Loan forbearance No such thing as a free lunch

Loan forbearance
No such thing as a free lunch
Summary
One of the most striking differences between the
1990s recession and the present Financial Crisis has
been the way that banks, building societies and other
lenders have dealt with customers facing financial
difficulties. This time round, lenders have made greater
use of forbearance strategies, granting concessions to
customers, both consumer and corporate, in actual or
apparent distress to avoid, where possible, the pain of
collecting on the debt.
There are potential gains for everybody. Customers benefit from greater flexibility and extra time to resolve their
financial difficulties; lenders may improve their chances of recovering the full amount of the debt.
However, our analysis shows there may be hidden costs and additional risks to forbearance:
•Operations teams face a whole new set of complex challenges to balance short term gain with longer term costs
and heightened risks.
•Ill-considered use of forbearance can place customers in further financial distress worsening their financial
position and treating them unfairly.
•Impairment accounting and disclosures become trickier.
•Returns on capital may be lower, new business volumes may be constrained, and prices may rise for all
customers.
There are ways to reduce the costs and mitigate the risks, as we discuss below, but forbearance is far from the free
lunch it might seem at first glance. To deal with the issues that forbearance creates, the Operations, Finance and
Risk functions within each firm need to work together. Otherwise, what seems like a quick fix today could become
a value destroyer for the lenders in the medium to long term.
Loan forbearance No such thing as a free lunch 1
Introduction
During the early 1990s, the high interest rate environment incentivised lenders to ensure quick resolution of
defaulted assets which minimised the economic losses to the business but, arguably, gave customers insufficient
time to get back on their feet. This time round things are different. Partly because of low interest rates,
partly from concerns to safeguard their reputation, and partly to defer potential losses, lenders have responded
to the downturn by making greater use of forbearance for all types of customers.
The Financial Services Authority (FSA) defines forbearance to have occurred “when a bank grants a concession for
reasons relating to the actual or apparent financial stress of a customer” and can benefit both the customer and
the lender. The customer can be helped by receiving additional time to recover their financial position. The lender
may also benefit through:
• Gaining a positive reputational impact compared with starting a collections process.
• Demonstrating that it is “Treating Customers Fairly”, which is a central theme in the FSA’s retail market regulation
and will be a high priority for the new Financial Conduct Authority.
• Improving its chances to recover more, if not necessarily all, of the debt in the future.
The advantages for both the lender and customer will vary by product, portfolio type and the strength of the
relationship between the lender and the customer. The approach to forbearance and associated benefits differs
particularly between retail and corporate customers.
The advantages for both the lender and customer will
vary by product, portfolio type and the strength of the
relationship between the lender and the customer.
2
Retail portfolios
Consumers typically have a mix of lending products including mortgages, overdrafts and credit cards.
Whilst forbearance is applied across all these products, it is most widely used in the context of retail
mortgages, where a special agreement between the lender and borrower will delay a foreclosure. In return,
the borrower agrees a change in the terms of borrowing for an agreed period. For example, a different
payment schedule will be agreed where the borrower can make lower monthly payments, such as on an
interest only basis, if they have become unemployed or have a reduced income for other reasons. This can
allow the borrower to make smaller payments or have a payment holiday whilst they find a new job or
improve their finances, and then revert to the original terms and repay the arrears.
The FSA forbearance review carried out on behalf of the Bank of England (BoE) suggested that 5%–8%
of mortgages are subject to forbearance, with 5% of this group of customers avoiding moving into arrears
for six or more months due to restructuring of their mortgage terms. Therefore, the FSA estimates that in
the absence of forbearance, mortgage arrears rates would have been 1.7% rather than the 1.2% reported.
This remains at historically low levels compared to arrears rates in the early 1990s, but is perhaps a more
accurate reflection of possible default levels.
Retail customers with a full banking relationship (“franchise customers”) can benefit from forbearance
across a range of products, negotiating a revised repayment profile across mortgages, overdrafts and credit
cards to ensure that the most expensive debt is repaid most quickly. However, non-franchise customers
may need to negotiate different forbearance agreements with each lender, and at different times, making
it harder to optimise the structure of their debts or repayment plan. For non-franchise customer, the role of
debt advisers in helping to manage arrears and identify forbearance options with a shared outcome in mind
is critical.
