Professional Level – Business Planning: Banking - December 2019

MARK PLAN AND EXAMINER’S COMMENTARY

The marking plan set out below was that used to mark this question. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.

Question 1

Total Marks: 40

General comments

The candidate’s role is in the financial planning and analysis department of FreshBank, a new bank that
was authorised at the start of the current accounting period. FreshBank recruited a newly qualified ICAEW
Chartered Accountant, Mia Piel, as the head of its financial control department. Mia requests advice about
some financial reporting issues.

The financial reporting issues are:

 Non-performing loans held within a securitisation arrangement

 The derecognition of collateral posted to a central clearing house
 The valuation of investments in unquoted bonds
 Fee income

The candidate is also asked to provide advice on the use of blockchain in its syndicated loans process.

1.1 Financial reporting treatment

Issue 1 – Transfer of non-performing loans to CLL

FreshBank transferred the non-performing loans to Canwell Loans Ltd (CLL) for 90% (1-(380-342)/380) of
the fair value. It must be determined whether the loans may be derecognised by FreshBank. There are
two factors to consider. Firstly, CLL is controlled by FreshBank and will be recognised as a subsidiary.
Therefore, FreshBank will need to consolidate CLL. Secondly, in FreshBank’s individual financial
statements, the loans may be derecognised from financial assets only if FreshBank transfers substantially
all the risks and rewards of ownership of the financial assets to CLL.

The risks and rewards of ownership have not passed completely to the SPE if there is recourse to
FreshBank for any loans in default. The recourse limit of £250 million must be compared with the
transferred fair value of £342 million to decide if it is substantially all of the risk or not. Furthermore, it is not
clear whether FreshBank has any rights over the cash flows arising from the underlying loans in return for
the recourse limit. On balance, it appears that the risks and rewards have not transferred and therefore,
FreshBank should continue to recognise the loans.

Because the loans were purchased credit impaired, no impairment allowance is recognised on initial
recognition. A credit adjusted effective interest rate should be used. Subsequent changes in credit risk are
recognised in profit or loss.

Issue 2 – Collateral provided to CCH

The derecognition of the collateral provided to CCH depends on whether the risks and rewards have
transferred to CCH. CCH holds the collateral in case FreshBank defaults on the settlement of its derivative
balances. In the case of FreshBank’s default, the collateral would be seized and FreshBank loses the risks
and rewards of ownership. At the point of default in its settlement, FreshBank should derecognise the US
Treasury bills.

Another key factor is whether CCH has the right to sell or repledge the collateral. If it does, FreshBank
should continue to recognise the collateral, but must reclassify it to pledged/ encumbered assets separate
from other assets.

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 Professional Level – Business Planning: Banking - December 2019

The haircut is relevant to the volume of Treasury bills that must be pledged for collateral because CCH
values the US Treasury bills at 6% less than fair value. The US Treasury bills are measured at fair value in
FreshBank’s financial statements, ignoring the haircut, until the collateral is derecognised at which point a
loss on disposal is recognised.

The cash provided to CCH as variation margin must be derecognised from FreshBank’s statement of
financial position as cash and is instead recognised as a financial asset (receivable). It is disclosed as an
encumbered financial asset under IFRS 7. The variation margin is likely to be netted off against the
derivatives balances because, per IAS 32 Financial Instruments: Presentation, there is a legal right to
offset and an intention by FreshBank to settle net.

Issue 3 – Investment in unquoted bonds

Because the bonds are unquoted it is not possible to apply level 1 of the IFRS 13 fair value hierarchy
which requires quoted prices in an active market. Therefore, FreshBank is applying level 2 which allows
observable quoted prices for similar financial assets in active markets and other observable inputs such as
interest rates and credit spreads.

The bonds are held within a portfolio that meets its objectives by collecting interest and realising capital
gains so there may be recent prices in an inactive market that could be used as a level 2 input.

The widening credit spreads for the quoted bonds is likely to be indicative of increased doubt over the
ability of bond issuers to meet future payments of interest or capital. The inputs to the IFRS 13 valuation
model must reflect a number of quoted bonds and must make adjustments for differences in credit quality.
Mia should consider using the yield on quoted bonds with similar credit quality as one input in the present
value calculation.

Widening credit spreads across the bond market indicate deteriorating or volatile economic conditions
which can affect the bonds in which FreshBank has invested. Given the limited secondary market and
liquidity for unquoted bonds, the economic volatility could indicate a significant increase in credit risk
therefore requiring the need to revisit the impairment allowance.

Changes in fair value and the impairment allowance should be recognised in other comprehensive
income.

Issue 4 – Recognition of fee income

FreshBank must reflect IFRS 15 Revenue from Contracts with Customers recognition rules. The
performance obligations are the arranged overdraft and holiday insurance. These performance obligations
are met over time (12 months) by FreshBank and therefore revenue must be recognised over the 12-
month period.

Revenue should be recognised only if it is probable that it will not be reversed in the future.

The average unexpired period is 8 months therefore £120 million (8/12 x 180m) fees must be removed
from the current year profit and deferred until the following year. £180 million comprises the fees received
from 1 January 2019 to 30 November 2019 so the deferred income must be updated at year end.

Examiner’s comment

Most candidates made a fair attempt at this question and could demonstrate some knowledge of all four
issues.

The majority of candidates correctly discussed the derecognition criteria for issues 1 and 2 with
explanations varying in length.

In issue 1, the impairment of purchased credit-impaired loans was dealt with appropriately in
approximately half of the scripts. The application of the derecognition criteria was dealt with competently
by the majority of candidates.

The derecognition of initial or variation margin was explained well. However, it was often incorrectly
recommended that the haircut should be applied to the value of the collateral in FreshBank’s financial
statements.

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 Professional Level – Business Planning: Banking - December 2019

The fair value considerations in issue 3 were dealt with well and discussion of whether the bonds should
be classified as level 2 or level 3 in the IFRS 13 fair value hierarchy was awarded marks. Issue 3
requested advice on fair valuation, but many candidates wasted time discussing the classification and
measurement rules instead. The question stated that the bonds are measured at FVTOCI so further
explanation was not necessary.

Issue 4 covered revenue recognition and candidates could confidently discuss the application of IFRS 15.
As it is a new standard, candidates were well prepared.

Total possible marks 22

Maximum full marks 18

1.2 Audit documentation required with reasons

Issue 1 – Transfer of non-performing loans to CLL

Incorporation documents for Canwell Loans Ltd (CLL) are needed to verify its legal ownership structure. If
FreshBank controls more than 50% of CLL, it must be consolidated.

The sale agreement for the transfer of the non-performing loans is needed and the terms and conditions
for the recourse for bad debts and any participation by FreshBank in the returns from the loans. The
recourse of £250 million may be substantially all of the risks and rewards of ownership that are retained by
FreshBank.

Initial loan documentation for the transferred loans is needed to show the nature of the credit impairment,
relevant interest rate and future cash flows. This is to determine credit impairment on initial recognition.

Internal credit risk analysis should be provided to substantiate whether there has a significant increase in
credit risk. Only if there has been a significant increase in credit risk, an impairment allowance should be
recognised.

Issue 2 – Collateral provided to CCH

The contract with CCH is needed to determine the rights of CCH to repledge or sell the collateral
FreshBank provides to it.

A copy of the CCH contract or exchange rules is needed to ensure FreshBank has netting rights.

Documentation of the CCH haircut policy is needed to determine the correct valuation of the US Treasury
bills for CCH.

FreshBank’s internal liquidity measures such as loans to deposits ratio, leverage or liquidity coverage ratio
are needed to ascertain its likelihood of default and whether the collateral is likely to be seized by CCH.

Issue 3 – Investment in unquoted bonds

Loan documentation is needed to verify the cash flows included in the present value calculations to
determine fair value.

Evidence of recent sale transactions by Freshbank should be provided to see if the bonds are sold at an
amount significantly different to the latest valuation.

The portfolio of quoted bonds used for observable interest rate inputs to the present value calculations
should be provided to assess the bonds for comparability to FreshBank’s assets.

Documentation of the adjustments to interest rates used for quoted bonds is needed to ensure that credit
and liquidity risk of the unquoted bonds is reflected.

Published financial statements of bond issuers are needed to analyse whether a significant increase in
credit risk has occurred.

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 Professional Level – Business Planning: Banking - December 2019

A review of any downgrades in the credit rating of the bucket of quoted bonds should be provided to
identify if any of the reasons for downgrades are applicable to unquoted bond holdings.

Issue 4 – Recognition of fee income

Terms and conditions of the contract with premium account customer is needed to ascertain the different
performance obligations and whether they are all satisfied over the same 12-month period.

Know your customer (KYC) and compliance documentation is needed so that the auditors can assess the
risk of mis-selling.

The calculation of the average unexpired 8-month period is needed to assess the accuracy of the
estimate.

Fee income received until 31 December 2019 must be provided to ensure that the financial statements for
the year ending 31 December 2019 are complete and cut-off is addressed appropriately.

Examiner’s comment

Candidates performed well on this requirement. The requirement asked for documentation that may be
required by the external auditors, with reasons. A minority of candidates provided a list of audit procedures
without focusing on the items of documentation. However, credit was awarded when candidates stated the
documentation and why it is needed.

Candidates often stated what the auditors would need to gain assurance over, without explaining the
documentation required to gain the assurance. For example: ‘verify that observable market data has been
used to determine price’ does not specifically state that external prices from e.g. Reuters should be
obtained for similar quoted bonds.

Total possible marks 22

Maximum full marks 15

1.3

Advantages, risks and practical concerns

Distributed ledger technology, such as blockchain, could reduce administrative costs and increase the
speed of offering loans to customers due to increased efficiency and collaboration.

FreshBank would benefit from increased accuracy because the loan terms and conditions and supporting
documentation are verifiable by all syndicate members.

The duplication of data inherent in the nature of distributed ledger technology ensures that all syndicate
participants can have confidence in the accuracy and immutability of the data recorded. This enhances
trust between syndicate members.

If the syndication participants are not well known to each other and, as a consequence, have limited trust
in each other, blockchain can increase the likelihood of them operating well together. This may help
FreshBank to establish business relationships because it is in its first year of operation and has a limited
track record.

Risks include the variability in speed and its reliability in case of system disruption.

Privacy and cyber security are important issues. The private ledger, if set up correctly, should limit access
so that only approved parties may view it.

Other risks include the risks of outsourcing to an external software house, such as establishing terms of
engagement, roles and responsibilities.

The appropriate legal structure of the syndicated loans arrangement must remain.

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 Professional Level – Business Planning: Banking - December 2019

Scalability, to ensure the blockchain system can cope if application numbers increase, with the same
security levels, is vital.

Implications for external audit

The external auditor must have sufficient skills and knowledge to audit the blockchain process.

Any ongoing support or input from the software house must be subject to audit as an outsourced supplier.
The external auditor must have appropriate access to any outsourcer’s records and controls.

Cyber security will be a key area of controls testing.

The movement of the loan origination process to distributed ledger technology is still subject to regulation
and ‘know your customer’ rules.

Examiner’s comment

Candidates were well prepared for this requirement as it focused on technology aspects of the syllabus
which are increasing in prominence each year. An appropriate number of advantages, risks and practical
concerns were provided by the majority of candidates.

There were two common errors that candidates made: the question asked for a discussion of blockchain in
the context of FreshBank’s syndicated loans process and a minority of candidates ignored this context and
discussed blockchain in abstract terms, limiting the marks available to them; and a minority of candidates
discussed bitcoin, or cryptocurrencies in general, rather than blockchain.

Total possible marks 11

Maximum full marks 7

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 Professional Level – Business Planning: Banking - December 2019

Question 2

Total Marks: 30

General comments

The candidate is placed in the role of credit analyst in Serpent Bank’s lending division. The candidate is
analysing the loan application from Boomslang Ltd, an online fashion retailer.

Details are provided of the terms of the proposed loan, financial information for Boomslang and
preliminary financial ratios.

The ethics scenario is that the candidate is given information about Boomslang by his father, who is the
partner on the Boomslang audit.

2.1

a) Quantitative and qualitative analysis

Financial stability

Boomslang has achieved significant sales growth from 2018 to 2019 of 35.7% ((1,919-1,414)/1,414).
Gross profit margin has been maintained, suggesting revenue growth has not been achieved at the
expense of profitability. Also, the cost of sales trajectory is similar to last year which indicates that there
has been no efficiency achieved year on year.

The forecast level of revenue growth from 2019 to 2020 at 28% ((2,456-1,919)/1,919) is less than that
achieved in the previous year, which gives some comfort that it is achievable. Forecast improvements in
both operating and gross margins also appear consistent with the last two years. Forecast revenue growth
is likely to be partly facilitated by the investment in the logistics centre.

Operating margin has improved over the last two years consistent with increased returns to scale. A more
modest improvement in operating margin is forecast for 2020.

Therefore, based on the information provided, the profit forecast appears reasonable and is consistent
with the stated benefits expected to be derived from the investment in the new logistics centre.

Inventory days appear fairly constant over the last two years. A small reduction is forecast in 2020 despite
increasing sales, however this is consistent with some of the efficiency benefits from the new logistics
centre coming through.

Payables days is also fairly consistent but appears to be fairly high at approximately six months. This may
be due to advantageous terms of trade that such a large retailer can negotiate with fashion wholesalers.
Also, the figure of trade and other payables may contain significant accruals related to operating
expenses.

The very low value of receivables is to be expected due to the retail nature of the business. The
combination of these factors means that Boomslang benefits from negative working capital of £121 million
(£326m + £24m – £471m) in 2019, forecast to rise to negative £203 million (£402m + £23m - £628m) in
2020

Affordability

Currently the company has no other borrowings and we have no information regarding the existence of
any undrawn revolving credit facilities such as overdrafts.

Based on the forecast for 2020, interest cover for the proposed loan would be a very comfortable 33.6
times (168/5). Meeting interest payments should not be difficult for Boomslang provided the strong
forecast performance is achieved and continues for the life of the loan.

Therefore, affordability appears good provided that the 2020 forecast is achieved and the trend in revenue
and margins continues.

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 Professional Level – Business Planning: Banking - December 2019

Viability

Provided Boomslang does not exercise the early repayment option, the principal of £100 million will be
repayable at the end of 2024.

The profit after tax for 2019 is £99 million and is forecast to grow to £139 million in the following year.
It is probable that the capital expenditure necessary to support the company’s growth will mean that the
increase in cash will be lower than these figures, although if working capital retains its current structure it
will be a source rather than a drain on cash.

Thus, the viability of repayment appears good provided the forecast is achieved and further capital
expenditure is controlled. It would appear to be fairly likely that Boomslang’s cash position will enable it to
exercise the early repayment option should it wish to do so.

We have no information regarding dividend payments, although the equivalence of profit for the year and
the change in retained earnings indicates that no dividends were paid in 2018, 2019 or are forecast to be
paid in 2020.

Substantial future dividend distributions could undermine the viability of repayment. However, this concern
could be addressed by a loan covenant preventing or limiting payment of dividends before the loan has
been repaid.

Security

The security is provided by a fixed charge over the logistics centre for which funding is sought. Although
the principal of £100 million will be invested into the logistics facility this amount may not be realised if
security is exercised due to:

 Significant legal and other costs connected with enforcing the charge;
 The fact that non-current assets purchased are likely to be highly specific to the operations of
Boomslang and as a consequence will not be realisable at a sum close to the amount invested; and
 The proportion of loan funds to be spent on developing bespoke software and automation systems is
likely to have little or no value if Boomslang ceases to operate.

As a consequence, the amount of the loan is unlikely to be fully covered by the realisable value of secured
assets should default occur. This increases the loss given default, and thus credit risk for the proposed
loan.

Management

The management team is described as having the core skills necessary to run a business of this nature.

In addition, since they are the original founders of Boomslang, they have demonstrated the ability to create
a successful business and grow it to its current scale.

These factors suggest management competence and ability to deliver growth and reduce credit risk.

Capital structure

Currently Boomslang has no outstanding debt and is therefore entirely financed by equity.

Based on the statement of financial position for 2019, if the loan were extended debt to equity would be
0.43 (100/233), falling rapidly to 0.27 (100/372) at the end of 2020. This low level of gearing can be
expected to reduce further over the term of the loan provided Boomslang remains profitable.

b) Reasoned recommendation on whether Serpent should approve the loan

The analysis above indicates that Boomslang is a successful, fast growing company with a 2020 forecast
that appears achievable. This suggests that management has implemented an effective business strategy.

Both affordability and viability appear strong and the capital structure will contain only modest gearing if
the loan is granted. Something to bear in mind is that the 2019 position is unaudited and therefore not
independently validated.

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 Professional Level – Business Planning: Banking - December 2019

Security is a weakness as the probable value of the secured assets, should security be enforced, is
unlikely to be the same as the principal extended. This means that the loan would, in effect, be partially
unsecured and therefore the loss given default would be higher. Credit risk could be reduced if further
security was available.

Given the information we have, there is nothing to suggest that the forecast for 2020 is not reasonable and
achievable.

Management’s track record in developing Boomslang to its current scale also indicates a level of financial
competence and the ability to generate growth.

However, it should be noted that a failure to generate the expected level of sales growth in 2020 and
beyond would be a threat to the company’s financial stability and could undermine the viability of making
the principal repayment on schedule.

On balance, assuming that the rate of interest is appropriate, I would recommend approving this loan
application due to Boomslang’s record of financial and commercial success combined with the high
expected affordability and good viability.

Examiner’s comment

This requirement was well answered by all but the weakest candidates.

Common errors included copying information from the question without adding further analysis which did
not gain any marks and wasted time. The loan structure heading should include an explanation of whether
the loan appears to be appropriate to Serpent Bank and Boomslang’s needs. No marks were awarded for
ratios provided in the question without further explanation or interpretation.

Candidates are reminded to avoid unjustified statements such as ‘gearing is good/healthy’. It is not
possible to draw such conclusions without industry comparisons and further analysis.

The security in this question is the new logistics centre, which is not yet built. Therefore, comments
regarding obtaining the latest valuation of the centre were not appropriate.

The error of treating retained earnings as cash was seen again in the weaker candidates’ scripts.

In general, answers were well structured and covered all headings of the analysis. Candidates also
provided recommendations regarding whether to approve the loan and marks were awarded for reasoned
conclusions.

Total possible marks 23

Maximum full marks 17

2.2

Additional risks of the loan to Boomslang

Interest rate risk

This is the risk to earnings or capital, arising from the effect of the movement of interest rates on items in
the banking book. The loan to Boomslang would be held in Serpent’s banking book and would be subject
to interest rate risk as a result of the embedded early repayment option attached to the proposed loan.
Boomslang’s decision to exercise this option will affect Serpent’s earnings giving rise to interest rate risk.

The option is likely to be exercised by Boomslang if market interest rates fall enabling replacement with
cheaper funding. It is not clear whether Boomslang will hedge its interest rate risk. In the absence of a
hedge, Boomslang will be exposed to the downside risk.

Credit concentration risk

The fact that 18% of Serpent’s loan book consists of lending to the UK retail sector indicates that it has
significant expertise in this area, but also suggests that its loan book may not be fully diversified. This

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 Professional Level – Business Planning: Banking - December 2019

creates significant exposure to the retail sector of the economy. Concentration should also be considered
by looking at geographical concentrations and single name exposures.

Operational risk

There is huge operational risk associated with building a new logistics centre, customisation to the
business as well as development of bespoke software and automation systems. If there are delays
experienced with this project then it will have a knock-on impact on revenue and profits, which in turn will
directly impact Boomslang’s ability to service its loan.

Examiner’s comment

Candidates did not perform well on this requirement. It appeared that candidates did not read the
requirement carefully and focused on the risks to Boomslang rather than the risks to Serpent Bank for
extending the loan. Marks were awarded if the risks to Boomslang were linked to the credit risk to the
bank.

Despite directing candidates towards the prepayment option in the question, it was not always discussed.

Given the length of some answers to the previous requirement, some candidates may have not managed
their time on the question effectively and did not spend sufficient time on this requirement.

Total possible marks 6

Maximum full marks 5

2.3

I have breached the duty of confidentiality contained within the ICAEW Code of Ethics by telling my
parents the name of the company seeking a loan whose credit analysis I am currently working on.

My father is a member of ICAEW and has also breached his own duty of confidentiality by providing me
with information about an audit client of the firm at which he is a partner.

In addition, it is likely that my father has breached the duties of integrity and professional behaviour by
knowingly giving me confidential information to provide me with a professional advantage, despite the fact
that it could have a detrimental impact on an audit client.

Given the events that have occurred, I am now placed in a difficult position as I would be acting without
integrity to allow this information to affect my decision on the Boomslang loan. If I were to pass on the
information regarding Boomslang’s recent performance I would also be knowingly committing a further
breach of confidentiality.

I also owe a duty to Serpent as my employer to act in its best interests in the course of my employment.
Making a recommendation on the Boomslang loan without taking into account all the information that I
have in my possession may breach this duty.

Essentially, the combination of breaches of ethical duties by my father and myself, have placed me in a
compromised position. I could appear to be committing further breaches of my ethical duties regardless of
whether I consider the information provided by my father or not and regardless of my recommendation on
the loan.

Even if I were able to make a decision without allowing the confidential information to influence me there is
a danger that in retrospect my decision may appear tainted if the relationship between my father’s firm
comes to light.

The safest approach may be for me to disclose to Serpent (without disclosing any confidential information)
that I have become ethically compromised and therefore unable to have any further involvement with the
credit analysis or loan appraisal in relation to Boomslang’s loan application.

My father should discuss his error of judgement with the ethics partner at his firm.

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 Professional Level – Business Planning: Banking - December 2019

Examiner’s comment

Almost all candidates identified that the key ethical issue was one of confidentiality but fewer candidates
generated appropriate suggestions for actions to take once the ethical breach had occurred. The fact that
the breach was made by ‘your’ father, who is an audit partner, seemed to limit some responses.

There were some answers which did not apply the ethical standards appropriately and suggested that the
information should be used in evaluating the loan application.

However, a significant minority of scripts stated appropriate actions to take and scored highly on this
requirement.

Total possible marks 9

Maximum full marks 8

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 Professional Level – Business Planning: Banking - December 2019

Question 3

Total Marks: 30

General comments

The candidate works for Grey plc, the external auditors of Rillo Bank. A significant proportion of Rillo’s
lending is in the country of Leku. The economic environment in Leku has changed considerably since the
prior year which is having an impact on Rillo’s impairment allowances, risk appetite and hedging
arrangements.

3.1

Key audit risks

Impairment allowances

Increased impairment allowances in profit or loss will reduce retained earnings and reduce capital
adequacy. At the same time, required capital is likely to increase because the probability of default has
increased, further reducing capital adequacy. If sufficient capital is not maintained, Rillo could be at risk of
fines and penalties.

Rillo’s capital planning strategy may not be sufficiently robust to ensure minimum capital levels are
maintained at all times. The impact of reduced retained earnings is expected to be offset by a reduced
expected loss in excess of impairment allowance (EL-P) deduction.

Sufficient disclosures may not be made to ensure that users of the financial statements understand the
impact of economic instability.

There are a number of estimates and uncertainties that Rillo’s board must address and that generate audit
risks:
 Forecast macroeconomic data is more difficult to predict in a changing economic environment
 Forecast interest rates and unemployment rates are estimates mentioned by the Rillo board but it
must also reflect GDP growth and house prices etc.
 The number of economic scenarios that Rillo uses is subjective and it must apply probability
weightings to each scenario
 Information used must reflect forward looking information on the reporting date
 Reliability of internal data
 Reliability of purchased external economist data
 Definition of default
 Significant increase in credit risk flags must pick up increases in credit risk before default otherwise
there may be an error in the model.

Manual adjustments generate high audit risk because there can be little third-party evidence to support the
board’s decision.

Historical data analysis becomes less relevant in changing economic environments where past behaviour
may not represent future trends.

Changes to ECL models must be subject to appropriate governance and approved by the audit and risk
committees.

Risk appetite for new loans

There is an audit risk that credit lending is not undertaken in line with credit risk appetite. This may lead to
unrecognised impairment allowances if loans are incorrectly categorised.

The directors’ report in the annual report must be consistent with the financial statements.

Hedging rebalancing

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 Professional Level – Business Planning: Banking - December 2019

Rillo may not appropriately reflect the required rebalancing of the hedging arrangement by changing the
quantity of the hedged item or hedge instrument.

The rebalancing may not be appropriately accounted for under IFRS 9 as a continuation of the hedging
relationship.

Rillo must maintain the other hedge criteria of:

 There is an economic relationship between the hedged item and the hedging instrument ie, they
move in the opposite direction because of the hedged risk
 The effect of credit risk does not dominate the fair value changes
 The hedge ratio of the hedging relationship is the same as that resulting from the actual quantity of
the hedged item and hedging instrument used.

Examiner’s comment

Candidates did not perform very well on this requirement because of a lack of application of the
requirement to the question. Candidates tended to write down generic audit risks, often from other
questions in the question bank, only some of which gained limited marks if they were relevant.

Further marks were available if candidates had used the information in the question to identify audit risks
specific to Rillo Bank and provided explanations of the risks.

A minority of candidates wasted time presenting audit procedures for which no marks were awarded.

Total possible marks 19

Maximum full marks 17

3.2

Critical analysis of the draft strategic report

Grey must form an opinion on the consistency of the strategic report with the figures in the financial
statements. The bullish stance in the strategic report does not appear to match the impact that was
discussed with Amar Khan in Exhibit 1. Therefore, the report may need to be redrafted.

Under the UK Corporate Governance Code, the strategic report must be a fair and reasonable
assessment of the business’ performance.

Impact on audit approach

The wording of the strategic report implies the changing economic environment will have little impact on
the financial statements. This increases the inherent risk of the audit because this does not agree with
Grey’s assessment of the impact.

Professional scepticism must be applied throughout the audit to question how Rillo has dealt with matters
of key judgement such as those mentioned in the previous requirement.

There is no suggestion that Rillo will not adjust the strategic report, nor that Rillo is intentionally seeking to
mislead its shareholders so no further impact is required at this stage.

Grey must assess the strategic report at the end of the audit when it is possible to compare the
disclosures with the final figures.

Examiner’s comment

A significant minority of candidates scored well on this requirement. Other candidates did not attempt the
requirement fully and missed out on available marks.

A common error was to state a number of audit procedures which was not required and did not gain
marks.

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 Professional Level – Business Planning: Banking - December 2019

Appropriate considerations for the audit approach such as increasing inherent risk, reducing materiality
and increasing professional scepticism were awarded marks.

Total possible marks 7

Maximum full marks 5

3.3

PRA supervisory powers under Pillar 2

Banks should have their own processes and strategy in place to manage capital levels using Internal
Capital Adequacy Assessment Process (ICAAP). The PRA can then use the Supervisory Review and
Evaluation Process (SREP) to review the bank’s ICAAP and identify any weaknesses or deficiencies.

The PRA also has the power to impose higher capital requirements for individual banks by implementing a
Pillar 2A requirement. Pillar 2A addresses risks not captured by the Pillar 1 framework. An example would
be basis risk which is not captured adequately by the Pillar 1 framework. The PRA can also set a PRA
buffer to capture specific risks not addressed by other buffers.

Depending on the size of Rillo’s business, it may be subject to stress testing by its regulatory supervisor.
In the UK, the Bank of England carries out stress tests annually to determine banks’ financial stability in
the event of a number of extreme scenarios. Depending on the outcome of Rilo’s internal stress testing
exercise, which will be outlined in its ICAAP document, the PRA may choose to apply additional capital
requirements, especially if the stressed risk appetite metrics are breached.

Move to AIRB approach to credit risk

The advanced internal ratings-based approach (AIRB) to credit risk is a regulatory approach that allows
Rillo to use internal models rather than standardised risk weightings. Under the AIRB approach banks may
use their own internal models to determine probability of default (PD), loss given default (LGD), exposure
at default (EAD) and maturity (M).

The AIRB approach often results in lower capital requirements because it is a risk-based approach that
captures the specific business model and the risks associated with it for a particular bank. However, the
use of the AIRB approach must be approved by the PRA and lowering RWA should not be the only reason
for the application to change approach.

It is concerning that Rillo intends to use the PD that it uses for IFRS 9 financial reporting purposes. The
PD for regulatory purposes should be based on long-run averages using historical data, whereas IFRS 9
figures are based on forward looking information. Also, Basel III uses a 12-month time horizon compared
with 12 months or lifetime expected credit losses under IFRS 9.

LGD will also differ for IFRS 9 and Basel purposes. LGD for regulatory purposes is based on a downturn
period which is unlikely to reflect an unbiased neutral estimate as required by IFRS 9.

Examiner’s comment

This requirement was attempted well by the majority of candidates. Candidates’ knowledge of the PRA’s
supervisory powers and the change to credit risk measurement was generally good.

Total possible marks 12

Maximum full marks 8

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