November 2020

SGV thought leadership on pressing issues faced by chief executives in today’s economic landscape. Articles are published every Monday in the Economy section of the BusinessWorld newspaper.
30 November 2020 Evert De Bock

How CFOs can transform Finance in the Age of Disruption

Even before COVID-19, finance leaders across a range of sectors were already in the process of evaluating their operating models in response to a broad and well-documented set of drivers and challenges. These include delivering value, managing costs, making efficient use of technology and automation, and complying with new regulations. The arrival of the pandemic, however, has accelerated the need to transform the finance function to meet current and upcoming disruptions. With most employees working from home, businesses were forced to run operations remotely, and had to swiftly deal with unexpected challenges. Pressing issues such as client payment delays became especially problematic due to cash flow drying up and supply chains coming under pressure. It is not anymore a question of whether organizations should adopt new and emerging technologies, but a matter of how and when. With the exponential acceleration of digital adoption, finance organizations are no longer simply seeking an increase in efficiency and productivity. They are now looking for ways to adapt to shifting marketplace pressures as well as to expand and compete in new markets. The question on the minds of executives now is how quickly these technologies can be adopted so that their organizations do not lose their competitive advantage. THE ROLE OF CFOS IN TRANSFORMATION With the pandemic dictating the new normal and pushing organizations to reconsider their business continuity, chief financial officers (CFOs) play a significant role in supporting business during these uncertain times. Finance leaders must aid the business while keeping finance operations running, supporting the workforce, planning for possible scenarios, and managing cash and liquidity while focusing on stability and revival. The finance function is gaining further importance while changing and expanding in scope. Historic reporting activity will continue to be vital but take less time, thanks to improved efficiency brought about by end-to-end reporting systems, consistent data and automation. Capacity will be available for more future-focused insights and analysis to support business units and decisions that drive increased stakeholder value. On the other hand, the need to satisfy regulatory information demands will continue and regulators may ask for more and possibly even real-time data, requiring finance teams to shape up their finance and business processes and leverage more advanced technology as an enabler. The reality of unrelenting disruptive change brought about by the pandemic has placed CFOs at the forefront, balancing competing demands and driving future growth. CFOs who will build long-term value will have to cultivate a transformational mindset — one that starts from the future and defines where an organization wants to be, working its way back to where the organization is today. This is indicative of how transformation is designed and brought to life, guided by three key transformation drivers — technology at speed, humans at center, and innovating at scale. TECHNOLOGY AT SPEED According to an EY and Forbes Insights survey covering 564 executives in large global enterprises, 57% of CFOs believe that it will be critical for the finance function to deliver data and advanced analytics for business intelligence and management. Despite this, many organizations still struggle to apply the promise of data analytics into improved performance. Moreover, most admit they still do not have an effective strategy in place to compete in a digital world and struggle with getting business users to adopt analytics insights. Two-thirds of adoption leaders, comprising the top 10% of all enterprises, rate this change management as a vital component of their data and analytics objectives; yet only one-third of the broader cross-section of respondents see it this way. As a role that spans across organizational silos, the CFO can extend the use of analytics from the traditional finance functions of budgeting and forecasting to the operational needs of the wider business. CFOs need to be the champions and drivers for the use of analytics in all current core financial processes under their responsibility, as financial data is one of the key inputs to many