Guest blog by BSA Associate, BDO LLP

The world economy has changed. The UK is affected more than most. And the uncertainty and volatility that come with it are likely with us for the foreseeable future. More than ever, since the introduction of IFRS9, firms should be treating their Expected Credit Loss methodologies with renewed scepticism and engaging with experts such that they are able to reflect and manage a very probable crisis in the lending market. For businesses with near term financial reporting requirements, the imperative is striking.

Economic commentary for the majority of this year has focussed on the cost of living and the inflationary pressures that have emerged in economies all around the world. The costs of everyday life essentials – heating, food and clothing most obviously – have suffered supply side pressures which has seen their underlying costs increase globally. In response, Bank of England (“BoE”) base interest rates have inexorably risen to control the (limited) portion of inflation which is driven by demand and to control currency driven inflation.

Against this background, the past few weeks has seen an (at present) localised financial shock in the UK following the now-former Chancellor’s mini-budget, much of which has since been reversed. Whilst markets were expecting temporary government assistance on energy prices, the accompanying permanent tax cuts (without associated OBR[1] forecasts or offsetting spending decreases) undermined markets’ confidence in the UK economy and its public finances.  The impact of the subsequent u-turn on market sentiment is, at the time of writing, yet to be seen.

The volatile and negative market reaction to the UK outlook necessitated action from the BoE in the UK government bond market and, in the near future, around interest rates. Market expectations around base rates have increased from an expected peak of 4 – 4.5% next year to close to 6%, before falling slightly to c. 5%. This has already affected mortgages, through rate rises and the withdrawal of mortgage products and offers from the market by many lenders, and will impact corporate lending and unsecured consumer borrowing. The prevalence of fixed rate mortgages and loans may delay the direct impact of those rate rises on the economy, but ongoing refinancing costs will be a substantial shock to corporate and household budgets, and may dwarf the increases in energy prices from which the UK government moved to insulate UK households (on which, incidentally, certainty has been reduced from 2 years to 6 months).

Now, rather than consumers and businesses wondering how they are going to afford to heat their home or premises, they may be wondering how they are going to be able to afford the property itself.

The rise of inflation and the corresponding rise of interest rates marks a sea change in the worldwide economy compared to the previous 10 to 15 years – to which the UK economy is more exposed than many others. Our advisory clients and the entities that we audit are often simply not used to assessing their Expected Credit Losses (“ECL”) in this economic environment.

Economic and statistical models all too often do not contain within them any direct ability to determine the impact of inflation and substantial interest rate rises on the likelihood of their customers defaulting and, so, on ECLs. This is a consequence of historical BoE base rates and inflation having no statistical link to recent historical fluctuations in default rates – they simply haven’t been a deterministic issue in the recent past. Going back further in time (say, to the 1990s or 2000s) means modelling a very different state of the world to that which exists now – which makes the modelling process challenging.

Ideally businesses would revisit their models and attempt to improve and augment their modelling to take into account these factors for the purposes of predicting future default rates. This is made all the more challenging by certain un-modellable events, such as government interventions and further market uncertainty, necessitating the need for modelling which is flexible (either by way of remodelling or robustly overlaying) in real time. However, for businesses that are approaching their financial reporting year end, there is very little time available to undertake this rather involved process.

This gives rise to two a two track issue, depending on businesses’ year end:

1. For businesses which have time until their next financial reporting year end, the time is now to start engaging with experts to expand on your modelling to include these hugely significant factors. This is a challenging and involved process which requires substantial work from economists and quantitative finance experts to develop robust models which can stand up to scrutiny by auditors and other stakeholders.
2. For businesses with shorter time frames available to them, the order of the day is to develop robust and well thought through quantitative overlays to your models. These may leverage customer data on affordability or exogenous data on affordability shocks, but should be quantitatively devised such that they also stand up to scrutiny. Alongside this (or shortly after), work will be required to future proof existing modelling for future financial reporting periods.

For those which the above affects, it is imperative that these matters are addressed in this swiftly changing economic environment. The situation is such that off-the-shelf analysis can be severely limited and institutions needs to look at these matters as they pertain to them in a bespoke way.

For more information:

BDO’s Quantitative Risk and Valuation Advisory and Economic Consulting practices can help in both regards. With our deep knowledge and experience of auditing and advising financial services firms, our multidisciplinary approach and our bespoke offering to each and every client, we can tailor an approach which is practical and built around your specific business needs and concerns.

Contact details

Tom Robinson, Director, Tom.Robinson@bdo.co.uk

Jyrki Kolsi, Director, Jyrki.Kolsi@bdo.co.uk