Bank of England warns lenders over loan loss estimates

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The Bank of England has warned lenders that the models they use to predict loan losses carry “high risks” and criticized them for failing to fully appreciate the impact of high inflation and interest rates on borrowers.

UK banks have posted relatively low loan loss charges this year despite soaring interest rates exacerbating a cost-of-living crisis that has left households owing around £22bn in basic bills.

But Vicky Saporta, the Bank of England’s head of prudential supervision, said in a letter to the chief financial officers of nine major banks on Friday that model risks were “elevated” and that some calculations were “not calibrated to reflect inflation.” and the impact of rising interest rates on borrowers’ ‘ability to repay’.

Loan loss charges are based on “Expected” losses Since 2018, banks have implemented accounting changes that force them to set aside funds for possible defaults rather than for defaults that have already occurred.

Loss forecasting models approved and monitored by banking regulators should take into account economic conditions and the bank’s experience during past recessions.

Saporta recommended that lenders adjust the model’s output to capture additional economic risks. She added: “We believe it is critical that companies question the completeness of model adjustments to ensure provision coverage reflects actual expectations of credit losses.”

The BoE also said it wanted banks to “question whether models are capturing affordability-related risks”, including the impact of rising prices and higher interest rates on vulnerable borrowers.

After raising interest rates in the past two years, the Bank of England kept interest rates at 5.25% this month to curb rising prices. Data from the Office for National Statistics showed that UK inflation was 6.7% in August.

Saporta highlighted particular concerns about banks’ assumptions about how much money can be recovered from bad loans, often through the sale of underlying assets.

Lenders are also being forced to examine the riskiest areas of their business. “We encourage all businesses to consider additional, more severe but reasonable economic scenarios, including shocks affecting industries or areas most vulnerable to rising inflation and interest rates,” Saporta wrote.

Real default rates remain low in 2023, but the Bank of England’s financial stability experts have repeatedly warned that households and businesses face “vulnerabilities” as debt continues to rise.

The Bank of England also reviewed the bank’s progress in assessing climate risks in 2022. While there has been improvement, significant obstacles remain, including identifying which loans are most at risk, the report found.

“Data availability and quality remain common challenges,” Saporta added, noting that methods for assessing climate data are “fragmented” and that there is a need to centralize data collection.