business decisions — whether in supply chain, procurement, operations or risk management. By viewing data from the perspective of a data and money-conscious CFO, organizations will be able to act on the opportunities and insights that analytics can reveal as they occur before it’s too late. Without necessarily owning the area of analytics application, CFOs can act as a catalyst to help encourage and drive the use of analytics in business processes outside core finance. HUMANS AT CENTER Harnessing new and emerging technologies allows companies to more readily respond to or even anticipate changing customer behaviors and expectations. According to a recent EY study, Digital Deal Economy, 90% of companies are prioritizing an increase in capital allocation toward digital transformation, with a majority of global finance leaders saying artificial intelligence will be vital to the finance function of the future, while other finance leaders see blockchain as the most important technology in the function. However, the pandemic has revealed that people aren’t merely anonymous elements of the many layers in an organization — they embody the organization and are its most critical asset. While it is undoubtedly a massive global crisis, the pandemic also serves as a live demonstration of how human resourcefulness, ingenuity, and diversity of experience can combine with the technology of today to create solutions and business models for the future, changing industries overnight and solving issues at scale. The skills and expertise required from teams will change in a remodeled finance function. CFOs will need to build a finance function consisting of the right people with the right skills to complement and get the most of new technologies, playing an important role in the overall people strategy of the organization. Qualified accountants will still be needed within the central core to implement and understand the implications of evolving accounting standards and other legal and regulatory requirements, but alongside them will be a new breed of data scientists and business analysts. These individuals will understand how to use data, the IT systems that generate it and the questions that business units will want help in answering. It will be a complex blend of skills gained partly through education, training and certainly, through frontline experience across the organization. Success will depend on combining the intelligence of smart technologies with the emotional intelligence and interpersonal skills of talented people. Companies that leverage technology and enable innovation at scale while placing humans at the center will be capable of accelerating long-term value. INNOVATION AT SCALE Though the world continues to evolve at an increasingly fast pace, many organizational structures and operating models remain unchanged. Digital initiatives are too often conducted within outdated frameworks — and superimposing 21st century technologies over 20th century structures and processes will likely result in suboptimal results, or even failure. In addition, the resulting economic fallout from the impact of COVID-19 will likely worsen before it can improve, with possible recovery only seen well into 2022. CFOs will be expected to save costs wherever possible and as soon as possible, with significant economic disruption in the interim, all while balancing financial resilience and business continuity. The finance function will need to become more agile in order to drive innovation with as little resistance as possible and be in a better position to create long-term value. It, like the rest of the organization, needs to become flatter, leaner, more fluid and globally integrated to become truly transformative. REFRAMING FINANCE FOR THE FUTURE The CFO will be one of the C-Suite’s most critical roles in reframing the future of the organization beyond the pandemic, according to the 2020 EY DNA of the CFO survey, with more than 800 senior finance executives and global CFOs as respondents. How organizations create value in this increasingly hyperconnected world will shift from within company walls to out into network space. The finance function needs to become more open and work as part of an extended ecosystem, collaborating deeper within as well as beyond the organization. This poses the opportunity for CFOs not just to adapt to the new normal, but to reframe finance for this new reality. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co. Evert De Bock is a Consulting Principal from SGV & Co.