Corporate portfolios
The range of customer and facility types in a corporate portfolio is more diverse than for retail customers
but one area where there has been significant focus on forbearance strategies employed is Commercial
Real Estate (CRE).
CRE financing has faced specific challenges during the financial crisis with current commercial property
values remaining around 35% below their peak in 2007 and increased stresses to rental income. This has
resulted in lenders providing forbearance to customers by waiving Loan To Value (LTV) and debt service
covenants, extending maturities and agreeing payment holidays. The FSA has found that in the six largest
UK lenders, approximately a third of CRE loans are subject to forbearance. In many instances, there is
insufficient rental income to reduce outstanding debt to ensure full repayment from sale or refinance
of the property. Corporate Credit Risk departments are hoping that applying a forbearance strategy for
CRE loans, where the borrower can continue to make repayments, will result in higher recoveries as
CRE prices or rental incomes increase in the future. However, this remains something of a gamble and
has fuelled refinancing requirements over the next three years.
Loan forbearance No such thing as a free lunch 3
In recent times, both the BoE and the FSA have become
concerned about some of the potential drawbacks:
•Forbearance may not always be employed in the
best interests of the customer as it could lead to
the loan moving permanently on to non-sustainable
terms and increase customer losses.
•New lending may be restricted by forbearance,
impeding further economic growth.
•Loan impairment methodologies may not effectively
capture the impacts of forbearance, reducing the
accuracy of lender performance reporting.
The FSA published finalised guidance in October 2011
in relation to forbearance and impairment provisions
for mortgages. Its review was then extended to cover
other consumer debt and CRE, the results of which
were published by the BoE in December 2011.
However, the widespread use of forbearance creates
costs and risks for lenders, and while it gives time to
borrowers, it can increase the financial risks which
they face if they are not able to return to regular, full
payments of the debt outstanding. Our analysis has
identified four areas for lenders to examine: collection
and recovery operations; conduct of business risks;
accounting processes and returns on capital calculated
using a risk-based approach.
Conduct risk
As previously noted, the FSA has conducted a thorough
review of the forbearance strategies operated by UK
firms. Weaknesses and shortcomings in the application
of forbearance were widely identified across both
corporate and retail portfolios. However, the focus
in the conduct area is retail portfolios and ensuring
consumer protection.
The FSA is taking an increasingly intrusive approach
to regulation. For instance, the latest Mortgage
Market Review (MMR) consultation paper (CP 11/31)
demonstrates the regulator has serious concerns
about arrears management in firms. Firms will need
to take account of evolving regulatory approaches on
affordability assessments and the use of interest only
loans as a coping strategy and forbearance tool.
Lenders will need to do more to evidence they have
considered the right outcome for consumers and not
just delayed the inevitable, or increased the level of
debt outstanding on foreclosure. Where consumer
detriment is identified by the FSA, and firms are unable
to evidence their rationale for the forbearance decisions
it takes, the FSA could take regulatory action.
4
We previously mentioned that mortgage lenders
are taking a more responsive approach to helping
consumers in financial difficulty, but in some cases
this can be to the financial detriment of the consumer
in the longer term. For example, moving a customer
from a capital repayment mortgage to an interest only
mortgage for a period of 6 months may result in lower
mortgage payments and can provide some respite from
repossession proceedings. However, if the underlying
issue is that the consumer is living beyond their means
and has not been able to address the imbalance,
then at the end of the 6 months the reversion to their
normal contractual repayments could result in the
accumulation of further arrears.
Forbearance provided without careful consideration
of the individual circumstances of the consumer can
place them in an even worse position and make it
unlikely that they could recover their financial position
in the future. Falling house prices, arrears charges,
and possible interest rate rises add to consumers’
financial risks. Consumers need to understand their
options to make informed choices. Firms must promote
and articulate these options and consider the risks
associated with the decisions of consumers based on
their particular circumstances. Furthermore, a firm
must be able to demonstrate why the option was
appropriate for the consumer and that the outcomes
can be evidenced.
Lenders should not assume that the consolidation
of arrears is necessarily the best option, even though
this may have been the assumption in the past.
This option seems only viable for consumers with
short term difficulties, who can manage the financial
difference in interest charges.
