In a letter to the chief financial officers of selected firms, the Prudential Regulation Authority (PRA) has set out feedback after its review of the written auditor reports received in 2021. The thematic findings relate to the IFRS 9 expected credit loss accounting (ECL) and the benchmark reform. The letter also sets out how PRA intends to use next year’s round of written auditor reports to explore risks related to climate change. To this end, PRA has asked for auditor views on the robustness of a firm’s risk assessments with respect to the impact of climate change on balance sheets and the quality of the underlying data, models, and processes to support these assessments. This letter contains general feedback while PRA provides specific feedback to firms and their auditors through continuous assessment meetings; regular auditor–supervisor bilateral meetings; and trilateral meetings involving supervisors, auditors, and audit committee chair.
PRA findings on IFRS 9 ECLs relate to model risk, economic scenarios, and recovery strategies. The letter notes that model performance deteriorated in 2020, partly due to the unprecedented levels of government support distorting recent credit data and the limitations in firms’ approaches, including lack of granularity in reflecting sector-specific risks. It was also noted that firms and auditors increased their use of peer benchmarking and sensitivity analyses to inform challenge around the use of alternative economic assumptions. PRA believes it is essential for firms to develop capabilities to perform more comprehensive economic sensitivity analysis more quickly to inform robust governance and support comparable public disclosures. To make progress, firms need to define the capabilities they need and set realistic timelines for implementing them. PRA also noted that firms are making less progress in adopting high-quality practices for recovery strategies used in estimating loss given default (LGD) than in other areas of ECL. Limited use of adjustments to LGD to reflect the elevated risk that past experience may not necessarily be a good predictor of future recovery rates. Thus, PRA believes it will be important for firms to monitor the impact of the unwinding of government support to make realistic assumptions about recovery strategies for vulnerable sectors. As part of the next steps, PRA identified eight new areas where further mitigating actions are needed to ensure that firms recognize changes in credit risk in a timely way; these areas mainly relate to model risk management and capturing sectoral risks.
The findings on the benchmark reform indicate benchmark transition remains a significant operational and financial risk while liquidity is decisively shifting toward robust alternative risk-free rates. In the context of written auditor reporting, PRA reminds firms of the importance of managing and controlling the financial reporting aspects of the transition. To encourage firms to identify practical improvements that can be made in financial reporting, the letter sets out the PRA views on the most significant gaps between practices that auditors observed when they reported back to PRA vis-à-vis the high-quality practices shared with firms in 2020. PRA sees opportunities for greater use of independent review and challenge of risk-free rate transitioning plans. PRA found that some firms were still making extensive use of manual processes to capture and aggregate IBOR exposures for internal reporting and external financial reporting disclosures. Noting the short time remaining, PRA reiterated the benefits of automated systems being in place to support aggregate reporting of IBOR exposures and to ensure there is a single, standardized, and accurate view of both conversion progress to date and the scale of conversion activity remaining. Where further automation is not practical, it is important that reliance on manual processes be governed by formalized and documented controls over data extraction, validation, and aggregation.
Related Link: Letter
Keywords: Europe, EU, Banking, IFRS 9, Benchmark Reforms, ECL, Climate Change Risk, COVID-19, Reporting, ESG, Credit Risk, LGD, BoE
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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