Read More
26 November 2020 Warren R. Bituin

Cybersecurity during the pandemic Part 2

(Second of two parts) In last week’s article, we highlighted the challenges of cybersecurity in terms of remote working, identity and access management risk, physical security and data privacy. In this second part, we will focus on cybersecurity management and discuss additional challenges that require recalibrating traditional security for the remote workspace; potential analyst disruption; the pandemic’s impact on cybersecurity budgets; and reassessing the cybersecurity function as we adjust to the new normal of business. Global and larger Philippine companies, in general, have been able to ride out the storm more comfortably than smaller companies. While recent news of a vaccine is a welcome development, many organizations still expect the current working protocols to continue at least until the end of 2021. For the chief technology officers (CTOs) and chief information security officers (CISOs), this means that budgets will be affected as the full risk impact is assessed. Companies will continue to engage in projects designed for effective remote working and are expected to invest more on network upgrades, mobile devices, cloud applications and infrastructure. Budgets around these areas can therefore be reasonably expected to increase. How the pandemic affected cybersecurity management varies according to organizations’ size, geography, and industry. Small- and medium-sized companies noticed the impact the most, with higher network and staff disruptions, as well as a disproportionally higher number of cyber threats such as phishing, malware, ransomware and zero-day exploits. Large companies have faced remote-working challenges but, perhaps unsurprisingly, have been more resilient to cyber threats. RECALIBRATING TRADITIONAL SECURITY The cybersecurity team needs to adapt quickly to the dynamically changing threat landscape. It needs to be more proactive in identifying new threats and detecting attackers. The traditional security solutions, such as firewalls, threat monitoring software, vulnerability management tools and identity solutions may need to be recalibrated to address the new working setup in the enterprise. An EY research study conducted during the pandemic confirms that the COVID-19 crisis has caused significant disruption in day-to-day security operations, particularly with enabling remote working. It is a mixed picture, but the research shows that what most leaders seem to agree on is that day-to-day security operations have been disrupted, almost a third (29%) saying significantly so. Remote-working support was the biggest challenge (71%), followed by budget restrictions (41%), network overload (40%) and reduced staffing levels (37%). Indeed, during the total lockdown when physical movements of employees (including cybersecurity professionals) were very limited, providing 24/7 operational support from remote locations remains a formidable challenge for many CISOs. For example, additional privileged workstations were configured and deployed for a more secure remote connection by system and security administrators. Physical security of the work areas of these privileged users were also required and at times supported by companies. ANALYST DISRUPTION Many CISOs also learned to be prepared for any disruptions in the security operations caused by the unavailability of a security analyst becoming unavailable either due to home network or health issues. It becomes a real concern for CISOs when one or two analysts contract the virus and become indisposed for a long period. A viable plan to address reduced staffing levels should be ready and implemented immediately as required. Considering that incidents of phishing and other threats like malware and ransomware are on the rise, CISOs should increase focus on the people side of cybersecurity. A well-designed security awareness campaign that includes webinars, periodic advisories, as well as directed phishing tests should be continuously implemented to address this risk. CYBERSECURITY BUDGET IMPACT Disruption is definitely happening, and with respect to budgets, change is expected to happen fast. In the same EY research study, 79% of respondents expect cybersecurity budgets to be impacted within the next six months if not sooner (21% believe “immediately”), though not all think budgets will be cut. As many as a third (32%) think that investment will increase or at the worst, stay the same (24%). Identity and access management and data protection and privacy are considered priority areas for an increase in spending. Additionally, outsourcing is being considered, notably for data protection, privacy, risk, compliance and resilience. A majority of businesses surveyed in the EY research study are considering (or would consider) outsourcing security operations as part of their cybersecurity strategy. The findings tend to be consistent across geographies, sectors and roles, although there is a bias within smaller companies to prioritize security operations as well as architecture and engineering. Interestingly, there is a marked difference between CISOs and CTOs in their attitude toward outsourcing security operations: 44% versus 81%. REASSESSING THE CYBERSECURITY FUNCTION Following the COVID-19 pandemic, should we expect any more longer-lasting or even permanent changes in cybersecurity strategy and approach? Certainly, some security leaders expect their function to become even more important and visible at the board/executive level. Some Philippine companies are starting to step back and reassess their cybersecurity posture as they become accustomed to the new normal of business operations. With the introduction of surveillance mechanisms (such as mobile apps) to track and manage the virus vis-à-vis the ongoing DoLE and DoH requirements to collect health details of employees and customers, data privacy will further increase in value and importance. In a related survey by PSB Research of 1,000 US consumers (April 2020), the findings suggest that consumers are especially reluctant to surrender their personal privacy, regardless of the challenges posed by the pandemic, and similarly are not convinced that any such engagement will be for their own good. While the survey was done in the US, similar public sentiments may emerge here judging from recent advisories and activities by the National Privacy Commission on the use COVID-19-related personal data. As we emerge slowly into a post-crisis world and a new normal, it will be interesting to see if the cybersecurity teams’ predictions of an elevated status will come true and are to be embedded beyond the short term. While this is yet to be seen, it is evident that there has never been a better time for CTOs and CISOs to demonstrate their mettle and validate their deserved place in the C-Suite. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views reflected in this article are the views of the author and do not necessarily reflect the views of SGV, the global EY organization or its member firms. Warren R. Bituin is the Technology Consulting Leader of SGV & Co.

