Letter from Victoria Saporta ‘Thematic feedback from the 2022/2023 round of written auditor reporting’

The Executive Director of Prudential Policy at the Prudential Regulation Authority (PRA), Mrs. Victoria Saporta, has published an open dear CEO letter addressed at PRA-supervised deposit taking institutions in which she presents the key feedback from institutions‘ auditors as to the status quo on the implementation of IFRS 9 on expected credit loss (ECL) accounting and accounting for climate-related financial risks during the past financial reporting period. The Executive Director also outlines the upcoming supervisory focus of the PRA in those two areas based on the findings .
#### Key findings as regards the application of IFRS 9 and upcoming supervisory focus
– While firms have made overall progress in monitoring and measuring credit losses, there are significant variations in practice, leading the PRA to believe that more needs to be done to improve ECL accounting.
– Model risk remains a key concern of the PRA: Most firms face challenges in understanding model limitations, identifying vulnerable borrowers, and assessing post-model adjustments (PMAs) to ensure fairly accurate ECL forecasts and loss provisions.
– A key finding was that firms have little experience with high inflation and interest rates and the adjustment of their ECL models to account for these factors.
– Also, many firms encountered difficulties in identifying customers and loans particularly affected by high inflation and interest rates for purposes of adjusting their ECL models leading to a one-size fits all approach in implementing ECL model adjustments or making no adjustments at all.
– The PRA also notes that several institutions fail to regularly review their ECL models to ensure they still capture all the risks associated with corporate and retail lending.
As a consequence, a key focus of the PRA for the upcoming financial reporting period will be to monitor the steps firms are taking to enhance their model capabilities, their efforts to enhance the quantification of post model adjustments to particularly capture those risks associated with high inflation and interest rates, and their overall implementation of ECL accounting policies and procedures.
#### Key findings as regards the accounting for climate-related financial risks and upcoming supervisory focus
– Most institutions did not make significant adjustments to their methodologies or calculations for expected credit losses in response to climate risks, leaving the PRA to believe that many financial institutions are not yet fully integrating climate-related factors into their risk assessment models.
– Institutions generally found the impact of climate risks on expected credit losses to be either immaterial or difficult to reliably quantify.
– A key challenge institutions faced was the identification of metrics for assessing climate risk on loan portfolios and the identification of high risk loan portfolios.
– However, there was also notable progress in these two areas: some firms with a corporate lending focus used geographical locations and the industry sector of the borrower to derive climate change related financial risks. Others even developed „data-led frameworks using data on emissions, external indices, and impairment rates implied by the Climate Biennial Exploratory Scenario (CBES)“.
– Finally, some institutions have also not yet even outlined their strategies for building climate accounting capabilities or established systems to monitor progress.
Based on these findings, the supervisory focus of the PRA for 2024 will primarily lie on the assessment of firms‘ efforts to identify potential ECL impacts and loan portfolios that are most at risk as regards climate change. Furthermore, the PRA will focus on the assessment of how well institutions are incorporating climate change related risks into governance and decision making and enhance their climate change financial risk accounting capabilities.