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Financial Planning
and Stress Testing
Incorporating IFRS 9

July 2018
Contents

Page

Introduction 1

Demystifying IFRS 9 forecasting 2

Multiple economic scenarios 3

Forecasting stage migration 4

Bringing it all together 5

How we can help 6

Contacts 7

Financial Planning and Stress Testing: Incorporating IFRS 9 July 2018

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Introduction
Background
• Now that the implementation date for IFRS 9 has
passed, incorporating this new accounting standard
into Financial Planning and Stress Testing remains
a key challenge.
• Some of the pinch points and focus areas include
multiple economic scenarios and forecasting stage
migration.
• Simple approaches to tackle these challenges have
started to emerge, however, some firms are now
moving towards more refined capabilities.
• This paper discusses some of the key challenges with
IFRS 9 for Financial Planning and Stress Testing and
presents some solutions to overcome these obstacles.
Understanding the challenges
1. Multiple economic scenarios
- How should IFRS 9 economic scenarios and
scenario weights evolve over the forecasting
horizon?
2. Exposure evolution
- How should new business, run-off, and refinance
assumptions evolve over the forecasting horizon?
- How will exposure assumptions impact the
forecasting of stage migration?
3. Forecasting stage migration
- How should forecasted exposure migrate through
the IFRS 9 stages under each scenario over the
forecasting horizon?
- How should the IFRS 9 staging criteria be applied
when forecasting significant increase in credit risk
(SICR)?
4. Forecasting/Execution
- How should multiple economic scenarios,
exposure evolution, and stage migration come
together to forecast the IFRS 9 provisions?
- How should the execution engine be used to
understand the sensitivities and impacts of key
assumptions and approaches adopted?
• When answering these questions, a key challenge is to
ensure that the IFRS 9 solution for Financial Planning
and Stress Testing is consistent with the solution for
estimating reporting date provisions.
Financial Planning and Stress Testing: Incorporating IFRS 9
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Further considerations
• Understanding the forecasts: The profile of
forecasted provisions is expected to change with IFRS 9
having a front loading effect. Through detailed impact
assessments, sensitivity analysis, and enhanced
documentation, banks should focus on understanding
the drivers of change including the key parameters,
assumptions, and judgements driving the estimates.
• Review, challenge, and governance: IFRS 9
introduces additional challenges in estimation and
modelling and therefore banks should demonstrate
an appropriate level of review and challenge. Model
adjustments and overlays should also be considered,
particularly if the simplicity of initial forecasting
solutions results in uncertainty.
• Monitoring and MI: Bespoke monitoring and MI
tools should be used to maintain a detailed
understanding of provision forecasts, including:
- How forecasts they have been arrived at and
how they are evolving over time.
- The appropriateness of key modelling
components and assumptions, triggering
recalibrations when required.
- Transparency on model assumptions and
limitations, to facilitate an appropriate level
of review and challenge.
• ICAAP submissions: Firms are preparing their
ICAAP documents where IFRS 9, Financial Planning,
and Stress Testing will come together. These should
highlight how the forecasts have been arrived at, and
how the capabilities could be refined and improved over
time.
Key benefits
• Increased understanding of portfolio sensitivities and
how provisions would evolve under various scenarios.
• More granular and improved understanding
of portfolio risk profiles, loss contributions,
and profitability.
• Increased confidence in the capital assessment used to
steer management actions and Financial Planning
within the business.
• Improved accuracy of capital assessments and
resulting capital buffer requirements.
• An improved forward looking toolkit that can allow for
better risk management.
• Future proofing for regulatory requirements, which,
are expected to become more sophisticated.
July 2018
1
Demystifying IFRS 9 forecasting

1 Multiple economic scenarios

How should IFRS 9 scenarios and scenario

weights evolve over the forecasting horizon?
There are various ways to approach this,
GDP growth

including the use of perfect foresight, corridor,

and re-forecasting approaches. See page 3 for
further details.

0 1 2
Forecasting horizon

2 Exposure evolution
How should new business, run-off, and refinance
Live portfolio New Business Y1 assumptions evolve over the forecasting horizon?
New Business Y2 New Business Y3
New Business Y4
Total Exposure
New Business Y5 These assumptions should vary under each
scenario and consider the firm’s risk-appetite as
well as how industry competition and market
Exposure

conditions are expected to react and evolve.

0 1 2 3
Forecasting horizon
Exposure evolution assumptions can affect the
forecasting of stage migrations due to the
resulting risk profile as well as income and cost
4 5
forecasts.

