Note 17: Allowance for expected credit losses continued
Adjustments to loss given defaults: £(52) million (2023: £(64) million)
A number of adjustments have been made to the loss given default (LGD) assumptions used within unsecured credit models. The adjustments
reflect the impact of changes in collection debt sale strategy on the Group’s LGD models, incorporating up to date customer performance and
forward flow debt sale pricing.
Following a review of the loss given default approach for commercial exposures, management continues to judge that ECL should be adjusted
to mitigate limitations identified in the approach which are causing loss given defaults to be inflated. These include the benefit from
amortisation of exposures relative to collateral values at default and a move to an exposure-weighted approach being adopted.
These temporary adjustments will be addressed through future model development.
Corporate insolvency rates: £(35) million (2023: £(47) million)
The volume of UK corporate insolvencies continues to exhibit an elevated trend beyond December 2019 levels, revealing a marked
misalignment between observed UK corporate insolvencies and the Group’s equivalent credit performance. This dislocation gives rise to
uncertainty over the drivers of the observed trends in the metric and the appropriateness of the Group’s Commercial Banking model response
which uses observed UK corporate insolvencies data to anchor future loss estimates to. Given the Group’s asset quality remains strong with low
defaults, a negative adjustment is applied by reverting judgementally to the long-term average of the insolvency rate.
Generation of multiple economic scenarios
The estimate of expected credit losses is required to be based on an unbiased expectation of future economic scenarios. The approach used to
generate the range of future economic scenarios depends on the methodology and judgements adopted. The Group’s approach is to start from
a defined base case scenario, used for planning purposes, and to generate alternative economic scenarios around this base case. The base case
scenario is a conditional forecast underpinned by a number of conditioning assumptions that reflect the Group’s best view of key future
developments. If circumstances appear likely to materially deviate from the conditioning assumptions, then the base case scenario is updated.
The base case scenario is central to a range of future economic scenarios generated by simulation of an economic model, for which the same
conditioning assumptions apply as in the base case scenario. These scenarios are ranked by using estimated relationships with industry-wide
historical loss data. With the base case already pre-defined, three other scenarios are identified as averages of constituent scenarios located
around the 15th, 75th and 95th percentiles of the distribution. The full distribution is therefore summarised by a practical number of scenarios
to run through ECL models representing an upside, the base case, and a downside scenario weighted at 30 per cent each, together with a
severe downside scenario weighted at 10 per cent. The scenario weights represent the distribution of economic scenarios and not subjective
views on likelihood. The inclusion of a severe downside scenario with a smaller weighting ensures that the non-linearity of losses in the tail of
the distribution is adequately captured. Macroeconomic projections may employ reversionary techniques to adjust the paths of economic
drivers towards long-run equilibria after a reasonable forecast horizon. The Group does not use such techniques to force the MES scenarios to
revert to the base case planning view. Utilising such techniques would be expected to be immaterial for expected credit losses since loss
sensitivity is minimal after the initial five years of the projections.
A forum under the chairmanship of the Chief Economist meets at least quarterly to review and, if appropriate, recommend changes to the
method by which economic scenarios are generated, for approval by the Chief Financial Officer and Chief Risk Officer. The Group continues to
judge it appropriate to include a non-modelled severe downside scenario for Group ECL calculations. The scenario is generated as a simple
average of a fully modelled severe scenario, better representing shocks to demand, and a scenario with higher paths for UK Bank Rate and CPI
inflation, as a representation of shocks to supply. The combined ‘adjusted’ scenario used in ECL modelling is considered to better reflect the
risks around the Group’s base case view in an economic environment where demand and supply shocks are more balanced.
Base case and MES economic assumptions
The Group’s base case economic scenario has been updated to reflect ongoing geopolitical developments and changes in domestic economic
policy. The Group’s updated base case scenario has three conditioning assumptions. First, cross-border conflicts do not lead to major
disruptions in commodity prices or global trade. Second, the US pursues a more isolationist economic agenda, with policies including trade
tariffs; immigration cuts; and unfunded tax cuts. China, EU and UK are assumed to retaliate to US tariffs imposed on them. Third, UK Budget
public investment plans are assumed to have a small but positive impact on trend productivity growth, subject to further review as more
specific policy detail emerges.
Based on these assumptions and incorporating the economic data published in the fourth quarter, the Group’s base case scenario is for a slow
expansion in GDP and a rise in the unemployment rate alongside modest changes in residential and commercial property prices. Against a
backdrop of some persistence in inflationary pressures, UK Bank Rate is expected to be lowered gradually during 2025. Risks around this base
case economic view lie in both directions and are largely captured by the generation of alternative economic scenarios.
The Group has accommodated the latest available information at the reporting date in defining its base case scenario and generating
alternative economic scenarios. The scenarios include forecasts for key variables in the fourth quarter of 2024, for which actuals may have
since emerged prior to publication.
Scenarios by year
The key UK economic assumptions made by the Group are shown in the following tables across a number of measures explained below.
Annual assumptions
Gross domestic product (GDP) growth and Consumer Price Index (CPI) inflation are presented as an annual change, house price growth and
commercial real estate price growth are presented as the growth in the respective indices over each year. Unemployment rate and UK Bank
Rate are averages over the year.
Five-year average
The five-year average reflects the average annual growth rate, or level, over the five-year period. It includes movements within the current
reporting year, such that the position as at 31 December 2024 covers the five years 2024 to 2028. The inclusion of the reporting year within the
five-year period reflects the need to predict variables which remain unpublished at the reporting date and recognises that credit models utilise
both level and annual changes. The use of calendar years maintains a comparability between the annual assumptions presented.
Five-year start to peak and trough
The peak or trough for any metric may occur intra year and therefore not be identifiable from the annual assumptions, so they are also
disclosed. For GDP, house price growth and commercial real estate price growth, the peak, or trough, reflects the highest, or lowest cumulative
quarterly position reached relative to the start of the five-year period, which as at 31 December 2024 is 1 January 2024. Given these metrics
may exhibit increases followed by greater falls, the start to trough movements quoted may be smaller than the equivalent ‘peak to trough’
movement (and vice versa for start to peak). Unemployment, UK Bank Rate and CPI inflation reflect the highest, or lowest, quarterly level
reached in the five-year period.