Consumers have often been provided with the option
of changing to an interest only mortgage. This tool
may be appropriate on a short term basis, but the
impact of such a move in the longer term needs
careful consideration. Lenders need to consider how
the borrowing will be repaid at the end of the term;
whether the consumer has, or will be able to meet
their contractual obligations and have a viable
repayment strategy; and whether this strategy is based
on appropriate assumptions. Reliance on an inheritance
or a rising housing market would not be appropriate
assumptions. Lenders need to think about how they
will evidence assessment of a consumer’s current,
short and long term situation in providing a solution
which leads to a positive outcome for the consumer.
Moving a consumer onto interest only will erode the
equity in the property, and may lead to increased
arrears making it more difficult to retrieve the situation
if it is allowed to go too long.
There are, of course, other options which can be
considered though some firms have been restricted
by their own systems and IT to deliver the alternatives.
Options such as payment holidays, temporary reductions
in monthly payments or capitalisation of existing arrears
are likely to be more appropriate when the consumer
has suffered a short term problem. However, where
the consumer has or is likely to suffer a longer term
set-back, such as reduced wages or a breakdown of a
relationship, then a more permanent solution may be
required such as a extending the term of the mortgage
or assisted voluntary sale. Again, the full circumstances
of the consumer need to be considered to assess what
is realistic.
Recommendations
We recommend that lenders should:
•Tailor their forbearance approach in relation
to different types of consumer, and track the
performance of different forbearance tools over time.
•Ensure there is a fully documented rationale
demonstrating the most appropriate forbearance
option was chosen for the consumer based on the
available information at that time, with regular case
reviews to ensure that forbearance remains the
best approach.
•Regularly review their arrears management policies,
forbearance approaches and consumer outcomes
against evolving regulatory expectations on
conduct risk.
Operational issues
Lenders need to be confident that their credit
operations can handle the more complex demands of
forbearance strategies. Training, skill sets, IT systems
and management information must all evolve to meet
these demands. We have identified six key areas
for consideration.
Lenders need to up-skill retail collections to ensure
the right customers are on the right forbearance
strategies
As retail collections processes have become more
standardised and mechanised over recent years,
there has been a gradual de-skilling of the typical
collections role. However, collectors these days are
required to recognise and handle retail customers who
are increasingly over-indebted, as well as identify and
implement forbearance strategies, comply with credit
policy guidelines, provide appropriate communication
to senior management and ensure compliance with the
relevant regulatory requirements. As a consequence,
some portion of the retail collections function will
need to be considerably up-skilled to ensure that
forbearance strategies are embedded and implemented
into the operational infrastructure of the organisation.
This is likely to increase training costs and create
upward pressure on payroll costs.
Forbearance can come in many forms, creating
potential issues with systems and manual
workarounds
A forbearance agreement may modify the term length
or make temporary or permanent changes to the
interest rate. Multiple strategies will need to be created
within the collections systems to deal with a range of
scenarios. This implies that the collections systems need
to be extremely flexible and fully linked to the standard
product and finance systems. For some organisations,
this might require significant IT development whereas
for others this may not be an option with processes
relying on manual exception processes to monitor
customer performance against agreed forbearance
terms. Forbearance strategies employed on most
corporate (and some retail) portfolios are not usually
systematically flagged, so again IT developments
and manual workarounds will likely be needed.
Lenders need to be confident that their credit operations can handle the
more complex demands of forbearance strategies. Training, skill sets,
IT systems and management information must all evolve to meet these
demands. We have identified six key areas for consideration.
Loan forbearance No such thing as a free lunch 5
Finding the right forbearance strategy for each
customer means looking at their overall debt position Some organisations still structure their collections
functions along product lines or at least split them
between secured and unsecured collections. Most
organisations have separate corporate and retail
collections functions. In order to demonstrate that
all the customers’ financial obligations are being
considered and forbearance strategies are being
applied across multiple products and portfolios,
greater interaction between collection teams and
systems will be required. Moreover, what a customer
can truly afford to repay will depend on what debts
they have elsewhere. For example, there will be
a greater onus on consumer collections teams to
complete income and expenditure forms using
up-to-date bureau information to validate some of
this information and to fully understand the
indebtedness profile of the customer.
Customer circumstances change: the collections
function must stay up to date
The initial focus of forbearance is to identify customers
whose circumstances have worsened and who are
suitable for a specific forbearance strategy. Over time,
though, collections functions will need to ensure
that they also proactively look for customers who
are adhering to their forbearance terms but whose
circumstances have improved and whose forbearance
strategy and terms should be altered.