3 Forecasting stage migration

Stage 1 Stage 2 Stage 3 Total Exposure

How should forecasted exposure migrate through
the IFRS 9 stages over the forecasting horizon?
There are various ways to approach this,
Exposure

including the use of transition matrices, or

0 1 2 3
Forecasting horizon
forecasting the risk profile and re-assessing
against SICR criteria. See page 4 for further
details.
4 5

4 Forecasting/Execution

Stage 1 Stage 2
Stage 3 Total Provision How should multiple economic scenarios,
exposure evolution, and stage migration come
Forecasted IFRS 9 provision

together to forecast the IFRS 9 provisions?

The execution engine should aggregate, reconcile,
and produce outputs at a level of granularity that
meets reporting requirements and allows for
meaningful insights to influence Financial
Planning and portfolio risk management.
0 1 2 3 4 5

Forecasting horizon

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Multiple economic scenarios

Under the new accounting regime, IFRS 9 provision calculations as at a reporting date should incorporate the impact of
multiple economic scenarios. For Financial Planning and Stress Testing, these requirements and complexities are
amplified over the forecasting horizon.
The majority of industry has adopted a ‘perfect foresight’ approach for initial implementation of forecasting models that
incorporate IFRS 9. However, firms are moving towards more sophisticated and complete approaches to overcome the
limitations of using this simplification.

Option 1: ‘Perfect foresight’ approach

Single ‘perfect foresight’ variable path • Applies a single variable path with an implied scenario
weight of 100%.
• Does not fully capture the intention of multiple
GDP growth

economic scenarios under IFRS 9 i.e. to capture

uncertainty around forecasted expectations and
non-linearity of expected losses.
• As such, this approach is not strictly in line with how
provisions would be assessed in reality over the
0 1 2
forecasting horizon.
Forecasting horizon

Option 2: ‘Corridor’ approach

Driving scenario • Applies a single set of variable paths around a driving

scenario with scenario weights that remain fixed over
the forecasting horizon.
GDP growth

• For Financial Planning, these could be the IFRS 9

scenarios and scenario weights used in the reporting
date provision calculation.
• For Stress Testing, the multiple scenarios and scenario
weights would be generated around the driving Stress
0 1 2
Testing scenarios e.g. the BoE’s Annual Cyclical
Forecasting horizon
Scenario (ACS), the EBA’s adverse macroeconomic
scenario, or internal stress scenarios.
Option 3: ‘Re-forecasting’ approach

Re-forecasting’ variable paths at each reporting point

• This is the most sophisticated and complete approach,
which, requires dynamic economic scenario generation
techniques to produce expected variable paths and
GDP growth

scenario weights at each reporting point in the

forecasting horizon.
• Applies multiple variable paths around a driving
scenario, which, can either be a Financial Planning base
scenario or Stress Test scenario.
0 1 2
Forecasting horizon

Further considerations:
• A hybrid of the above approaches may be adopted. For example;
a) ‘perfect foresight’ can be used up until each reporting point for determining the IFRS 9 staging; and
b) ‘re-forecasting’ can be used from that reporting point onwards for calculating the scenario-weighted
Expected Credit Losses (ECL).
• Economic plausibility, reasonability, and coherence of scenarios and model outputs will be a key focus area, as re-
forecasting scenarios will be significantly dependent on statistical techniques.

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Forecasting stage migration

For Financial Planning and Stress Testing, banks are required to estimate how exposures migrate through the IFRS 9
stages over the forecasting horizon. Migrations should be based on IFRS 9 staging criteria that are consistent with
reporting date calculation, and the impact of different scenarios on these migrations should also be captured.
The following approaches calculate the probability of being in each stage at each reporting point over the forecasting
horizon, and differ depending on sophistication of modelling techniques and SICR criteria.

Option 1: ‘Stage Migration Matrix’ approach

S1 S2 S3 Exit • This approach is typically used where PD thresholds are

unavailable, and/or there is a significant reliance on
𝑃𝑆1 – 𝑃𝐷1 –
S1
𝑃𝑆21
𝑃𝑆21 𝑃𝐷1 1 – 𝑃𝑆1 qualitative criteria.
• Uses a matrix of transition rates to estimate the
𝑃𝑆2 – 𝑃𝐷2 –
S2 𝑃𝑆22 𝑃𝐷2 1 – 𝑃𝑆2 probability of an account being in each stage at each
𝑃𝑆22
reporting point.
𝑃𝑆3 – 𝑃𝐷3 –
S3 𝑃𝑆23 𝑃𝐷3 1 – 𝑃𝑆3 • Transition rates into stage 3 are calculated using the
𝑃𝑆23
forecasted marginal probability of default (PD) under
Exit 0% 0% 0% 100% each scenario.
• All other transition rates are conditioned on historical
𝑃𝑆𝑖 = Probability of survival given in stage i. migrations and adjusted for each scenario using
𝑃𝑆2𝑖 = Probability of being in stage 2 given in stage i. economic response models and/or assumptions.
𝑃𝐷𝑖 = Probability of default given in stage i. • The probability that an account has survived, but not
defaulted, is spread across stage 1 and stage 2. Adjusting
this spread under each scenario remains a key challenge
where only qualitative SICR criteria exist.

