Nationwide Building Society Report on Transition to IFRS 9

Transcription

1 Report on Transition to IFRS 9: Financial Instruments As at 5 April

2 Contents Page Summary 3 Introduction 6 Balance sheet and reserves adjustments 8 Loans and advances to customers and provisions reconciliations 10 Expected credit loss approach 11 Regulatory capital 16 Revised accounting policies 17 Glossary 20 Contacts 20 Forward looking statements Certain statements in this document are forward looking with respect to plans, goals and expectations relating to the future financial position, business performance and results of Nationwide. Although Nationwide believes that the expectations reflected in these forward-looking statements are reasonable, Nationwide can give no assurance that these expectations will prove to be an accurate reflection of actual results. By their nature, all forward looking statements involve risk and uncertainty because they relate to future events and circumstances that are beyond the control of Nationwide including, amongst other things, UK domestic and global economic and business conditions, market related risks such as fluctuation in interest rates and exchange rates, inflation/deflation, the impact of competition, changes in customer preferences, risks concerning borrower credit quality, delays in implementing proposals, the timing, impact and other uncertainties of future acquisitions or other combinations within relevant industries, the policies and actions of regulatory authorities, the impact of tax or other legislation and other regulations in the jurisdictions in which Nationwide operates. As a result, Nationwide s actual future financial condition, business performance and results may differ materially from the plans, goals and expectations expressed or implied in these forward-looking statements. Due to such risks and uncertainties Nationwide cautions readers not to place undue reliance on such forward-looking statements. Nationwide undertakes no obligation to update any forward-looking statements whether as a result of new information, future events or otherwise. This document does not constitute or form part of an offer of securities for sale in the United States. Securities may not be offered or sold in the United States absent registration or an exemption from registration. Any public offering to be made in the United States will be made by means of prospectus that may be obtained from Nationwide and will contain detailed information about Nationwide and management as well as financial statements. Basis of preparation This document has been prepared on the basis of International Financial Reporting Standards, incorporating IFRS 9 and its consequential amendments to other standards including IFRS 7, as endorsed by the EU and including transitional arrangements for regulatory capital as appropriate. All other accounting policies are unchanged from those published in the Annual Report and Accounts Comparative information for the accounting periods prior to adoption will not be restated, as permitted by IFRS 9. This document is unaudited. Terminology used in this report is consistent with that used in the Annual Report and Accounts Copies of the Annual Report and Accounts 2018 are available on the Group s website at nationwide.co.uk. A full glossary can also be found on the Group s website. 2

3 Summary Impact of IFRS 9 The day one impact of IFRS 9 is limited, leading to a reduction in members interests and equity of approximately 1.3%, primarily due to increased impairment provisions. The impact on the main capital ratios is not significant. These impacts are based on assumptions and judgements at 5 April 2018 which are subject to change. IFRS 9 provisions may be more volatile compared to IAS 39 due to the forward-looking nature of expected credit loss (ECL) provisions. Movement from IAS 39 to IFRS 9 impairment provisions The chart above shows the components of the overall increase of impairment provision from IAS 39 to IFRS 9. The key differences between IAS 39 and IFRS 9 impairment provisions are summarised as follows: 1) Previously under IAS 39, provision was held in relation to up to date loans where a loss event had occurred but had not yet been identified through evidence of arrears ( 110 million). 2) By contrast under IFRS 9, a provision is calculated for all loans. The value of a 12 month ECL for all up to date loans is 83m. 3) The IFRS 9 approach increases ECL provisions from a 12 month ECL to a lifetime ECL when there is evidence of a significant increase in credit risk since origination, or when the loan is impaired. This is one of the main drivers of the increase in provisions from IAS 39 to IFRS 9, particularly for loans which are not yet impaired. The impact of this is 89 million, of which the increase for loans impaired under IAS 39 is 15m. 4) The impact of including an allowance for multiple economic scenarios (MES) is the other significant driver of the increase in impairment provisions under IFRS 9. The effect of this factor is 110 million. 3

4 Summary continued Analysis of loans and advances including stage distribution The calculation of ECL uses a three stage approach (stage 1 for performing assets, stage 2 for assets with a significant increase in credit risk since origination and stage 3 for assets which are credit impaired). Staging is explained in more detail in the expected credit loss approach section of this report. The following table summarises the impact of the initial adoption of IFRS 9 expected credit losses on loans and advances to customers which are carried at amortised cost on the balance sheet. The tables show the stage allocation of loans at 5 April 2018, the IFRS 9 impairment provisions and the resulting provision coverage ratios. The provision coverage ratio is calculated by dividing the ECL provision by the gross loans for each main lending portfolio. These indicators will be included in our interim results for the period ending 30 September 2018 and in the Annual Report and Accounts For investment securities that are subject to ECLs, the expected credit losses are below 1m and therefore immaterial for the purposes of this report. Analysis of loans and advances at amortised cost Stage 1 Stage 2 Of which <30 DPD (Note 3) Of which >30DPD Stage 3 Stage 3 POCI (Note 4) m m m m m m m Gross Loans (Note 1) Residential mortgages (Note 2) 156,647 19,072 18, , ,114 Consumer banking 3, ,107 Commercial and other lending 9, ,611 Total at 5 April ,120 20,012 19, , ,832 Provisions ECL Residential mortgages Consumer banking Commercial and other lending Total at 5 April Provision coverage ECL as a % of gross loans Residential mortgages Consumer banking Commercial and other lending Notes: 1 A reconciliation between this table and the IFRS 9 balance sheet is presented on page 10 of this report. 2 Nationwide s residential mortgages include both prime and specialist loans. Prime residential mortgages are mainly Nationwide branded advances. Specialist lending includes buy to let mortgages originated under the Mortgage Works (UK) plc (TMW) brand. 3 Days past due, a measure of arrears status. 4 Purchased or originated credit impaired (POCI) loans. The gross balance for POCI is net of the lifetime ECL at transition. Of the 20,012 million stage 2 loans that have experienced a significant increase in credit risk, 481 million are loans where this is due to arrears of 30 days past due or more, whilst 19,531 million is due to non-arrears factors. Consumer banking stage 3 gross loans and ECL include charged off balances. These are in relation to accounts which are closed to future transactions and are held on the balance sheet for an extended period (up to 36 months) whilst recovery procedures take place. The total consumer banking provision coverage ratio excluding both the charged off balance and the related ECL ( 185 million and 175 million respectively) is 4.84%. The stage 3 POCI loans were recognised on the Group s balance sheet when the Derbyshire Building Society was acquired in December These mainly interest only residential loans were 90 days or more in arrears when they were acquired by the Group and so have been classified as credit impaired on acquisition. A lifetime ECL provision of 7 million has been deducted from the gross carrying amount as a transitional adjustment. Any subsequent changes (favourable or unfavourable) in lifetime ECL will be recognised in the income statement from 5 April Total 4

5 Summary continued Potential volatility of ECL provisions Despite the fact that actual cash flows and losses realised on loans are unaffected by the adoption of IFRS 9, ECL provisions are expected to be higher, and potentially more volatile, than IAS 39 incurred loss provisions. This is due to the change to an expected credit loss basis for calculating provisions. In the future, if expectations of economic conditions or observed loss rates deteriorate, the level of ECL provisions will be expected to increase as models and assumptions are revised. Conversely when economic forecasts become more optimistic, provisions are expected to reduce. In addition, volatility could occur when significant numbers of loans move between stages, particularly from stage 1 to stage 2, changing the basis of provisioning from 12 month to lifetime ECL. Overall the degree of volatility from these factors is uncertain and is likely to fluctuate with changing circumstances, particularly macroeconomic conditions and outlook. 5

6 Introduction With effect from 5 April 2018 Nationwide Building Society and its subsidiaries (the Group) has adopted IFRS 9: Financial Instruments to replace IAS 39 Financial Instruments: Recognition and Measurement. IFRS 9 includes requirements for the classification and measurement of financial instruments, impairment of financial assets and hedge accounting. The Group s first results prepared under IFRS 9 will be published in the Interim Management Statement for the quarter ending 30 June The Group s first full year set of financial statements prepared under IFRS 9 will be published in the Annual Report and Accounts for the year ending 4 April This document summarises the financial impact of IFRS 9 at adoption on 5 April Additional information is included to allow readers to understand the approach taken to calculating expected credit losses under IFRS 9, including the key concepts and judgements made. The principal requirements of IFRS 9 are as follows: Classification and measurement The classification of financial assets is based on the objectives of the Group s business model and the contractual cash flow characteristics of the financial instruments. Financial assets are classified as held at amortised cost, at fair value through other comprehensive income (FVOCI), or at fair value through profit or loss (FVTPL). The impact of changes from the accounting treatment under IAS 39 for Nationwide is limited. Assets with contractual cash flow characteristics that have resulted in a reclassification from amortised cost to FVTPL include some closed book equity release and shared ownership retail loans, and a small number of commercial loans. The only changes to the classification and measurement of financial liabilities are where liabilities are elected to be measured at fair value on the balance sheet on adoption; the Group has not made any such election. The review of the contractual terms of financial assets has resulted in asset values reducing by 36 million as a result of certain loans being reclassified from amortised cost to FVTPL. Most of this reduction in value relates to the removal of fair value hedge accounting adjustments for equity release loans. Impairment of financial assets IFRS 9 changes the basis of recognition of impairment on financial assets from an incurred loss to an expected credit loss (ECL) basis for amortised cost and FVOCI financial assets. IFRS 9 introduces a number of new concepts and changes to the approach to provisioning compared with the previous methodology under IAS 39: Expected credit losses are based on an assessment of the probability of default, exposure at default and loss given default, discounted to give a net present value. The estimation of ECL is unbiased and probability weighted, taking into account all reasonable and supportable information, including forward looking economic assumptions and a range of possible outcomes. IFRS 9 has the effect of bringing forward recognition of impairment losses relative to IAS 39 which requires provisions to be recognised only when there is objective evidence of credit impairment. On initial recognition, and for financial assets where there has not been a significant increase in credit risk since the date of advance, IFRS 9 provisions are recognised for expected credit default events within the next 12 months. A key feature of IFRS 9 compared with the previous approaches under IAS 39 is that where a loan has experienced a significant increase in credit risk since initial recognition, even though this may not lead to the conclusion that the loan is credit impaired, provisions are made based on expected credit losses over the full life of the loan. For assets where there is evidence of credit impairment, provisions are made for lifetime expected credit losses under IFRS 9. Interest will be recognised net of impairment provisions. All IFRS 9 ECL provisions take account of forward looking economic assumptions and a range of possible outcomes. Under IAS 39, provisions were based on the asset s carrying value and the present value of the estimated future cash flows. IAS 39 did not explicitly take account of a range of possible economic outcomes including forecasts of any downturn in the economic cycle. Further details of our approach are contained in the expected credit loss approach section of this report. 6

7 Introduction continued Hedge accounting The hedge accounting requirements of IFRS 9 are designed to create a stronger link with financial risk management. The International Accounting Standards Board (IASB) is currently exploring an accounting model for dynamic risk management accounting (macro hedge accounting). The Group currently takes the option permitted by IFRS 9 to continue to apply the hedge accounting requirements of IAS 39. The Group will however implement the revised hedge accounting disclosure requirements included in the related amendments to IFRS 7 Financial Instruments: Disclosure. Implementation strategy The Group established an IFRS 9 implementation programme in 2014 with formal governance reporting to the Chief Financial Officer and Chief Risk Officer. Progress was reported regularly to the Audit Committee during the life of the programme. This included formal oversight of the new IFRS 9 ECL calculations and economic assumptions ahead of the adoption of IFRS 9. The Group s implementation strategy for IFRS 9 has been based on an integrated solution using common systems, tools and data to assess credit risk and account for ECL. This is consistent with guidance issued by the Basel Committee on Banking Supervision (BCBS), and has entailed changes to the governance, controls, models and business processes relating to credit loss provisioning. The IFRS 9 implementation programme was completed in advance of adoption on 5 April 2018, allowing a period of refinement of the new IFRS 9 systems, models and processes during the 2017/18 financial year. Governance IFRS 9 impairment provisions are subject to review and oversight through Nationwide s existing risk governance frameworks. This includes controls over the data, models and financial controls used in the IFRS 9 processes. In addition, monthly forums comprising members of the Risk and Finance communities review model outputs, challenging the assumptions used and approving changes to the operation of ECL models. They consider whether modelled outputs adequately reflect credit risk, and regularly review any adjustments required to modelled provisions. A new forum has been created to review and approve the forward-looking economic scenarios used as part of the ECL calculation. Provisions are ultimately approved by the CFO and regularly reviewed by the Group s Audit Committee. 7

8 Balance sheet and reserves adjustments The Group s balance sheet has been adjusted as follows with the adoption of IFRS 9 as at 5 April 2018: Adjusted Group balance sheet IAS 39 category IFRS 9 category As at 4 April 2018 Classification Measurement Impairment IFRS 9 carrying value at 5 April 2018 Notes m m m m m m m Assets Cash Amortised cost Amortised cost 14, ,361 Loans and advances to banks Amortised cost Amortised cost 3, ,422 Investment securities 1 AFS FVOCI 11,926 (45) ,881 Investment securities 1 AFS FVTPL Investment securities Amortised cost Amortised cost 1, ,120 Derivative financial instruments FVTPL FVTPL 4, ,121 Fair value adjustment for portfolio hedged risk 2 FVTPL FVTPL (109) - (35) - (144) Loans and advances to customers 3,4,5 Amortised cost Amortised cost 191,664 (246) (2) (171) 191,245 Loans and advances to customers 6 Amortised cost FVTPL Assets not impacted by changes arising from - - IFRS 9 2, ,495 Deferred tax Total assets 229,098 - (28) (133) 228,937 Liabilities Liabilities not impacted by changes arising from IFRS , ,422 Provisions for liabilities and charges Total liabilities 216, ,696 Members interests and equity Capital and reserves not impacted by changes arising from IFRS , ,377 General reserve , (28) (134) 9,802 Fair value through other comprehensive income reserve (13) Total members interests and equity 12,403 - (28) (134) 12,241 Total members interests, equity and liabilities 229,098 - (28) (133) 228,937 8

9 Balance sheet and reserves adjustments continued Notes: 1. Includes a debt security that has been transferred from available for sale investment securities to FVTPL due to its contractual cash flow characteristics. 2. This reduction in fair value for portfolio hedged risk relates to removal of fair value hedge accounting adjustments for loans that have been reclassified from amortised cost to FVTPL, and which therefore no longer qualify for hedge accounting. 3. The reduction of amortised cost loans and advances to customers under IAS 39 relates to loans reclassified under IFRS 9 as FVTPL due to their contractual cash flow characteristics million is the net impact of the transitional lifetime ECL adjustment on the balance sheet carrying value of POCI loans, and the adjustment to credit impaired loans to restore the carrying value to the contractual amount owed. 5. The reduction of the amortised cost loans and advances to customers due to impairment ( 171m) is the difference between IFRS 9 ECL impairment and the IAS 39 incurred loss provisions. 6. Carrying values of FVTPL loans and advances to customers increased by 1m on transition to IFRS The valuation of the deferred tax assets recognised on adoption of IFRS 9 reflects HMRC s legislation that the tax effect of the impact on adoption of IFRS 9 should be realised over the ten years following adoption. Deferred tax is determined using tax rates and laws that are expected to apply in the period when the deferred tax asset is realised based on rates enacted or substantively enacted at the balance sheet date, including the banking surcharge when applicable. 8. An additional 1 million has been provided separately within provisions for liabilities and charges. This relates to provisions against separately identifiable irrevocable commitments for the pipeline of personal loans, commercial loans and mortgages. Overdrafts and credit card commitments are provided for within the ECL provision models, with allowance for future drawdowns made as part of the exposure at default (EAD) element of the ECL calculation for each account. 9. The transfer from fair value through other comprehensive income reserve to general reserve relates to the accumulated available for sale reserve in respect of financial instruments that have been reclassified from AFS to FVTPL. 9

10 Loans and advances to customers and provisions reconciliations Reconciliation of loans and advances to customers The following table shows the constituents of the loans and advances to customers total in the balance sheet after the transition to IFRS 9 on 5 April 2018: Reconciliation of loans and advances to customers Amortised cost Gross loans ECL Other (Note 1) Balance sheet amortised cost loans Balance sheet FVTPL Loans m m m m m m Residential mortgages 177,114 (235) - 176, ,068 Consumer banking 4,107 (365) - 3,742-3,742 Commercial and other lending 9,611 (29) 1,042 10, ,682 Total 190,832 (629) 1, , ,492 Note: 1. Amortised cost loans and advances to customers include the fair value adjustment for micro hedged risk (for commercial loans hedged on an individual basis). Total Reconciliation of impairment provisions The table below reconciles the closing IAS 39 impairment provision balance to the opening IFRS 9 ECL provision on the adoption of IFRS 9 on 5 April 2018: Reconciliation of impairment provisions within staging bands 12 month ECL Lifetime ECL not credit impaired Lifetime ECL credit impaired Total ECL Less IAS 39 provisions Increase in provision on adoption of IFRS 9 m m m m m m Residential mortgages (145) 90 Consumer banking (298) 67 Commercial and other lending (15) 14 Total (458)

11 Expected credit loss approach Measuring credit losses Expected Credit Loss (ECL) is calculated using the following formula: These terms are defined as follows: Term Probability of default ( PD ) Exposure at default ( EAD ) Loss given default ( LGD ) Probability of default ( PD ) x Exposure at default ( EAD ) x Loss given default ( LGD ) Definition The probability of a default event occurring, based on conditions existing at the reporting date and future economic conditions that affect credit risk. Probability of default has been determined based upon unlikeliness to pay indicators, plus backstop criteria based upon a measure of days past due. The lifetime PD forms part of the IFRS 9 stage assessment as well as the ECL calculation. The expected outstanding balance of the asset at default, considering the repayment of principal and interest from the reporting date to the date of default, together with any expected drawdown of committed facilities. The proportion of the exposure that is expected to be lost in the event of default, taking account of the impact of collateral and its expected value at the point of realisation, as well as recoveries and other means of loss mitigation. Models have been developed for all portfolios for the IFRS 9 ECL calculation. The overall modelling approach is aligned to the IRB (internal ratings-based) regulatory capital models, amended to reflect differences in modelling requirements. For example, for residential mortgage portfolios the IFRS 9 definition of default is based on arrears of 90 days past due, rather than 180 days past due in the IRB models. To calculate the lifetime ECL for a loan, separate 12 month ECL calculations are performed for each year of the loan s expected life. The outputs of these calculations for each year are then combined and discounted at the effective interest rate. The PD, EAD and LGD inputs for the 12 month ECL calculations incorporate management s expectations of future performance, including forward looking economic assumptions. To reflect the uncertainty inherent in economic forecasting, multiple ECL calculations are performed using different sets of assumptions (scenarios) that are considered possible. The provisions reported at 5 April 2018 incorporate the results of scenarios which have been weighted according to management s assessment of their likelihood. Modelled ECL provisions may be adjusted by management if it is considered that they do not adequately reflect known credit risks, for example, risks where there is insufficient historic loss data on which to develop models. Any such post model adjustments (PMAs) are subject to thorough internal review before being applied. 11

12 Expected credit loss approach continued Significant judgements and estimates To ensure that ECL provisions fulfil IFRS 9 requirements, judgement and estimation is required in a number of areas. The areas where the impact of judgement and estimation are most material are: the approach to applying the staging requirements the basis of forward looking information and multiple economic scenarios. the proportion of interest only mortgages that will redeem or refinance at maturity the period of exposure to credit risk for revolving loans. Our approach to each of these judgements is described in more detail below. Staging requirements The calculation of an asset s ECL will depend on the changes in its credit risk since it was originally recognised. The impact of changes in credit risk on the calculation of ECLs is achieved using a three stage approach: an asset that is not credit impaired on initial recognition is classified in stage 1, with a loss allowance equal to 12 month ECL, when a loan s credit risk increases significantly, it will be moved to stage 2. The loss allowance recognised will be equal to the loan s lifetime ECL, and if a loan meets the definition of credit impaired, it will be moved to stage 3 with a loss allowance equal to its lifetime ECL. A loan may remain in stage 1 for its entire life if there is no significant change in credit risk. Identifying significant increases in credit risk (stage 2) The identification of significant increases of credit risk is the most judgemental element of the staging criteria. Management regularly monitors Nationwide s loans to determine whether there have been changes in credit risk. This is assessed using quantitative and qualitative indicators which vary depending on the nature of the portfolio and the information available. The primary quantitative indicators are the outputs of internal credit risk assessments. For example, for retail exposures, PDs are derived using modelled scorecards, which use external information such as information from credit reference agencies as well as internal information such as known instances of arrears or other financial difficulty. While different approaches are used within each portfolio, the intention is to combine current and historical data relating to the exposure with forward-looking macroeconomic information to determine the likelihood of default. The credit risk of each loan is evaluated at each reporting date by calculating the residual lifetime PD of each loan. For retail loans, the main indicators for a significant increase in credit risk are either of the following: the residual lifetime probability of default (PD) exceeds a benchmark determined by reference to the maximum credit risk that would have been accepted at origination the residual lifetime PD has increased by at least 75bps and a multiple of the original lifetime PD (8x for mortgages, 4x for consumer banking). These complementary criteria have been reviewed through detailed back-testing, and found to be more effective in capturing events which would constitute a significant increase in credit risk (as determined by management performance indicators and actual default experience) than either criterion individually. For commercial loans, the main indicators for a significant increase in credit risk are either a significant change in the internal credit rating of a loan as judged by risk management personnel, or transfer of a loan to a watchlist. In addition, loans will automatically be moved to stage 2 when certain backstop events occur. This includes arrears of greater than 30 days past due and the granting of certain concession events such as forbearance, where full repayment of principal and interest is expected. Identifying credit impaired loans and the definition of default (stage 3) The identification of credit impaired loans and the definition of default is another important judgement within the IFRS 9 staging approach. A loan is credit impaired where it is considered unlikely that the borrower will repay its credit obligations in full, without recourse to actions such as realising security. Loans will be classified as credit impaired in any of the following circumstances: a contractual payment is 90 days past due instances of bankruptcy, possession, litigation or the death of borrower a concession is granted which is not expected to lead to full repayment of principal and interest (eg interest suppression for unsecured loans). 12

13 Expected credit loss approach continued Reduction in credit risk Loans in stage 2 or 3 can transfer back to stage 1 or 2 once the criteria for significant increase in credit risk or impairment are no longer met, for example if arrears are cleared and if probability of default also reduces below the relevant quantitative threshold. For loans subject to concession events such as forbearance, accounts must first be up to date for a period of 12 months before they can transfer back to stage 1 or 2. Use of forward looking economic information Forward looking economic information is incorporated into the measurement of provisions in two ways: as an input to the calculation of ECL and as a factor in determining the staging of an asset. Expectations of future economic conditions are incorporated through modelling of multiple economic scenarios (MES). The use of multiple economic scenarios ensures that the calculation of ECL captures a range of possible outcomes. It addresses the risk of non-linearity in the relationship between credit losses and economic conditions, with provisions increasing more in unfavourable conditions (particularly severe conditions) than they reduce in favourable conditions. The IFRS 9 ECL provision reported in the accounts is therefore the probability-weighted sum of the provisions calculated under a range of economic scenarios. For the retail and commercial portfolios, Nationwide has adopted the use of three economic scenarios (referred to as the central, upside and downside scenarios). The scenarios and the weightings are derived using external data and statistical methodologies, together with management judgement, to determine scenarios which span a wide range of plausible economic conditions. In addition to the modelled scenarios, allowance has been made at 5 April 2018 for the risks associated with a low probability but extremely severe economic downturn, since this is also a potentially material cause of non-linearity in credit loss outcomes. The central scenario represents the most likely economic forecast and is aligned with the central scenario used in Nationwide s financial planning processes. The upside and downside economic scenarios are less likely. The table below provides a summary of the average values of the key UK economic variables used within the central economic scenario over the period from April 2018 to March Central scenario economic variables Average (%) GDP 1.7 Unemployment 5.0 HPI 1.8 BoE Base Rate 0.9 The impact of the economic variables varies according to the portfolio. For example, mortgages are most sensitive to house prices and base rates, whereas consumer banking products are more sensitive to unemployment rates. Due to the adverse net impact of the less likely scenarios, the ECL increases under MES, as outlined in the table below: Impact of multiple economic scenarios Central scenario ECL m ECL incorporating MES m Difference m Residential mortgages Consumer banking Commercial and other lending Total The additional allowance for the credit risks associated with a low probability but extremely severe economic downturn represents 85 million of the impact of economic scenarios in the table above. 13

14 Expected credit loss approach continued Performance at maturity of interest only mortgages The third key area of management judgement and estimation is the allowance for the risk that a proportion of interest only mortgages will not be redeemed at the contractual maturity date, because a borrower does not have a means of capital repayment or has been unable to refinance the loan. Buy to let mortgages are typically advanced on an interest only basis. Nationwide does not offer any new advances for prime residential mortgages on an interest only basis, although there are historical balances which were originally advanced as interest only mortgages or where a change in terms to an interest only basis was agreed (this option was withdrawn in 2012). The impact of the adjustment in the central scenario amounts to 58 million, with an additional impact of 16 million arising from multiple economic scenarios (see above). Interest only loans which are judged to have a significantly increased risk of inability to refinance at maturity are transferred to stage 2. Expected lives The final key area of estimation in calculating the ECL is in determination of the expected lives of revolving credit loans. For products such as mortgages and personal loans, the period over which the Group is exposed to credit risk is the maximum contractual life. However, for revolving credit loans such as credit cards and overdrafts, the Group is exposed to credit risk, including drawn and undrawn facilities, beyond the typically short contractual notice period, so therefore the full expected behavioural life is taken into account. Behavioural lives are based on empirical experience of revolving credit portfolios and are in excess of 10 years. Other considerations in measuring changes in credit risk Purchased or originated credit impaired (POCI) loans POCI accounting is required for credit impaired loans purchased from third parties, or where the Group has derecognised an existing credit impaired loan and then immediately restructured by the recognition of a new loan, where the new loan is also credit impaired. The accounting treatment applied is to recognise a carrying amount at initial recognition net of the lifetime ECL at that date. Thereafter, any subsequent change (favourable or unfavourable) in the lifetime ECL is recognised in the income statement. POCI loans are separately disclosed as credit impaired loans and cannot be transferred out of the POCI designation, even if there is a significant improvement in credit quality. Modifications Nationwide may on occasion modify the contractual terms of loans provided to members and other customers. When this is solely for commercial reasons and considered part of the ordinary course of business, there is no impact on the impairment approach. However, modifications can also be indicative of, or precipitate, changes in credit risk. In some cases, the terms of a loan may be modified so significantly that it is substantially a different financial asset. Where this is the case, the original loan is derecognised and a new loan is recognised in its place. In most cases concerning residential mortgages, forbearance does not result in a recognition of a loss on a modified contract as the revised contractual terms will continue to be interest bearing and will recover interest in full. In certain forbearance cases within consumer banking some contractual interest may be suspended, however the impact is immaterial and no adjustment has been made on transition to IFRS 9. Write-off Loans remain on the balance sheet net of associated provisions until they are deemed no longer recoverable, when such loans are written off. Nationwide s definition, assumptions and timing for write-off of loans have not changed with the adoption of IFRS 9. 14

15 Expected credit loss approach continued Credit quality The table below shows the loan balances and ECL for amortised cost residential mortgages by PD band. The PD distributions shown are based on IFRS 9 12 month probability of default at the reporting date. Loan balance and ECL by PD band (Residential mortgages) Gross loans ECL ECL coverage PD range Stage 1 Stage 2 Stage 3 Total Stage 1 Stage 2 Stage 3 Total m m m m m m m m % 0.00 to <0.15% 147,728 10, , to < 0.25% 4,969 1, , to < 0.50% 2,317 1, , to < 0.75% 1,014 1, , to < 2.50% 619 1, , to < 10.00% - 1, , to < 100% , % (default) Total 156,647 19,072 1, , The ECL allocated to the lowest PD bands primarily reflects allocation of the provision for performance at maturity of interest only mortgages. Loan balance and ECL by PD band (Consumer banking) Gross loans ECL ECL coverage PD range Stage 1 Stage 2 Stage 3 Total Stage 1 Stage 2 Stage 3 Total m m m m m m m m % 0.00 to <0.15% , to < 0.25% to < 0.50% to < 0.75% to < 2.50% to < 10.00% to < 100% % (default) Total 3, , Consumer banking stage 3 gross loans and ECL include charged off balances. These are in relation to accounts which are closed to future transactions and are held on the balance sheet for an extended period (up to 36 months) whilst recovery procedures take place. 15

16 Regulatory capital Capital position and key ratios The impact of the increase in IFRS 9 impairment provisions on the Common Equity Tier 1 (CET1) ratio at 5 April 2018 is a reduction of 31 basis points. CET1 capital resources reduce by 67 million primarily due to increased impairment provisions and the impact of the classification and measurement requirements, which are partly offset by the current excess of regulatory expected losses over impairment provisions. With effect from 5 April 2018, Nationwide will apply transitional arrangements, as permitted by EU Regulation (2017/2395), which allows relief to capital ratios to reduce the impact of IFRS 9 ECLs. This is applied by adding back to CET1 capital resources, on a reducing basis over the next five years, the impact of IFRS 9 ECLs and then adjusting any related deferred tax assets and Tier 2 provisions. Following the application of these transitional arrangements, the reduction in the CET1 ratio is 10 basis points. The impact on the UK leverage ratio is minimal. The implementation of IFRS 9 does not therefore have a significant impact on Nationwide s capital position. Capital structure 4 April 2018 IFRS 9 Full impact IFRS 9 Transitional arrangements applied m m m Capital resources Common Equity Tier (CET1) Capital 9,925 9,858 9,915 Total Tier 1 capital 10,917 10,850 10,907 Total regulatory capital 13,936 13,935 13,930 Risk weighted assets (RWAs) 32,509 32,619 32,579 UK leverage exposure 221, , ,982 CRR leverage exposure 236, , ,458 CRD IV capital ratios % % % CET1 ratio UK leverage ratio CRR leverage ratio Total Tier 1 ratio Total regulatory capital ratio Capital planning The Group expects IFRS 9 ECL provisions to be more volatile and respond differently in terms of the business cycle (cyclicality and procyclicality) than IAS 39 provisions. This will impact CET1 capital planning and will be taken into account in the capital strategy. The impact of IFRS 9 has been included in the latest financial forecast and strategic plan that is approved by the Board. The Group does not expect the implementation of IFRS 9 to result in any significant changes to strategic plans or Nationwide s business model. Capital adequacy The management of Nationwide s capital position is built on the foundations of the internal capital adequacy assessment process (ICAAP) and stress testing framework. These ensure that the capital plan is sufficiently resilient to withstand the impact of severe financial stress. The ICAAP and 2018 stress testing exercises currently underway have incorporated IFRS 9 ECL impairment provisions to ensure that the impacts of IFRS 9 are taken into account. 16

17 Revised accounting policies The Group s full statement of accounting policies is disclosed within the 2018 Annual Report and Accounts. The policies for financial assets and impairment of financial assets have changed from 5 April 2018 following the adoption of IFRS 9, and the revised policies are set out below. Financial assets Financial assets comprise cash, loans and advances to banks, investment securities, derivative financial instruments and loans and advances to customers. Recognition and derecognition All financial assets are recognised initially at fair value. Purchases and sales of financial assets are accounted for at trade date. Financial assets acquired through a business combination or portfolio acquisition are recognised at fair value at the acquisition date. Financial assets are derecognised when the rights to receive cash flows have expired or where the assets have been transferred and substantially all the risks and rewards of ownership have been transferred. The fair value of a financial instrument on initial recognition is normally the transaction price (plus directly attributable transaction costs for financial assets which are not subsequently measured at fair value through profit or loss). On initial recognition, it is presumed that the transaction price is the fair value unless there is observable information available in an active market to the contrary. Any difference between the fair value at initial recognition and the transaction price is recognised immediately as a gain or loss in the income statement where the fair value is based on a quoted price in an active market or a valuation using only observable market data. In all other cases, any gain or loss is deferred and recognised over the life of the transaction, or until valuation inputs become observable. Modification of contractual terms An instrument that is renegotiated is derecognised if the existing agreement is cancelled and a new agreement is made on substantially different terms (e.g. renegotiations of commercial loans). Residential mortgages reaching the end of a fixed interest deal period are deemed repricing events, rather than a modification of contractual terms, as the change in interest rate at the end of the fixed rate period was envisaged in the original mortgage contract. Classification and measurement The classification and subsequent measurement of financial assets is based on an assessment of the Group s business models for managing the assets and their contractual cash flow characteristics. The Group has classified its financial assets into the following 3 categories: (a) Amortised cost Financial assets held to collect contractual cash flows and where contractual terms comprise solely payments of principal and interest (SPPI) are classified at amortised cost. This category of financial assets includes cash, loans and advances to banks, the majority of the Group s residential and commercial mortgage loans, all unsecured lending, and certain investment securities within a hold to collect business model. Financial assets within this category are recognised on either the receipt of cash or deposit of funds into one of the Group s bank accounts (for cash and loans and advances to banks), or when the funds are advanced to customers (for residential, commercial and unsecured lending). After initial recognition, the assets are measured at amortised cost using the effective interest rate method, less provisions for expected credit losses. (b) Fair value through other comprehensive income Financial assets held in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, and where contractual terms comprise solely payments of principal and interest are classified and measured at fair value through other comprehensive income (FVOCI). This category of financial assets includes most of the Group s investment securities which are held to manage liquidity requirements. Financial assets within this category are recognised on trade date. The assets are measured at fair value using, in the majority of cases, market prices or, where there is no active market, prices obtained from market participants. In sourcing valuations, the Group makes use of a consensus pricing service, in line with standard industry practice. In cases where market prices or prices from market participants are not available, discounted cash flow models are used. 17

18 Revised accounting policies continued Interest on FVOCI assets is recognised in the income statement using the effective interest rate method. Unrealised gains and losses arising from changes in value are recognised in other comprehensive income, except for foreign exchange gains or losses which are recognised in the income statement and expected credit losses which are recognised in the income statement and accumulated in the FVOCI reserve. Gains or losses arising on sale are recognised in the income statement, including the transfer of any cumulative gains or losses, and net of the cumulative expected credit loss charge already recognised. (c) Fair value through profit or loss All other financial assets are measured at fair value through profit or loss (FVTPL). Financial assets within this category include derivative instruments and a small number of residential and commercial loans and investment securities with contractual cash flow characteristics which do not meet the SPPI criteria. The contractual terms for these cash flows include contingent or leverage features, or returns based on movements in underlying collateral values such as house prices. Fair values are based on observable market data, valuations obtained by third parties or, where these are not available, internal models. All interest income and gains or losses arising from the changes in the fair value of these instruments and on disposal are recognised in the income statement. Financial assets which are classified as FVTPL are not eligible for hedge accounting. Impairment of financial assets Financial assets within the scope of IFRS 9 expected credit loss (ECL) requirements comprise all financial debt instruments measured at either amortised cost or FVOCI. These include cash, loans and advances to banks, and the majority of investment securities and loans and advances to customers. Also within scope are irrevocable undrawn commitments to lend and intra-group lending (the latter being eliminated on consolidation in the Group accounts). The ECL represents the present value of cash shortfalls following the default of a financial instrument or undrawn commitment. A cash shortfall is the difference between the cash flows that are due in accordance with the contractual terms of the instrument and the cash flows that the Group expects to receive. The allowance for ECLs is based on an assessment of the probability of default, exposure at default and loss given default, discounted at the effective interest rate to give a net present value. The estimation of ECLs is unbiased and probability weighted, taking into account all reasonable and supportable information, including forward looking economic assumptions and a range of possible outcomes. ECLs are typically calculated from initial recognition of the financial asset for the maximum contractual period that the Group is exposed to the credit risk. However, for revolving credit loans such as credit cards and overdrafts, the Group s credit risk is not limited to the contractual period and therefore the expected life of the loan and associated undrawn commitment is calculated based on the behavioural life of the loan. For financial assets recognised in the balance sheet, the allowance for ECLs is offset against gross carrying value so that the amount presented in the balance sheet is net of impairment provisions. For separable loan commitments where the related financial asset has not yet been advanced, the provision is presented in provisions for other liabilities and charges on the balance sheet. Forward looking economic inputs ECLs are calculated by reference to information on past events, current conditions and forecasts of future economic conditions. Multiple economic scenarios are incorporated into ECL calculation models. These scenarios are based on external sources where available and appropriate, and internally generated assumptions in all other cases. To capture any non-linear relationship between economic assumptions and credit losses, a minimum of three scenarios is used. This includes a central scenario which reflects the Group s view of the most likely future economic conditions, together with an upside and downside scenario representing alternative plausible views of economic conditions, weighted based on management s view of their probability. 18

19 Revised accounting policies continued Stage 1: 12 month expected credit losses On initial recognition, and for financial assets where there has not been a significant increase in credit risk since the date of advance, provision is made for losses from credit default events expected to occur within the next 12 months. Expected credit losses for these stage 1 assets continue to be recognised on this basis unless there is a significant increase in the credit risk of the asset. Stage 2: significant increase in credit risk Financial assets are categorised as being within stage 2 where an instrument has experienced a significant increase in credit risk since initial recognition. For these assets, provision is made for losses from credit default events expected to occur over the lifetime of the instrument. Whether a significant increase in credit risk has occurred is ascertained by comparing the risk of default at the reporting date to the risk of default at origination, and is made based on quantitative and qualitative factors, with a backstop indicator. Quantitative considerations take into account changes in the residual lifetime PD of the asset. As a backstop, assets with an arrears status of more than 30 days past due on contractual payments are considered to be in stage 2. Qualitative factors that may indicate a significant change in credit risk include concession events that still envisage full repayment of principal and interest, or downgrades to external credit ratings. Stage 3: credit impaired (or defaulted) loans Financial assets are transferred into stage 3 when there is objective evidence that an instrument is credit impaired. Provisions for stage 3 assets are made on the basis of lifetime expected credit losses. Assets are considered credit impaired when: contractual payments of either principal or interest are past due by more than 90 days; there are other indications that the borrower is unlikely to pay such as signs of financial difficulty, probable bankruptcy, breaches of contract and concession events which have a detrimental impact on the present value of future cashflows; or the loan is otherwise considered to be in default. Interest income on stage 3 credit-impaired loans is recognised in the income statement on the loan balance net of the ECL provision. The balance sheet value of stage 3 loans reflects the contractual terms of the assets, and continues to increase over time with the contractually accrued interest. Purchased or originated credit impaired (POCI) loans Where loans are credit impaired on origination, or when purchased from third parties, the carrying amount at initial recognition is net of the lifetime ECL at that date. Thereafter, any subsequent change (favourable or unfavourable) in the lifetime ECL is recognised in the income statement. POCI loans are separately disclosed as credit impaired loans and cannot be transferred out of the POCI designation, even if there is a significant improvement in credit quality. Transfers between stages Transfers from stage 1 to 2 occur when there has been a significant increase in credit risk and from stage 2 to 3 when credit impairment is indicated as described above. For assets in stage 2 or 3, loans can transfer back to stage 1 or 2 once the criteria for significant increase in credit risk or impairment are no longer met. For loans subject to concession events such as forbearance, accounts must first be up to date for a period of 12 months before they can transfer back to stage 1 or 2. Write-off Loans remain on the balance sheet net of associated provisions until they are deemed no longer recoverable. Where a loan is not recoverable, it is written off against the related provision for loan impairment once all the necessary procedures have been completed and the amount of the loss has been determined. Subsequent recoveries of amounts previously written off decrease the value of impairment losses recorded in the income statement. 19