Collections teams will need to provide accurate,
insightful and timely information on forbearance
portfolios
The burden on collections teams to produce
management information (MI) is likely to increase,
as senior management will need more detailed
analyses of the collections performance and
specifically, the performance of the various forbearance
strategies in support of their own business strategies.
This will guide provisioning and operational decisions,
aid external disclosure and is likely to include
information on customers who have requested
forbearance strategies (which may be a signal of
deteriorating credit quality). It will also be necessary
to provide ad hoc and more regular information to the
FSA. Industry standard roll-rate and cycle delinquency
reporting will need to be supplemented with specific
forbearance strategy reporting, and the associated cash
flow and capital implications of these strategies.
6
For customers on specific forbearance strategies,
the MI requirements associated with predicting the
performance and cash flows will become increasingly
onerous, as future cash performance levels can no
longer be extrapolated from previous performance.
Additionally, manual reporting on accounts outside of
standard collections systems, particularly in corporate
portfolios, will need to be amalgamated with standard
collection reporting.
Greater linkage required between Operations, Credit Risk and Finance
One final implication of forbearance is the need for
a greater linkage between functions. The collections,
credit risk and portfolio management teams must work
together to ensure the continued appropriateness of
forbearance strategies. For example, customers who
move to interest-only mortgages may need to be advised
of their negative equity positions under adverse house
price scenarios, to better understand whether the
agreed strategy is still appropriate for them. In addition,
Finance will need to work closely with Credit Risk to
ensure that they understand the MI produced to aid
provisioning decisions and the associated disclosures.
Recommendations
We recommend that lenders should:
•Focus resources on training and up-skilling their
business support and collections teams to better
identify and manage customers who are increasingly
over-indebted and potential risks.
•Review and refine their credit risk policies to clearly
identify the specific forbearance strategies to be
employed and the specific circumstances under
which they can be applied, and for how long.
•Enhance communication mechanisms between
departments and divisions to improve the early
identification of potential financial distress and also
the application of appropriate forbearance strategies
that considers all the customer’s credit exposures
within the organisation. The use of external bureau
information should also be considered for the early
identification of potential financial distress but also
to gain a better perspective as to the true financial
situation of the customer across all their
credit exposures.
•Where possible, upgrade collections and recoveries
systems plus the associated MI reporting framework
so that the application of forbearance strategies
can be consistently applied and reported without
considerable manual workarounds and the associated
increased resource costs and operational risk.
Financial and Accounting implications
Lenders need to be confident that their provisioning
processes and financial disclosures accurately reflect
the impact of their forbearance strategies.
The process of calculating impairment provisions
needs to be reassessed
Forbearance strategies employed may impact the size
of a lender’s loan impairment provisions which are
accounted for under IAS 39: Financial Instruments:
Recognition and Measurement. Under IAS 39,
impairment events include significant financial
difficulties of the obligor and the lender’s granting
to the borrower a concession that the lender would
not otherwise consider due to the borrower’s financial
difficulty. Given the FSA’s definition of forbearance
described in the introduction, the granting of
forbearance is likely to constitute an impairment
trigger, meaning that the loan should be assessed
for impairment, either individually or as part of a
collective assessment. Lenders should also assess
whether borrower requests for forbearance amount to
impairment triggers – even where forbearance is not
granted – as the request may imply the borrower is in
financial difficulty.
In an individual assessment, forbearance may reduce
the size or delay the timing of future cash flows
generated from the loan, thereby reducing their
present value and potentially leading to impairment
being recognised. The impact of forbearance should
also be taken into account in collective assessments
(including incurred but not reported assessments)
through methods including:
• Disaggregation of those loans subject to forbearance,
into a separate pool from the remainder of
the portfolio. The inputs used in the collective
assessment models (such as Probability of Default
(PD), roll rates and emergence periods) should be
representative of that pool of assets. Refinement
of the collective assessment may be conducted by
further disaggregation of the forbearance portfolio
until all loans in a pool are deemed to have similar
credit risk characteristics, for example by splitting out
buy-to let mortgages from the overall forbearance
mortgage portfolio.
• Collective impairment may also be calculated by
aggregating the model-driven result for each loan
that is being collectively assessed whereby specific
inputs will be determined for each loan. The impact
of forbearance should be implicitly recognised
through the inputs used. For example, forbearance
portfolio loans are likely to have higher than average
probabilities of default and longer emergence periods.
