ESG in the banking industry - Ep2 (Part 2)

Transcript

Kyla: Welcome back Dipthi where we will be continuing with ESG impacts in the banking industry. In the previous podcast, you touched on the accounting considerations for the lenders, however I am really curious about the borrowers. Would you mind taking our listeners through that lens as well?

Dipthi: There are a few considerations to keep in mind from the borrower’s perspective. Firstly, whether the green variability features give rise to an embedded derivative, secondly if it does give rise to an embedded derivative, should that derivative be accounted for separately from the loan? And thirdly, how is this green variability remeasured if there are any changes in circumstances?

Kyla: Let’s perhaps dig into each consideration separately. Where does one start with the assessment, Dipthi?

Dipthi: Let’s start with the first consideration which is whether the green variability meets the definition of an embedded derivative. There are 3 criteria which need to be met in order for the definition of a derivative to be met:

• The first criteria is that the instruments value changes in response to the change in a specified variable or the ‘underlying’.
• Secondly, it requires no initial net investment or a minimal net investment; and
• Lastly, it is settled at a future date.

For green variability to meet the definition of a derivative, the value of the green variability feature must fluctuate in response to either a financial variable, or a non-financial underlying variable that is not specific to a party to the contract.

Kyla: What does one need to consider to determine whether this first criterion is met?

Dipthi: Well, the type of the sustainability-linked measure is important. If the sustainability-linked measure is based on a factor specific to either the borrower or the lender, no embedded derivative would exist. 

However, where the sustainability-linked measure is a variable that is not specific to the borrower or the lender, given it will be settled at a future date, the feature could meet the definition of a derivative. For example - green measures such as indexation to the trading prices of carbon emissions credits are unlikely to be specific to a borrower or lender.

Kyla: So to summarise when thinking about derivatives, the key consideration is around whether the ESG measure is specific or non-specific to the borrower or lender?

That is very useful to keep in the back of one’s mind. I am sure you are going to guess my next question, would you mind illustrating this concept of specific vs non-specific in an example?

Dipthi: Of course, Kyla. Let’s say a loan is issued and the sustainability-linked measure is based on the borrower’s specific CO2 emissions. 

Let me test your knowledge, in this scenario, would there be an embedded derivative?

Kyla: My answer is no, there is not an embedded derivative.

Dipthi: And why is that?

Kyla: Well, like you stated earlier, if the sustainability-linked measure is specific to either the borrower or lender - in this case to the borrower, there is no embedded derivative.

Dipthi: That is 100% correct, Kyla.

Kyla: Thanks Dipthi, assuming that there is an embedded derivative, what are the next steps?

Dipthi: The second assessment is whether this embedded derivative should be accounted for separately or not.

Where the sustainability-linked feature meets the definition of a derivative, one will need to consider whether it is closely related. Where the measure is not specific to the borrower or the lender, the economic characteristics and risks of the sustainability-linked feature would often not be closely related to the economic characteristics and risks of the host contract being the loan contract. In this case, the sustainability-linked feature would be separately accounted for if all other conditions are met.

Kyla: Interesting, that makes sense. However, how does this impact the initial measurement?

Dipthi: Well, there are two ways that the assessment can go.

If it is assessed that there is no embedded derivative or a closely related embedded derivative then there is no need to separate the embedded derivative. However the green feature is still going to cause variability in the cash flows and therefore that variability will be accounted for differently depending on whether it's commensurate with credit risk or not. Where it is commensurate with credit risk then there is limited variability in the income statement because the interest rate is just updated every time the feature changes. 

Where it is not commensurate with credit risk there is volatility in the income statement because the interest rate remains unchanged so the catch up adjustment required is recognised in P/L.

If on the other hand there is an embedded derivative that is required to be separated then the borrower can choose to separate the embedded derivative and measure at FVTPL and then account for the loan itself at amortised cost or alternatively designate the entire loan at FVTPL.

Kyla: Thanks Dipthi, the more I think about this, I realize that the SPPI and embedded derivative considerations are not the only places where judgement is involved.

Dipthi: Yes, that is correct, Kyla. Other areas for banks in particular which also require key judgements would be the expected credit losses on loans and receivables and fair value considerations.

Kyla: What should listeners be on the lookout for with regards to expected credit losses?

Dipthi: The impact of climate change on expected credit losses is relevant as it may also affect a lender’s exposure to credit losses for its financial assets. 

There are a couple of areas for consideration as it relates to ECL. 

Firstly, the assumptions to estimate ECL:  IFRS 9 requires an entity to measure ECL in a way that reflects an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes using multiple scenarios. In doing this assessment reasonable and supportable information that are specific to the borrower must be used and an assessment of both the current as well as forward looking information must be used.  

The probability-weighted scenarios should be assessed to determine whether climate related changes need to be factored in and this could potentially result in revisions to factor in specific climate-related outcomes, for example -  the impact of drought or flooding on loans provided to entities in the agricultural sector might have been factored in previously to some extent, however there might be a need to increase the extent and likelihood of the impact of flooding going forward because history might not be representative of climate changes in future. 

Another example in our local market would be the impact on inputs and assumptions used in the ECL calculation for loans where there is a move from coal to renewable energy. The challenge here is whether the information is reasonable and supportable and will surely be a significant judgment area. It's also important to remember that even though it might be difficult to estimate the impacts of climate change on ECL does not mean it's not considered.

