COVID-19: IFRS 9, capital requirements and loan covenants

The Prudential Regulation Authority (PRA) recently circulated a letter to the CEOs of all UK banks regarding the range of regulatory and supervisory measures it's taking to alleviate the financial stability impact of COVID-19.

The letter covers three key areas:

• guidance on reporting under IFRS 9 (which relates to the recognition of financial assets and liabilities) in the context of expected losses as a result of defaults
• treatment of borrowers who breach covenants due to COVID-19, and
• regulatory capital treatment of IFRS 9.

The overwhelming theme of the letter is that the PRA is advising calm and pragmatism regarding recognising and acting on defaults. It stresses the importance of recognising the extensive financial support being made available by the Government, and the likelihood that the current downtown is temporary and is likely to rebound sharply once social distancing measures are relaxed.

Where management of covenant defaults is concerned, the PRA is keen to emphasise that a distinction should be drawn between "normal" covenant breaches and those which are purely the result of prevailing economic challenges. In this vein, it specifically cites temporary changes in EBITDA, suspension of business, material adverse event clauses, modification of the audit report and delays in providing audited or unaudited financial statements, covenant compliance certificates, and third-party valuations as being types of defaults which lenders should not rush to act on.

Lenders are "urged to carefully consider their responses to potential breaches of covenants arising directly from the COVID-19 pandemic and its consequences". The letter even goes so far as to suggest that lenders should consider waiving covenant breaches arising from the current macroeconomic challenges, and should act in good faith not to impose new charges or restrictions following such covenant breaches.

This is the strongest signal yet that the regulators will frown on lenders seeking to improve their own position as a result of the current circumstances, and should provide borrowers some comfort that lenders are being strongly encouraged to take a pragmatic view of waiver requests.

Our team will continue to monitor the situation and will update our clients on any new developments that arise on these and other schemes in the coming weeks.