The BoE reported in their December 2011 Financial
Stability Report that among the six largest UK lenders,
provisions against commercial real estate loans with
forbearance arrangements in place may be understated
by up to £5bn (based on an FSA review). In addition,
for retail mortgages, the BoE reports that forbearance
actions do not appear to be fully reflected in lenders’
provisioning processes.
There is potential for under provisioning in relation to
forbearance caused by:
•Inaccurate data regarding loans subject to
forbearance.
•Overly optimistic assumptions used in determining
the timing and size of cash flows from forborne
loans in specific impairment assessments.
•Inappropriate inputs for collective assessments,
which do not reflect the particular characteristics of
loans subject to forbearance. For example, should the
PD be higher for commercial real estate loans subject
to forbearance?
IFRS 9 is expected to replace IAS 39 from 1 January
2015, at which time provisions will be recognised
using an expected loss (EL) model rather than the
current incurred loss model. Given that anticipated
future losses will increase on loans where forbearance
strategies have been employed, it is expected that
the impact of forbearance will continue to have a
significant impact on the level of provisions calculated
under IFRS 9.
For those lenders that report under “old” UK GAAP1
(primarily medium and small sized building societies),
consideration will need to be given to the extent to
which the application of forbearance gives need to
the rise for a specific provision, even if the account
status does not meet the usual criteria for specific
provisioning. The inclusion of forbearance accounts
in the general provision will reduce the visibility of
key performance trends, and the ability of management
to track the performance of the forbearance portfolio
over time.
1 Lenders that report under
“old” UK GAAP do not
have to apply FRS 26
which is the UK GAAP
equivalent of IAS 39
Loan forbearance No such thing as a free lunch 7
Impairment disclosures need to reflect the
materiality of the forbearance portfolio
The FSA set out in its finalised guidance on
forbearance and impairment provisions for mortgages
(October 2011) that forbearance disclosures should
be made under the auspices of IFRS 7: Financial
Instruments: Disclosures where forbearance is material.
While the guidance was specifically related to mortgages,
we believe that increasingly, regulators and other
stakeholders will expect these disclosures to be made
for all loan portfolios where forbearance is material.
In its consultation guidance published earlier in 2011,
the FSA set out specific disclosure requirements.
These included the type of forbearance strategy used,
the quantification of loans subject to forbearance,
the level of impairment on loans subject to different
types of forbearance and the number of pools used
in collective impairment calculations (including a
description of each pool). While the final guidance
was less prescriptive in the type and form of disclosure,
the consultation guidance highlights the FSA’s thinking
on this matter and lenders would be advised to
consider this guidance when drafting their disclosures.
Consideration should also be given to disclosing
use of forbearance in directors’ reports and the
risks and uncertainties section of annual reports.
Critical accounting estimates and accounting policy
disclosures may also need to be revisited to reflect
any changes in impairment methodology.
For old UK GAAP reporters, IFRS 7 does not apply but
the disclosures described above should still be seen as
best practice.
Recommendations
We recommend that lenders should:
•Review the accuracy of the data in relation to loans
subject to forbearance.
•Amend their accounting policies and procedures
manuals to ensure that the impact of employing
forbearance strategies on the calculation of
impairment provisions is explicitly documented.
•Review their specific provisioning calculations and
inputs into their collective provisioning models to
ensure that the impact of forbearance is appropriately
reflected.
•Examine their forbearance disclosures in light of the
FSA guidance.
•Incorporate the impact of forbearance into their
IFRS 9 implementation planning.
8
Regulatory capital and pricing impacts
The insights of the Credit Modelling function need to
be factored into decisions on forbearance programmes
so that lenders optimise their capital while furthering
their business strategies.
The impact on current and future regulatory capital
requirements needs to be understood
The use of forbearance strategies has identifiable
benefits for lenders and customers, as noted previously,
particularly in times of an economic downturn.
However, the strategy has longer-term downside risks
for lenders, which could have longer term implications.
One of the main risks is the potential for future
incremental increases in regulatory capital requirements
for lenders which could lead to reduced lending
volumes and higher borrowing costs. This section
discusses this aspect in more detail.
The minimum regulatory capital requirements for the
major lenders in the UK are calculated using the Basel II
Internal Ratings Based (IRB) risk based approach.
