On 26 March 2020, the PRA published a Dear CEO letter setting out guidance in three areas:
- consistent and robust IFRS 9 accounting and the regulatory definition of default;
- the treatment of borrowers who breach covenants due to COVID-19; and
- the regulatory capital treatment of IFRS 9.
The PRA states that all aspects of the Dear CEO letter need the urgent attention of firms. In particular, messages on accounting will be relevant to firms finalising March/April year-end annual financial statements and Q1 quarterly reports based on IFRS, as directors will need to take decisions about forward-looking expected credit loss (ECL) estimates in the coming days and weeks.
In terms of the treatment of borrowers who breach covenants due to COVID-19, the Dear CEO letter asks lenders and other users of financial statements to carefully consider their response. The PRA recognises the important role loan covenants play in lenders’ credit risk management but it is also important that such risk management takes into account the differences between ‘normal’ covenant breaches and some of the breaches that might occur because of the COVID-19 pandemic. The PRA states that where uncertainties are of a general nature or are firm-specific but unrelated to the solvency or liquidity of the borrower, it would expect lenders to consider the need to treat them differently compared to uncertainties that arise because of borrower specific issues and in doing so consider waiving the resultant covenant breach. The PRA would expect firms to do so in good faith and not to impose new charges or restrictions on customers following a covenant breach that are unrelated to the facts and circumstances that led to that breach.
The PRA’s expectation is that a covenant breach or waiver of a covenant relating to a modification of the audit report attached to audited financial statements because of the COVID-19 pandemic should not automatically, other things being equal, trigger a default under the Capital Requirements Regulation or result in a move of the loans involved into stage 2 or stage 3 for the purposes of calculating ECL. This expectation extends to other covenant breaches and waivers of covenants with a direct link to the COVID-19 pandemic.
In terms of regulatory capital treatment of IFRS 9, firms are asked to consider the guidance in the annex to the Dear CEO letter when taking decisions about ECL and regulatory capital estimates in the coming days, weeks and months.