Read More
16 November 2020 Maria Vivian C. Ruiz

How boards can set the course for a stronger future

As society continues to evolve towards a post-pandemic world and the economy adjusts to the new normal, organizations are presented with the opportunity to set the tone for how they adapt their operations and positively impact society. The current situation allows boards an expanded role in steering their organizations along this journey. EY’s Global Board Risk Survey reveals that only 43% of board members in the Asia-Pacific considered their organization as “more than somewhat effective” in managing emerging risks, compared to 58% for traditional risks. Based on the survey, there are three pressing issues that boards should prioritize, reflecting the unique blend of challenges and opportunities in these uncertain times. These involve building trust in the face of digital disruption; managing capital allocation through business transformation scenarios; and addressing enterprise risk resulting from climate change. BALANCING DIGITAL TRANSFORMATION, RISK AND TRUST Organizations have been forced to rely almost completely on digital infrastructure to communicate, function, and be competitive. Looking ahead after the crisis passes, companies will need to consider becoming fully and truly digital. As digital adoption deepens, more businesses are investigating new ways to embed emerging technologies across their ecosystem while navigating increasing vulnerability to cyber-attacks. Boards will need to regularly discuss data and digital issues such as data privacy, ethical and disinformation risk, and cybersecurity in board meetings. There is a need to ensure that they have the expertise to oversee these risks by way of a standalone sub-committee or subject matter experts. The stakes are especially high because should systems fail, customers, regulators and shareholders will hold executives and boards accountable for the resulting reputational and financial costs. Furthermore, boards are expected to support their executives in building digital trust across emerging technologies such as intelligent automation, blockchain and artificial intelligence. Boards must understand what these emerging technologies mean for their organizations, what risks they bring, and the role of their Audit Committees in managing those risks. PLANNING FOR MORE VARIED BUSINESS TRANSFORMATION SCENARIOS When the EY Global Capital Confidence Barometer (CCB) was published in March, 55% of organizations in the Asia-Pacific were expecting a U-shaped recovery extending well into 2021. This resulted in organizations exercising more caution by renegotiating contracts, revisiting financial plans, and monitoring how direct cost increases affect their margins. However, many also planned to take advantage of a rise in distressed assets coming to market and lower valuations to either build resilience or support their digital transformation agenda. In addition, the CCB found that 52% of respondents from the Asia-Pacific expressed the intention to pursue mergers and acquisitions (M&A) within the next 12 months. These reactions establish the necessity within organizations to balance the need to be cautious against seizing opportunities for sustainable growth through targeted acquisitions. Boards can reinforce this by influencing management to protect the organization’s assets while also taking calculated risks that offer the best chances of seizing a competitive advantage. Divestments are another attractive option to fund much-needed investment in technology, as presented in a recent EY divestment study, in which 56% of Asia-Pacific companies responded that they are more likely to divest for this purpose compared to the 31% that articulated the same intention before the pandemic. Boards need to discuss strategy on an ongoing basis as well as utilize scenario planning for a much wider range of possibilities. Employing this tool ensures that the models created remain relevant and updated, consequently placing the organization in a better position to quickly predict and adapt to a post-crisis future. Boards must also plan for different economic outcomes and scenarios within a range of time frames. It is also vital to determine if they have a framework in place to assess their performance and progress. They need to question how frequently they oversee and challenge how their organizations allocate resources and capital, making sure they protect their assets, optimize operations and consider long-term growth strategies. DRIVING TO COMBAT CLIMATE CHANGE In the 2019 EY CEO Imperative survey, 40% of CEOs in the Asia-Pacific cited climate change as a top global challenge, while investors globally ranked climate change as the joint priority issue along with national or corporate security. However, what is more significant than the ranking itself is the investors’ expectation that CEOs respond to this appropriately. According to the 2020 EY Global Institutional Investor survey, investors are more rigorously evaluating environmental, social and governance (ESG) disclosures while factoring in disclosures made as part of the Task Force on Climate-related Financial Disclosures (TCFD) framework. The COVID-19 crisis spurred this on by exposing unsustainable business practices. The pandemic revealed that climate action is vital to becoming a responsible, resilient organization that prioritizes long-term impact over short-term gain. Many of our ASEAN neighbors and Japan and South Korea have announced plans to stimulate low-carbon industries in their respective nations through their economic recovery. Board members are in a prime position to advocate for their organizations to reduce their carbon footprint. This can be achieved by encouraging management to analyze the risks and opportunities resulting from climate change and transition to a decarbonized future. Boards can help management identify effective, non-financial KPIs that quantify progress when setting and acting upon climate targets. It will be imperative to understand the role the organization plays in transitioning to a green recovery, as well as to more comprehensively communicate these through TCFD reporting. In addition, boards need to assess if they themselves have the skills, structures and processes to guide management teams in addressing climate change. The sooner management understands climate risks and opportunities, the better the organization can take actionable steps to transform the business to suit a low-carbon economy and create a competitive advantage. CHARTING A COURSE FOR THE FUTURE Decisions that leaders make are crucial as they set the course for the future. Such decisions give organizations the ability to adapt to that envisioned future through a well-crafted plan. Focusing on these priorities allows business leaders to navigate around uncertainty and to harness business transformation opportunities that will lead their organizations to a path of stronger resilience and greater competitive advantage. At this time of great uncertainty, the moment is for boards to seize. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views reflected in this article are the views of the author and do not necessarily reflect the views of SGV, the global EY organization or its member firms. Maria Vivian C. Ruiz is the Vice Chair and Deputy Managing Partner of SGV & Co.

