if banks are to continue providing support to viable borrowers, while faithfully reflecting the underlying credit risks in their financial statements.

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