The ECB launched a targeted review in November 2022 and asked 51 banks – almost half of the banks under direct supervision – how their IFRS 9 provisioning framework captured emerging risks.
In 2024, the ECB repeated the thematic review for the same banks, covering 2023 year-end financial figures.
The review, and in particular the repeated review after banks received specific recommendations for improvement, revealed clear progress in banks’ identification of novel risks. Only a small number of banks still ignore these risks in their provisioning process. The progress is particularly evident in the area of C&E risks, where the number of banks provisioning for those risks has increased from 16% to 55%.
Most banks are unable to capture novel risks in a fully functional and validated statistical model due to insufficient data. This problem is likely to persist for the foreseeable future. For most banks, the most adequate approach is to quantify emerging risks outside the existing models through "overlays". Accounting standard IFRS 9 does not include a definition of “overlay”; banks sometimes refer to overlays as “management adjustment”, “post-model adjustment” or “top level adjustment”.
Under these circumstances, an overlay is the best solution to capture novel risks. This overlay should be based on sound methodologies, like simulations and scenario analysis. Trying to include novel risks in statistical models with insufficient data is inferior to overlays because it sacrifices model quality. Ignoring novel risks altogether is the least acceptable practice as this systematically underestimates future loan losses.
When it comes to quantification and accounting implementation, banks still have a long way to go. Bad practices, such as considering novel risks only via their aggregate impact on future GDP, are widespread and tend to underestimate the true impact of novel risks on expected losses. In addition, far too many banks ignore the impact of novel risks on staging, which even contradicts the accounting requirements. Moreover, bad practices like the use of overlays on the total expected credit loss (ECL) level (instead of the parameter level) and responsibility and empowerment shortcomings in financial reporting functions create vulnerabilities. Evidence indicates banks with bad practices have, on average, lower provision coverage.
While progress is evident, some supervised banks are still far from considering all reasonable and supportable information, including that which is forward-looking, as required by IFRS 9. In any case, there is no level playing field in the industry. The ECB will thus continue to follow up with the laggards with appropriate supervisory measures, which may include requiring banks to apply a specific provisioning policy.