Read More
09 November 2020 Jose Rey R. Manuel

What is double nontaxation of income?

Tax law, as a rule, is constantly evolving and adapting, which is why tax authorities all over the world frequently issue new or enhanced rulings, policies and procedures to address new trends or situations that come up. It is, however, unusual to encounter new terms or definitions in new issuances. Take, for example, the seldom used phrase “double nontaxation of income,” which was found in Revenue Memorandum Order (RMO) No. 51-2019. The RMO was issued by the Bureau of Internal Revenue (BIR) when it laid down its guidelines and procedures for the processing and issuance of Tax Residency Certificates (TRCs) requested by those claiming to be “residents” of the Philippines. In theory, “nontaxation” occurs when income is left untaxed by a taxing jurisdiction. When this happens, say in the case of an individual receiving compensation from an international assignment — the impact would usually be, at the very least, on two taxing jurisdictions — the home and host countries. Put simply, these are contracting parties or states which are not able to impose tax on income earned by the individual, hence the term “double nontaxation.” While the chances of this happening are remote, considering the strict implementation of tax rules on cross-border transactions, such an occurrence could be the worst thing to happen in the eyes of a taxing authority. However, RMO 51-19 seems to address this as it endeavors to ensure that no income payment is left untaxed because of actions resorted to by taxpayers (individuals or corporations alike), who seek to obtain unintended tax treaty benefits by securing a TRC. WHAT IS A TAX RESIDENCE CERTIFICATE? This is a document secured by Philippine “residents” from the BIR to avail of preferential tax treatment, under the applicable and effective tax treaties of the Philippines, on income derived from sources within the jurisdiction of the Other Contracting State (i.e., non-Philippine state). For instance, in the past, foreign nationals would present the TRC issued by the BIR to their countries’ internal revenue authorities to claim non-resident status so that they can enjoy exemption from their home countries’ tax. In the Philippines, a TRC is a certificate issued by the International Tax Affairs office of the BIR to confirm the residency status in the Philippines of taxpayer applicants. These applicants claim to be “residents” of the Philippines and are subject to taxation in the Philippines for a given period of time. Documents are required for substantiation purposes before the application for TRC is processed and issued upon approval. WHAT IS THE MAIN PURPOSE OF TAX TREATIES? Tax treaties exist to avoid the effects and risks of double taxation with respect to taxes on income derived from sources outside of the Contracting State or the Philippines (in the case of taxpayers of the Philippines). In addition, they help ensure that exorbitant taxation in the source country is not a hindrance to cross-border investments, capital and trading activities. The taxing right is then allocated between the two states to make sure that income is taxed appropriately. At present, the Philippines is signatory to about 43 tax treaties worldwide. For a tax treaty exemption to be invoked, taxpayers must prove their residency in the Philippines. This is done through the application of a TRC by “residents.” Who are considered “residents?” WHO IS ENTITLED TO SECURE A TRC FROM THE BIR? In order to avoid double nontaxation of income, the tax bureau made it clear that only “residents” of a Contracting State who are subject to comprehensive liability to tax or full tax liability are entitled to TRCs. The BIR added that only those who are subject to tax on the basis of their worldwide income are entitled to claim treaty benefits. For individual taxation purposes, these taxpayers are categorized as “Resident Citizens.” It should be noted, however, that we do not have a definition of the term Resident Citizen in our Tax Code. What we have in Section 22E of the Code is an enumeration of those who are considered Non-Resident Citizens (NRCs) and who are taxed on their Philippine-source income