This requires lenders to estimate how many customers
they expect to default (PD) over a twelve-month period
and how much they will lose if these customers default
(Loss Given Default – LGD). The overall impact of
the IRB approach is that higher risk lending results in
increased PDs and LGDs which consequently, reduce
capital availability and increase capital requirements.
However, forbearance strategies create potential
consequences for current and future capital
requirements and capital availability where such
a risk based approach is used. We can understand
the range of possible effects by dividing forbearance
customers into three groups:
•“Cured” customers successfully make payments on
the basis of a new forbearance agreement.
•Non cured” customers regularly breach some element
of the forbearance agreement over time.
•“Defaulted” customers breach the forbearance
agreement continuously (e.g. fail to make the
payments under the new schedule) and proceed
to a recovery process.
Each of these groups will affect current and future
capital requirements in different ways:
Cured: This group will return to the performing
portfolio but differ from the rest of the performing
book due to the following characteristics:
•Debt affordability is lower with “cured” customers
because they are less capable of absorbing stress
events, be they idiosyncratic (e.g. reduced personal
income) or systematic (e.g. interest rate increases).
This causes default rates to remain high or rise in the
future. The PDs applied for this customer group are
typically very high.
•Collateralisation levels for “cured” customers
benefiting from waivers of LTV covenant breaches
will be significantly lower than those for new
customers. This will increase eventual losses for
customers who subsequently default on debt and
is a specific risk in certain sectors (e.g. commercial
real estate). This risk should be reflected in
increased LGDs.
•Customers in financial difficulty are likely to spend
less maintaining their assets. Reduced capital
expenditure on the assets that provide collateral,
such as residential real estate, will increase the
impact of depreciation which, combined with
reduced capital repayments, increases the real
LTV of the mortgage. This results in higher LGDs
for these customers.
The overall result is that “cured” customers will retain
a higher current PD and LGD compared with the rest
of the performing portfolio for a period of time.
This will attract higher regulatory capital requirements,
and consequently reduce current capital resources,
potentially constraining new lending capacity.
Non-cured: These customers do not return to the
performing portfolio and may remain within the
non-performing or defaulted portfolios over many years.
They have a high PD and therefore attract significant
regulatory capital requirements over a longer time
period. They will also attract impairment provisions
as previously discussed. This combination immediately
reduces capital resources which constrains
lending capacity.
Continued growth of this group of non-cured
customers creates a potentially longer term impact on
capital requirements for all customers of IRB lenders.
These lenders use a combination of application and
behavioural scorecards (or rating models) which are
calibrated from historical default rates to predict
the probability of default. Forbearance can lead to
more customers having multiple defaults over several
consecutive years, causing the average number of
defaults per year to increase. During the annual
recalibration of a bank’s PD models, this increasing
default rate will be reflected in the model outputs.
Consequently, the PDs applied to the IRB customer
population will on average rise. Over a number of
years, this delayed impact can lead to higher overall
capital requirements across the entire customer base,
driven by the increased frequency of defaults today.
Defaulted: This group of customers eventually move
into a recovery process as they are unable to meet
the revised lending terms within the forbearance
agreement. The time from initial default to recovery
can take many years and is typically longer for defaults
where forbearance has been applied. This can impact
the results of LGD assumptions and calculations.
LGD is an economic calculation of loss assessed at the
point of default, which is required by Basel II to be
calibrated to a downturn and to incorporate a discount
to recovered cash flows between the point of default
and time of recovery. This discount accounts for the
time value of money and the inherent riskiness in the
expected recovery at the time of default.
For example, LGDs for retail mortgages currently
assume that customers take 18-24 months to move
from default to recovery (based on observed data
from 1990 onwards). This assumption is combined
with a typical 9% discount rate to calculate the
downturn discount on recovered cash flows.
However, forbearance could increase the recovery
time assumption towards 36 months and beyond.
If this revised assumption is included in future LGD
model recalibrations, the lower resulting economic
recovery rates cause LGDs to increase for all customers,
which drives higher overall capital requirements.
Our analysis suggests that forbearance strategies
could ultimately lead to increases in both the PD
and LGD estimates, although the impact will vary
by financial institution and across asset classes.
This could be mitigated to some extent by reviewing
the existing PD and LGD models, to ensure the
calibrations techniques remain appropriate going
forwards and the benefits of forbearance for lenders
are reflected in the methodologies applied.
