Capturing new and emerging risks in estimating credit losses

credit risk

Organisations should update their credit risk measurement processes to reflect the current realities in the economy. PHOTO | SHUTTERSTOCK

The post-pandemic business environment and the Russian invasion of Ukraine have led to new and emerging risks across many economies such as supply chain snags, high commodity and food prices and the energy crisis.

Banking regulators in many countries have increased interest rates to stem inflation, leading to a rise in borrowing costs for many governments.

The increased geopolitical conflicts and political polarisation globally have also contributed to the rising levels of instability in many countries. These crises make it difficult to make predictions and estimates about the future.

Estimating credit losses using the Expected Credit Loss (ECL) approach of IFRS 9, requires organisations to consider the current economic conditions in which their counterparties operate. To achieve this, organisations should update their credit risk measurement processes to reflect the current realities in the economy.

Organisations should include additional scenarios in their IFRS 9 models as the future becomes less certain to improve the reliability of results; revise their cash flow projections to include additional scenarios that reflect the new and emerging risks impacting businesses in the operating environment; and consider revisiting their segmentations within their IFRS 9 models.

It is important because the impact of the new and emerging risks might differ for various segments of the organisation’s portfolio.

Organisations could also consider developing new or revised IFRS 9 models due to the limitations of existing models in the current environment and re-examine their loss distributions to enable them to identify scenarios where changes in the severity of economic or other conditions give rise to disproportionate losses and indicate areas where closer attention is required.

The price volatility in many markets impacting real estate, stocks, bonds, and other asset prices is difficult to predict. Rather than trying to achieve a single best estimate, organisations should apply the ECL principles of probability-weighted outcomes that include scenarios, even if they are less likely than others to capture new and emerging risks in their estimates of credit losses.

The writer is an Associate Director at PwC Kenya. He writes and speaks widely on corporate reporting.