only. These are Philippine citizens who: Establish to the satisfaction of the Commissioner the fact of his physical presence abroad with a definite intention to reside therein. Leave the Philippines during the taxable year to reside abroad, either as an immigrant or for employment on a permanent basis. Work and derive income from abroad and whose employment thereat requires him to be physically present abroad most of the time during the taxable year. A Philippine citizen who has been previously considered a non-resident citizen and who arrives in the Philippines at any time during the taxable year to reside permanently in the Philippines shall likewise be treated as a non-resident citizen for the taxable year in which he arrives in the Philippines, with respect to his income derived from sources abroad until the date of his arrival in the Philippines. Accordingly, those who do not fall under the definition of NRCs above may generally be considered Resident Citizens (RCs) who are subject to tax on their worldwide income. These RCs may apply for Tax Residency Certificates. For the purposes of this article, whether they are entitled to the treaty preferential tax rates or exemption later is a topic for another time. WHERE DOES THE CONFUSION LIE? For proper application of TRC, there is a need to distinguish individuals, particularly foreign nationals, who are residents for treaty purposes and residents for domestic tax purposes. This is because they may also be treated as “residents” for domestic tax rules or for income tax purposes but cannot apply for a TRC simply because they are not taxed on their worldwide income. Note that there are various categories of foreign national taxpayers in the Philippines. Foreign nationals (aka Aliens) are classified as either Resident or Non-Resident. We are guided by BIR Rulings 051-81 and 052-81 which mention that a foreign national assigned in the Philippines for a period of approximately two years is considered a non-resident alien engaged in trade or business (NRAETB) in the country. Since there is no specific tax rule that states who would be considered as a Resident Alien in the Philippines, residents are instead considered to be those whose length of assignment are, from the start, indefinite or exceed two years. However, although they are considered residents, they are taxed only on income from sources within the Philippines. In terms of who can properly secure a TRC, while it is true that foreign nationals are considered residents for income tax purposes or per domestic tax rules, they are not considered residents for treaty benefits purposes as they are taxed only on income from Philippine sources and therefore, cannot possess a tax residency certificate from the Philippine tax bureau. Doing so can possibly make them not taxable on income derived from their home country, which is not treated as subject to Philippine income tax either. If this is the case, this would mean double nontaxation of income. ENSURING COMPLIANCE DESPITE THE PANDEMIC Despite COVID-19, with foreign nationals in effect being stranded, residency in the country for the purpose of treaty exemption cannot be invoked by foreign nationals even though they have acquired resident alien status in the Philippines for domestic income tax purposes. Though foreign nationals may be forced to overstay due to the pandemic and have the assumption that the Tax Residency Certificate provides relief as regards taxation in their respective home countries, this will not work. There might not even be any residency status to begin with in this case as the tax bureau separately tackled this in its Revenue Memorandum Circular 83-2020, which provides guidance to individuals who are stranded in a country that is not their country of residence due to travel restrictions related to the pandemic. With foreign nationals unable to return home and a large number of OFWs returning home for good due to various COVID-related reasons, companies and taxpayers may wish to review these guidelines to ensure compliance and avoid potential tax issues. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co. Jose Rey R. Manuel is a Tax Senior Director from the People Advisory Services team of SGV & Co.

