Allowances represent estimate of credit losses expected to be incurred on loans and advances to customers at the reporting date over a 12-month horizon or the lifetime of the exposure.

As required by the applicable accounting standard, the measurement of expected credit losses includes forecasts of future economic conditions. Making assumptions about expected macroeconomic scenarios and the likelihood of their occurrence requires Management to use a significant dose of judgment.

The main risk area comprises the failure to identify existing impairment triggers and significant increase in credit risk, the application of inappropriate data to calculate the parameters of statistical model, which include the use of inappropriate macroeconomic assumptions, which may not adequately reflect the expected credit losses existing as at a given reporting date. For loans that are assessed on an individual basis there is a risk of applying inappropriate assumptions regarding recovery scenarios and valuation of collateral. Moreover, there is a risk of errors and risk of fraud occurring during the allowances calculation process. A relatively small change in significant assumptions and model parameters such as data and methods, could have a significant impact on the Bank's expected credit loss estimate.

Due to the COVID-19 pandemic and its impact on the macroeconomic environment, the uncertainty in the estimation of expected credit losses increased significantly compared to previous years.

The increased uncertainty caused by the sudden negative change in the macroeconomic situation required the Bank's Management Board to apply temporary qualitative changes to the existing credit risk models, which were developed based on the analysis of observed loss parameters in the past supplemented with management overlays. These changes were necessary as the models used in the Bank, due to their design and the scope of data they were built upon, could not fully reflect the impact of a sudden change in the economic environment on expected credit losses. Determining such temporary changes to the model requires the Bank’s Management Board to apply a significant level of judgment.

We considered this area to be a key audit matter because estimating the allowances for expected credit losses involves significant inherent risks of error and fraud as well as uncertainty and requires Bank’s Management Board to use significant judgment and, considering the size of the loan portfolio, has a material impact on the unconsolidated financial statements.

·        analysis of the structure and dynamics of the loan portfolio including quality ratios and provision coverage in order to identify groups of loans with underestimated allowances for expected credit losses;

·         taking into account the results of historical assessment of the model validity performed by the Bank, a critical assessment of significant assumptions and input data used in the estimation of expected credit losses models for individual key credit risk parameters, such as in particular transfer logic between stages, probability of default (PD), exposure at default (EAD) or loss given default (LGD);critical assessment of temporary qualitative changes to model aiming to include the impact of the COVID-19 pandemic on expected credit losses, including: loss parameters in the context of assumed macroeconomic scenarios and the appropriateness of the treatment of granted borrower consents from the perspective of allocation to risk categories (stages);

·        independent recalculation of selected risk parameters and allowances for expected credit losses for a selected sample of exposures, including selected methodology components designed to reflect the impact of the COVID-19 pandemic;

·        assessment of the adequacy of the allowance for losses expected over a 12-month horizon by referring to credit losses realized on individual homogeneous portfolios in the past;

·        analysis of the accuracy of allocation of loans and advances to customers to stages, taking into account qualitative and quantitative criteria;

·        for loans and advances to customers assessed individually on the basis of a selected sample including the impact of COVID-19 on the financial situation of borrowers – assessment of the appropriateness of identification of significant increase in credit risk and impairment triggers and for impaired assets – critical assessment of relevant assumptions adopted by the Bank and independent recalculation of impairment allowances;

·        an assessment of the completeness and appropriateness of disclosures in the financial statements regarding significant judgments and estimates of expected credit losses, including uncertainty arising from the possible impact of the COVID-19 pandemic, as well as a sensitivity analysis of the level of expected credit losses relative to key assumptions used in the model.

Conduct risk, including litigations related to denominated and indexed loans to CHF

The book value of loans granted in CHF to individuals amounted to PLN 2.191 million as at 31 December 2020 and PLN 2.597 million as at 31 December 2019. Due to the risk related to the current and potential legal claims with borrowers who have been granted in the past mortgage loans denominated or indexed to CHF, the book value of loan portfolio was reduced by PLN 329,7 million and the provision was recognized for loans repaid by customers that amounted to PLN 80,3 million as at 31 December 2020 (PLN 27,7 million and PLN 19,0 million as at 31 December 2019, accordingly) (Note 5.2 “Credit risk” and note 40 “Provisions”).

Key audit matter

Our response

Bank operating on regulated market are exposed to the risk of changes in law rulings and events (other than those arising from credit risk) that may result in lower than contractual cash inflows from financial contracts with customers or in an obligation or liability arising from past events, the settlement of which will require outflow of resources embodying economic benefits ("risk amount").

As at 31 December 2019, the above refers in particular to the impact of decision of the Court of Justice of the European Union ("CJEU") of 3 October 2019 (Case C- 260/18). Although this decision did not refer directly to the Bank, it has resulted in consequences we refer to below.

Our audit procedures included among others:

·        assessment of the accounting policy and the methodology for estimation of the financial effects of CJEU decision and legal claims;

·        assessment of the design, implementation and testing the operating effectiveness of internal controls with respect to identification, monitoring and estimate of risk resulting from disputes with clients;

·        analysis of the correspondence, reports and post-inspection recommendations received by the Bank from the regulatory authorities;

As a result of the decision, the number of court claims against the Bank filed by the borrowers who were granted mortgage loans denominated or indexed to CHF ("CHF loans") in the past years increased. The Bank assessed that this growth may continue for some time in the future, which in the absence of a single court ruling in this respect may result in lower expected cash inflows from CHF loans than those resulting from the contractual agreements. In order to determine an estimate of new expected cash inflows from the CHF loan portfolio, the Bank made scenario analysis regarding future possible events, taking into account both litigation and customer settlements and making significant assumptions regarding the number of lawsuits, the probability of losing the case and the probability of possible verdicts of the courts, as well as estimating the size of possible settlements with customers.

Estimates of risk arising from loans denominated or indexed to CHF are subject to a material uncertainty in respect of significant assumptions made. A relatively small change in significant assumptions may have a significant impact on the level of the Bank's losses.

For the above reasons, we consider making a reliable estimate of the amount of risk and appropriate disclosures in this respect in the Bank's unconsolidated financial statements to be a key audit matter.

·        assessment of the Bank's internal analyses and reports with respect to compliance and conduct risks;

·        analysis of confirmations of legal claims received from external legal counsels representing the Bank and their assessment of the financial impact resulting from these cases;

·        analysis of the legal opinion received by the Bank's Management Board from an external law firm dated 29 December 2020 which include assessment of the impact of the CJEU decision of 3 October 2019 on the Bank in the light of other judgments of common courts made in Poland in similar cases after the CJEU decision date, taking into account the characteristics of the practices and loan agreements templates used by the Bank for CHF loans as well as probability assessment of the possible scenarios defined by the Bank in terms of future court decisions;

·        reasonableness assessment of significant assumptions such as probability of adopted scenarios, the number of expected lawsuits from customers, the probability of losing the case, the probability of possible settlements by the courts based on the trends observed to date in the Bank and in the market;

·        assessment of the correctness of assumptions and estimation of financial consequences for the Bank in case of application of a settlement scenario with customers;

·        sensitivity analysis of estimates to changes in significant assumptions and an assessment of whether the level of those assumptions indicates bias of the Bank's Management Board;

·        assessment of the completeness and adequacy of the disclosures required by the International Financial Reporting Standards, which are related to the estimates presented.