Kyla: Another area I can think of being impacted would also be the risk rating and probability of default on these instruments?

Dipthi: That is correct, Kyla. Climate change could also affect the risk ratings for individual borrowers or groups of borrowers, or their probability of default. The challenge here is that even though an industry might be impacted by a climate related change it might not be possible at this stage to link a climate risk with a specific loan exposure.

In this case post model adjustments also known as overlays might need to be incorporated to take climate related risks into account. For example the Bank might assess that there is a higher risk for customers operating in the oil and gas and mining sectors but cannot link this to a specific customer yet. Consequently, the bank should consider whether it is necessary to increase the ECL provision associated with receivables in those sectors by way of a post model adjustment to capture the increased risk 

Furthermore ECL might need to be done at a more granular level than before if the current aggregation is not representative of the climate related changes that the  loan book is exposed to.

Kyla: Dipthi, would you also be of the view that the staging of the loans are also impacted?

Dithi: Yes, that is important too. Determining whether credit risk has increased significantly since initial recognition is a critical step in estimating expected credit losses because ECL is determined based on a lifetime probability of default if it is assessed that there is a significant increase in credit risk. Such a determination requires lenders to consider a range of factors to determine whether credit risk has increased significantly. For example, if a bank’s loan portfolio has significant exposure to fossil-fuel-intensive projects, it would identify the extent of this exposure and how climate-related risks could affect the staging of the loans for purposes of determining ECL which would impact the ECL recognised in its financial statements.

Borrowers could face a range of physical, regulatory and reputational risks that ultimately impact their credit risk, and increase the likelihood that they may be unable to meet their debt obligations. Banks generally use a 12 month PD to assess if there has been a SICR.

Kyla: Earlier on, you mentioned that climate risk is more judgmental given its longer term impact - therefore Banks should carefully consider whether using a 12 month PD is appropriate when assessing if credit risk has increased significantly because the 12 month PD might not capture the impacts of climate change. 

From what you’ve mentioned, I gather that there is no ‘one size fits all’ - different portfolios will have different risk exposures depending on industry, geography, etc.

Dipthi: Certainly Kyla! Banks should also consider other arrangements like insurance, guarantees, government subsidies (or other payments and policies) including how they’re structured and how their providers are thinking about (and responding to) evolving ESG risks and last but not least the disclosure of the estimates and assumptions and how these were derived.

Kyla: Thanks Dipthi, I am sure the listeners gained a lot of food for thought on these points (laughs). Lastly and very importantly - Disclosure. Are there any important financial instrument disclosures that our listeners should be aware of?

Dipthi: Yes, I believe this is a very important aspect.

IFRS 7 requires disclosure of information about the nature and extent of risks and how the company is managing those risks. 

Banks may have to change the way they are approaching their credit risk concentration disclosures to take into account climate risk. For example, more precision in geographic concentration may be necessary to reflect heightened risk in particular areas, (for example customers in particular regions) or more precision in the industry sector (for example a more precise disaggregation of exposure to the industrial products sector based on carbon intensity).    

Kyla: Now that you are mentioning fair values, would there be any important disclosures for the fair value measurement of assets and liabilities as it is impacted by ESG?

Banks will also need to consider disclosures about market risk. In some cases, sensitivity of investments and loans to CO2 emissions and other ESG metrics may be relevant. 

Liquidity risk may also be a consideration. As an entity’s climate risk exposures become more significant, there may be growing pressure on an entity’s debt covenants. In this context, disclosures about key covenants may become increasingly material. Banks may need to factor in the impact of climate change on their customer’s ability to settle payments.

And lastly but very importantly not forgetting IAS 1. Disclosure of assumptions that have a significant risk on material adjustments to the carrying amounts of assets and liabilities within the next financial year are also required together with the sensitivity disclosures for fair value inputs and ECL inputs & assumptions.

Diphi: The key consideration about the fair value measurement is that users should ensure that double counting is avoided.

Kyla: What do you mean by that?

Dipthi: Well, IFRS 13 fair value considerations are based on market participants' views and assumptions. A market participant view may already include assumptions about climate-related risk which may already be factored into the bank’s model.

Kyla: This has been a very interesting and useful session, and I’m sure it's given our listeners a lot to think about and consider. Do you have any closing thoughts for today’s podcast?

Dipthi: Indeed, Kyla. The IASB is currently seeking input on whether the guidance in IFRS 9 is sufficient to enable entities to determine whether financial assets with sustainability linked features have SPPI cash flows. They are also seeking input on whether the application of the contractual cash flow characteristics assessment to those financial assets results in those assets being measured using an approach that provides users of financial statements with useful information about the amount, timing and uncertainty of future cash flows. 

Please also be on the lookout for any future developments with regards to these topical matters that are on the IASB’s agenda for the post implementation review of classification and measurement in IFRS 9 as it relates to cash flows linked to ESG targets.

Kyla: Thank you for joining us today Dipthi and providing insightful food for thought as it relates to ESG in the banking industry.

To our listeners, please join us in our next Engaging ESG podcast where we will be discussing ESG related matters in the mining industry.

Dipthi: Thank you Kyla.

Kyla: "This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors."