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    FSI Examines Financial Stability Implications of Payment Deferrals

    May 28, 2020

    FSI published a brief note that examines challenges facing the banking sector as a result of the payment deferral programs put in place to support borrowers affected by the COVID-19 pandemic. The note also presents an overview of payment deferral programs and their accounting treatment, before moving on to discuss the associated practical considerations related to these payment deferrals. While analyzing the financial stability implications of implementation of these programs by the prudential regulators, FSI emphasizes the importance of timely classification and measurement of credit risk by banks.

    The note highlights that 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—amid an uncertain outlook—should help guide banks' efforts to support viable borrowers, while preserving the integrity of their reported financial metrics. 

    IFRS 9 allows banks to recognize 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 recognized in banks’ interest income accounts will increase, accentuating medium-term risks for borrowers and banks. The extent to which these risks materialize and how they affect the accounting classification and measurement of loans, depends on two factors: first is the ability of borrowers to repay the debt once the deferral period ends and second is the availability of collateral support, including the existence of public guarantees that back the underlying exposures.

    The note concludes that payment deferral programs provide an indispensable lifeline to consumers and businesses affected by COVID-19, but they could also increase future risks to the banking system. Therefore, their design will be critical in balancing the short-term needs of borrowers with longer-term financial stability considerations. The financial stability implications of payment deferral programs will be driven by the extent to which borrowers will be able and willing to repay their debt obligations once the payment holidays expire, particularly in the absence of a public guarantee. The cumulative impact of COVID-19 and payment deferral programs on bank balance sheets depends on many factors and will only become apparent over time. Therefore, the timely classification and measurement of credit risk is critical for banks to provide confidence to supervisors and their stakeholders on their financial health. Delaying loss recognition until the tide goes out may leave banks and supervisors with fewer options for dealing with the repercussions.

     

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    Keywords: International, Banking, Loan Moratorium, Loan Guarantee, Credit Risk, IFRS 9, Accounting, COVID-19, Financial Stability, FSI

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