Option 2: ‘PD only’ approach

• This approach is solely dependent on the PD under each

macroeconomic scenario (‘macro-adjusted PD’) for
Stage 2 PD
threshold estimating the probability that an account is in each
stage.
• The probability of an account being in stage 3 at each
No. of obligors

Shift in PD reporting point is equal to it’s forecasted macro-adjusted

distribution under Increase in Stage PD up until that point.
Stress 2 Population
• The forecasted macro-adjusted PD compared to the
SICR criteria determines whether the account is
expected to be in stage 1 or 2 with the remaining survival
probability. Qualitative stage 2 criteria are therefore not
explicitly applied.
• This is approach requires that stage 2 PD threshold(s)
exist and have a high correlation with the remaining
Probability of Default (PD) qualitative and backstop criteria.

Further considerations:
• Capturing the expected impact of macroeconomic scenarios on stage 2 transitions due to qualitative criteria remains a
key challenge. Many banks are therefore measuring the expected impact on stage 2 transitions due to quantitative
criteria, supplemented with supporting analysis that assess the reasonableness of this approach.
• Data available for developing a stage migration solution is limited to recent experience, and so supporting analysis is
required to show that these solutions hold under stress should this option be adopted.

Financial Planning and Stress Testing: Incorporating IFRS 9 July 2018

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Bringing it all together

Forecasted provisions are a Forecasted Retained Earnings

key input to Profit and Loss
accounts and directly impact Retained Earnings (IFRS 9) Retained Earnings (IAS 39) Impact on available capital

Forecasted retained earnings

the retained earnings
estimated over the
forecasting horizon.

The profile of forecasted

provisions is expected to
change with IFRS 9 having a
front loading effect,
particularly under a stress
scenario (graph for 0 00 1 1 1 2 22 3 3 3 4 4 4 55 5
illustration purposes only). Forecasting horizon

As discussed in this paper, there are number of crucial aspects to forecasting IFRS 9 provisions. These include
methodological design decisions as well as assumptions and judgements underpinning the IFRS 9 framework. These
can all have an impact on forecasted provisions and resulting capital assessments, emphasizing the importance of
understanding and implementing a robust IFRS 9 forecasting capability.

Understanding the forecasts

Firms should develop a comprehensive understanding of how provisions evolve over the forecasting
horizon; analysing the front loading effect of IFRS 9, sensitivities to key assumptions, and how provisions differ
from IAS 39 methodology.

Strategic decision making

An enhanced provision forecasting toolkit should also be used to measure the profitability and resilience of
portfolios under the various scenarios considered. This can help Senior Management understand the key drivers of
retained earnings and available capital, resulting in better informed management actions and strategic decisions.

Implications on Risk-Appetite

Provisions for loan losses are expected to be front loaded, thus impacting capital ratios earlier under a stress.
Firms should seek to understand this timing affect on its Risk Appetite framework and identify exposures that drive
available capital estimations, as these may be considered too risky to grow as compared to previous assessments.

Future proofing

The regulatory requirements for forecasting IFRS 9 provisions are expected to become more sophisticated over time.
Firms should aim to develop a complete solution ahead of these changes, accelerating the benefits that they bring,
and reducing the burden of future redevelopments.

Financial Planning and Stress Testing: Incorporating IFRS 9 July 2018

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How we can help

There are a number of key areas

we can support you in Development or validation of your IFRS 9 forecasting toolkit,
enhancing your Financial 1 including scenario generation models, stage migration solution, and
Planning and Stress Testing forecasting execution engine.
IFRS 9 solution.

Develop multiple IFRS 9 economic scenarios for each of your

2 Financial Planning and Stress Testing scenarios.

Detailed review and challenge of your end-to-end IFRS 9

3 forecasting methodologies, including comparison to challenger model
outputs and industry best practice.

Enhancing Monitoring and MI capabilities to maintain a detailed

4 understanding of results and effectively manage model risk.

Support on your ICAAP submission to ensure it appropriately

5 incorporates IFRS 9 in line with the regulators’ expectations.

Financial Planning and Stress Testing: Incorporating IFRS 9 July 2018

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Contacts

Raf Hussain
Partner

T: +44 (0) 7706 284 222

E: raf.hussain@pwc.com

David Wong
Partner

T: +44 (0) 7718 778 679

E: david.l.wong@pwc.com

Susie Thomas
Director

T: +44 (0) 7725 475 680

E: thomas.susie@pwc.com

Mark Randall
Director

T: +44 (0) 7764 988 946

E: mark.b.randall@pwc.com

Giustin Leonidou
Manager

T: +44 (0) 7802 660 459

E: giustin.p.leonidou@pwc.com

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© 2018 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC”

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