However, lenders should be aware of the potential
impact on future capital requirements.
Loan forbearance No such thing as a free lunch 9
Risk adjusted pricing mechanisms will reflect
changing capital requirements
Any increases in the regulatory capital requirements for
credit risk will result in a higher overall cost of capital.
Firms typically measure the impact of capital costs on
portfolio analysis and pricing decisions using
a combination of risk adjusted return on capital
(RAROC) or Economic Profit (EP) metrics. In order to
prevent longer term deterioration in RAROC and EP,
lenders will need to consider covering increased capital
costs from new lending. If the entire cost is passed to
new borrowers, this will result in marginal borrowing
costs increasing over the medium term or future
lending being constrained further.
Conclusions
Forbearance offers potential benefits for both
customers and lenders. However, as we have discussed,
forbearance is far from the free lunch it might seem
at first glance. Firms need to be aware of the hidden
costs and additional risks associated with forbearance
strategies, assessing whether:
Our analysis of an indicative mortgage portfolio has
shown that if forbearance results in a 10% increase
in long term default rates and a 20% increase in
economic losses (due to longer recovery timescales),
the portfolio average RAROC will fall from around 40%
towards 30%. If lenders choose to pass on these costs
to consumers in order to maintain a constant level of
RAROC, then mortgage rates would need to increase
between 0.25% and 1.10%. The largest impact will
be for higher risk lending with a 90% LTV mortgage
of £100,000 costing an additional £1,100 per year in
interest costs for the borrower.
•Impairment accounting and disclosures accurately
reflect the business positions.
Recommendations
We recommend that lenders should:
•Be able to identify “cured” customers within the
performing portfolio, monitor their performance
closely over time and assess how capital
requirements are being impacted.
•Monitor the frequency of forbearance customers
moving in and out of default and complete sensitivity
analysis of their PD models to understand the
potential impact on future PD model calibrations.
•Review their LGD methodologies to assess the risk
and potential impact of forbearance on future LGD
model assumptions and results.
•Complete a sensitivity analysis across all portfolios
where forbearance is being applied, to assess the
potential for increasing PD and LGD calibrations and
the resulting impact on capital requirements over
the medium term.
•Ensure they have a comprehensive understanding
of how increased capital requirements could
impact associated costs and review the potential
effect on strategic portfolio analysis and tactical
pricing decisions.
10
•Unconsidered use of forbearance is placing customers
in further financial distress.
•Operations teams are resourced and prepared to
meet the new challenges at a time of heightened
regulatory interest in conduct risk.
•Affordable new lending capacity will be available
for customers whilst achieving Returns on capital
aspirations.
Lenders should prioritise and tailor solutions to fit with
their strategic outlook, bearing in mind factors such as
their market position or risk appetite. Improvements
will require Operations, Finance and Risk functions
to work together in each firm, taking account of the
evolving regulatory landscape. However, failure to
assess the medium to long term impact of forbearance
could cause a good short term strategy to become a
value destroyer, both for lenders and customers.
Contacts
Conduct risk
Collections and recoveries Cindy Chan
Damian Hales PartnerDirector
020 7303 5836
020 7007 7914
cichan@deloitte.co.ukdhales@deloitte.co.uk
Michael Coogan
Sarah Wines Strategic advisor
Manager 020 7303 3317 020 7303 6381
mcoogan@deloitte.co.ukswines@deloitte.co.uk
Credit risk modeling
Tim Thompson
Partner
020 7007 7241
tthompson@deloitte.co.uk
Tom Clifford
Senior Manager
020 7303 6378
tclifford@deloitte.co.uk
Oliver Sharp
Manager
020 7007 3258
osharp@deloitte.co.uk
Finance Transformation Finance and Accounting
Mark Rhys Fiona Walker
Partner Partner
020 7303 2914
020 7303 7620
mrhys@deloitte.co.ukfiwalker@deloitte.co.uk
Chris Mather Ben Jackson
Senior Manager
Director
020 7303 8856
020 7303 7398
cmather@deloitte.co.ukbenjackson@deloitte.co.uk
Regions
Steve Williams
Partner
0113 292 1231
stephenwilliams@deloitte.co.uk
Michael Goddard
Senior Manager
0121 695 5119
migoddard@deloitte.co.uk
Loan forbearance No such thing as a free lunch 11
Notes
12
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