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    PRA Letter Offers Feedback on ECL Models, IBOR Reform, and Outsourcing

    October 02, 2020

    PRA published a letter that provides thematic feedback to firms and auditors on topics such as the IFRS 9 expected credit loss (ECL) accounting and the global benchmark reforms. This feedback letter, from Victoria Saporta of PRA, is a result of the review of written auditor reports received in 2020 and the subsequent discussions with firms. The letter briefly sets out the main thematic findings, with Annex 1 providing detailed findings on IFRS 9 ECL accounting and Annex 2 covering findings related to the global benchmark reform, investments in technology, and third-party controls.

    Each year, PRA receives a written report from auditors responding to its questions on issues of particular supervisory interest. PRA provides feedback on those reports through a number of channels, including a letter to the chief financial officers of firms. This letter highlights that significant progress has been made by all firms to enhance the controls and governance around their ECL models and data. As a result of significant efforts made by all firms, many of the high-quality practices, as described in the October 2019 letter, were already in place at the time the reports were written. However, further progress is needed. Against this background, PRA has set out the following key findings:

    • Significant progress was made by firms to enhance controls around ECL models and data. Nevertheless, there were weaknesses in aspects of firms’ controls, consistent with these controls being relatively immature. In addition, weaknesses in the underlying models and data had started to emerge prior to the start of the COVID-19 pandemic, with a number of significant models either failing validation or being rated as "needs improvement." PRA expects firms to consider the adequacy of their resourcing and infrastructure to monitor model performance and react to weaknesses identified, including the adequacy of management information to enable effective oversight of models and post-core model adjustments.
    • PRA noted limited progress in 2019 toward reducing reliance on post-core model adjustments by updating models, with some post-core model adjustments that appear suitable for incorporation into the model being in place longer than 12 months. PRA continues to expect firms to give due priority to the need to reduce reliance on post-core model adjustments when determining their longer term model redevelopment programs.
    • Firms are encouraged to ensure that control and governance frameworks are adapted to cope with the increased reliance on the tactical processes and data. Additionally, the time taken to run the ECL processes from end-to-end leaves little room for sensitivity tools that inform effective challenge around the use of alternative economic assumptions. PRA believes that it is essential for firms to develop the capability to perform more comprehensive economic sensitivity analysis more quickly to inform governance and public disclosures.
    • Firms made progress in enhancing the controls around the validation of a significant increase in credit risk (SICR) criteria. However, firms made relatively few changes to their SICR approaches in 2019. PRA believes that wider use of industry standard metrics are a good first step to benchmarking the effectiveness of different approaches across firms in recognizing SICR in a timely manner. PRA judged firms to have partially adopted the high quality practices related to SICR.
    • With respect to transition from LIBOR to robust alternative reference rates, firms generally appeared to have granular transition plans and robust governance structures in place. Responses indicated an awareness and active management of both current and future risks related to conduct, legal, markets, and operations. However, there are areas where improvements could be made, particularly for firms relying on manual processes to capture and aggregate IBOR exposures; this is because such manual processes increase the risk of error and limit the ability to proactively monitor exposures.
    • PRA noted instances where the risks associated with outsourcing activities to third parties were managed at the process level rather than at the third party level. Centralizing ownership and risk management would assist in ensuring the three lines of defense are appropriately engaged in managing the dependence on third parties and increasing a firm’s operational resilience. Auditors’ reports noted that firms did not always have controls reports for their material outsourcing service providers. Management continues to have a responsibility for ensuring that outsourced processes are the subject of robust and effective controls and one way of achieving this is through controls reports.

     

    Related Link: Letter

     

    Keywords: Europe, UK, Banking, IFRS 9, ECL, COVID-19, Credit Risk, Interest Rate Benchmark, LIBOR, IBOR, Thematic Findings, Outsourcing Arrangements, PRA

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