Read More
03 November 2020 Redgienald G. Radam

PFRS 9 expected credit losses: How can banks apply pre-pandemic models?

The pandemic has created disruptions affecting industries at a global scale. As an offshoot, we have seen unprecedented levels of government relief measures to help curb the pandemic’s economic impact. The pandemic and the subsequent government actions to aid borrowers on their loan payments, have, in turn, affected how banks apply their Expected Credit Loss (ECL) models under PFRS 9 Financial Instruments, which had been developed prior to the pandemic. The economic disturbances have led to liquidity issues for many entities and individuals, putting into question the credit quality of the financial assets or receivables currently held by banks. Yet events continue to unfold, which means that we have not seen the full extent of COVID-19 impact. This makes the measurement of ECL more challenging as PFRS 9 requires that the calculated ECL capture expectations of future economic conditions that will affect borrowers’ ability to pay. Under PFRS 9, ECL is a probability-weighted amount determined by a range of possible outcomes (scenarios) and requires the incorporation of reasonable and supportable information about past events, current conditions and forecasts of future economic conditions (i.e., forward-looking information) that are available at the reporting date. Relating these to the current crisis, banks should be making assumptions in their ECL calculation about the extent of the pandemic’s impact on the collectability of financial assets. As such, it is clear that banks will need to update the ECL models or assumptions previously applied to their reporting as of Dec. 31, 2019 reporting because those would not have foreseen the economic impact of the pandemic. INSIGHTS IN RELATION TO ECL MODELS Based on the EY survey results on COVID-19 benchmarking undertaken in March 2020 across selected global banks, we share some insights on how the impact of the COVID-19 pandemic was considered in the surveyed banks’ ECL models. While there are variations in the approach to quantify the impact of COVID-19, a majority used portfolio level overlays. This involves incorporating the effect of the pandemic to the forward-looking adjustment to be applied to a group of borrowers with similar credit risk characteristics. A majority of the banks surveyed also defined specific COVID-19 scenarios for their ECL models. Many have revised the probability weightings applied to the economic scenarios used in the ECL measurement. Some banks have captured staging movements (i.e., assessment of significant increase in credit risk) through management overlays while others are taking a “top down” approach by migrating part or all of the most impacted portfolios from Stage 1 (requiring 12-month ECL) to Stage 2 (requiring Lifetime ECL). Banks are also evaluating enhancements to credit risk monitoring measures (e.g., forbearance, watchlist, etc.) in response to recent regulatory requests for these data. For the surveyed banks, these approaches may just be short-term solutions for their interim financial reporting. Locally, we note that some banks have also applied the same or similar approaches for their own interim financials. Cognizant that the massive and lingering effects of the pandemic will continue to impact the measurement of ECL moving forward, it is imperative that banks develop a comprehensive response to the additional complexities to proactively prepare for year-end reporting and beyond. The approach to this response must be agile considering the time left from now until the year-end. It is vital for banks to have risk modelling capabilities to address the limitations of the short-term solutions adopted in the interim while understanding the impact of the model changes under different assumptions in the long term. URGENT PRIORITIES WHEN UPDATING ECL MODELS As banks prepare for the year-end and beyond, they will need to consider some urgent priorities in the immediate term when updating their ECL models, including: Incorporating the impact of government relief measures into the ECL calculation The impact of the relief measures imposed by the government, such as payment holidays or moratoriums, must be assessed to determine how they affect the measurement of ECL. The assessment should consider whether these measures address short-term liquidity issues rather than signal a significant increase in the credit risk of borrowers. Determining reasonable and supportable macro-economic scenarios These should include the integration of possible pandemic or crisis scenarios (including government relief measures over time) not envisioned previously and how these could have altered the other economic scenarios and their related probability weightings in the ECL measurement. In coming up with the scenarios, banks should also consider the expected duration of the pandemic and the recovery period of the economy. Due care must be exercised so that there is no double counting of the impact of the assumptions on the scenarios and on the other inputs to the ECL measurement. Consideration of management overlays As there is no consensus on how to forecast future conditions, banks may have to rely on overlays and on their own expert judgment. They will also need to determine the reasonableness of these overlays. Maintaining strong governance over the ECL process The operational impact of the changes to the ECL models on data, systems and controls must be considered. Increased governance around the significant judgments (including overlays) and assumptions, modelling changes and other changes to the PFRS 9 processes and controls must be in place to ensure the reasonableness of the ECL measurement. Also, they will need to consider the disruptions in operational processes within the bank that may lead to other constraints in running the calculation of ECL. Disclosures Given the high level of uncertainty and the inherent sensitivity of estimates, it is critical for banks to be transparent in the disclosures of the key assumptions used and judgments made to update the ECL models. However, as banks work on addressing the urgent priorities above, they must also look at long-term considerations in order to have more robust PFRS 9 ECL models. In addition to being able to model and simulate possible pandemic or crisis-specific data (e.g., default and recovery data) once historical data regarding the pandemic becomes more available, they should also consider approaches to credit management. There must be stronger integration between credit risk management (risk appetite framework, credit approvals, limits, etc.) and the PFRS 9 ECL triggers given current challenges and learnings. The current credit risk assessment process should also be strengthened by incorporating robust sensitivity analysis and stress testing in light of the use of significant judgments and management overlays in the ECL measurement. OPPORTUNITY IN RESILIENCE While current conditions are indeed unprecedented, banks should see this not just as a challenge in measuring ECL, but as a unique opportunity to advance their credit risk modelling capabilities. Doing so may help them become more resilient and even gain a competitive advantage in these unpredictable and uncertain times. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co. Redgienald G. Radam is a Partner from the Financial Services Organization service line of SGV & Co.

Read More
Leading the way in business

Other SGV News and Publications