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 [email protected]@deloitte.co.uk Michael Coogan Sarah Wines Strategic advisor Manager 020 7303 3317 020 7303 6381 [email protected]@deloitte.co.uk Credit risk modeling Tim Thompson Partner 020 7007 7241 [email protected] Tom Clifford Senior Manager 020 7303 6378 [email protected] Oliver Sharp Manager 020 7007 3258 [email protected] Finance Transformation Finance and Accounting Mark Rhys Fiona Walker Partner Partner 020 7303 2914 020 7303 7620 [email protected]@deloitte.co.uk Chris Mather Ben Jackson Senior Manager Director 020 7303 8856 020 7303 7398 [email protected]@deloitte.co.uk Regions Steve Williams Partner 0113 292 1231 [email protected] Michael Goddard Senior Manager 0121 695 5119 [email protected] Loan forbearance No such thing as a free lunch 11 Notes 12 Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited (“DTTL”), a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.co.uk/about for a detailed description of the legal structure of DTTL and its member firms. Deloitte LLP is the United Kingdom member firm of DTTL. This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. Deloitte LLP would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. Deloitte LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. © 2012 Deloitte LLP. All rights reserved. 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