Financial reporting of European banks: towards the end of the ‘golden age’ of post-model adjustments (‘PMAs’) / overlays to banks' expected credit losses (‘ECL’)?

When the Covid-19 pandemic broke out in 2020, the banks had to make post-model adjustments[1] (or management overlays) to incorporate the impact of this unprecedented situation into the expected credit losses recognised by the banks. While the end of the pandemic should have put an end to these exceptional adjustments, the events that followed (war in Ukraine, energy crisis, economic uncertainties, etc.) contributed to maintaining this mechanism.

Although this mechanism seems to be maintained over time, our previous studies of the annual and half-yearly financial statements of 26 banks in 11 European countries have nevertheless shown a notable change in trend since their creation in 2020.

A brief history of post-model adjustments since 2020

While cumulative PMAs amounted to 16% of ECL allowances recognised in the balance sheet in YE 2021, this proportion appears to have begun to decline in YE 2022, falling to 14% and returning to its level at the end of 2020.

A similar picture emerges if we look at changes in ECL impairment in the statement of profit or loss. In fact, if we consider the weight of cumulative PMAs change in ECL charge/release before PMAs[2], 2022 also marked a return to the levels seen at the end of 2020 when the PMAs had just been put in place, with changes in PMAs accounting for around 30% of the net ECL charge before PMAs at the end of 2022 (after a peak at 48% in YE 2021).

The year 2023 therefore seemed to be at a crossroads, the question being whether 2023 would confirm the start of the decline in overlays seen in 2022, mark a stabilisation of overlays at an incompressible level, or start to rise again depending on developments in the international environment.

For further analysis of these trends in expected credit losses in 2023, Forvis Mazars conducted an analysis of 26 banks in 11 European countries in June 2024, based on the banks’ year-end 2023 financial statements. The benchmark study on Financial reporting of European banks [3] follows on from previous editions of the report since its launch in 2020.

Further reduction in overlays in 2023

Unlike previous years, 2023 was not accompanied by any notable new events in the international geopolitical context. No new significant overlay had been reported in YE 2023 at a global level. The underlying reasons for the overlay therefore remained comparable to those observed in YE 2022 and still relate to uncertainties in the macroeconomic environment, including higher inflation and interest rates or difficulties for the property sector.

In the absence of any significant new event, and also due to the gradual integration of historical PMAs / overlays into IFRS 9 ECL calculation models, the weight of cumulative overlays in amortised cost loans ECL allowance continued to fall slightly on a regular basis during 2023 compared to previous years. The average weight of cumulated overlays in amortised cost loans ECL allowances stands at 12% on average in YE 2023 (14% in YE 2022).

When looking at the details of the cumulative overlays on the panel banks, we can see the following:

• the weightings in YE 2023 range from 0% to 48%, which is in line with the range observed in YE 2022;
• Spanish banks significantly decreased their cumulative overlays, which all stand now well below the average;
• the other geographical trends identified in YE 2022 remain valid in YE 2023:
  • UK banks have generally continued to reduce their overlays and remain below the average;
  • cumulated overlays of French, Dutch and Italian banks remained close to the average.

The downward trend in overlays is also consistent if we analyse the weight of changes in cumulative overlays in the ECL charge for the period: the average weight of cumulative PMAs change in ECL charge/release before PMAs stands at 18% in YE 2023 (compared to 30% in YE 2022 and 48% in YE 2021). So at a general level, the decrease of the average weight of cumulative overlay change in the net ECL charge in YE 2023 is consistent with the decrease of the cumulated overlays in the balance sheet, in a general context of a decrease in ECL allowances in YE 2023.

If we focus on the panel banks, we can see that the range has been reduced compared with YE 2022. In particular, no bank has experienced a cumulative change in overlays that exceeds the amount of the ECL charge before overlays (i.e. a weight that is greater than 100%) in YE 2023 (vs 2 banks in YE 2022). On a broader scale, changes in cumulative overlays stand for more than 50% of the ECL charge before overlays only for 2 banks in YE 2023 compared to 7 banks in YE 2022.

Given the way in which this ratio is calculated, it is also worth pointing out that the overall change in the ECL charge (i.e. the denominator of the ratio) is not a determining factor in this marked reduction in the weight of cumulative overlays in the ECL charge before overlays: the average ECL charge has in fact remained relatively stable in YE 2023 (-3% vs YE 2022), so the reduction in the weighting of the overlays can be explained primarily by a genuine reduction in overlays rather than by a base effect (i.e. a stability or an increase in these amounts which would be diluted in a larger general increase in provisions).

What’s next?

Although the gradual incorporation of PMAs into ECL models and the absence of any recent significant event seem at first sight to be sounding the death knell for this type of mechanism, it nevertheless remains valuable for incorporating (at least temporarily) exceptional events not anticipated by the models and still stands at a significant level despite a regular decrease since YE 2021.

As evidence of this new paradigm, post-model adjustments are one of the key topics identified by the International Accounting Standards Board (IASB) in their Post-implementation Review (‘PIR’) of IFRS 9 relating to impairment released in May 2023. This PIR consists in asking stakeholders to report back on any perceived fatal flaws in measuring ECLs, as well as granularity and consistency between information banks provide on post-model adjustments.

Although the IASB said that feedback and research carried out during the PIR showed that impairment requirements are meeting their objectives, they also acknowledge that some areas could benefit from clarifications or further improvements, including post-model adjustments or management overlays used for determining the ECL allowance. To meet these needs for specific improvements to the standard, the IASB has added a new project to its pipeline to investigate targeted improvements to the credit risk disclosure requirements in IFRS 7 Financial Instruments: Disclosures[4]. As specifically regards the PMAs, the feedback analysis provided by the IASB has reported a few examples of disclosures that stakeholders would find useful, such as the amount of PMAs as at reporting period, the reasons that led an entity to using PMAs and plans for unwinding of such PMAs. It remains to be seen whether these proposals will be included eventually in any future amendments to IFRS 7, as the project has no specific deadline at this stage and has been deemed to be of medium priority.

In a forthcoming article, we will see how the economic and geopolitical context in 2023, marked by the absence of any new major event and the apparent reduction in uncertainties not incorporated into the models, may also have had an impact on the assumptions made in the forward-looking information used in the ECL estimates.

[1] A post-model adjustment is an incremental ECL that increases (or decreases) the ECL resulting from the bank’s IFRS 9 impairment models

[2] The weight of overlays in ECL charge/profit before overlays (%) has been calculated by dividing the changes in overlays in absolute value by the ECL charge/profit in P&L before overlays.

[3] Financial reporting of European banks: benchmark study 2024 – Forvis Mazars Group

[4] https://www.ifrs.org/projects/pipeline-projects/