Two Faces of Prudence: Why IFRS 9 Overlays and CRR Ill MoCs Are Similar, Different - and Often Misunderstood

The strong reaction to recent discussions around IFS 9 overlays and CRR Ill Margins of Conservatism (MoC) highlights how easy it is to conflate these two adjustment mechanisms. Both arise when models face uncertainty, data gaps, or limitations. Both have the effect of moving estimates away from "pure" model output. And both are seen by stakeholders as adding prudence.

Yet beneath this surface similarity lie important differences in purpose, direction, and governance.

Misunderstanding these distinctions can lead to conceptual confusion and, in practice, to either excessive buffers or inadequate safeguards. This article builds on the lively debate around the topic to clarify where IFS 9 overlays and CRR III MoCs overlap, where they diverge, and how banks can manage them coherently.

1. Purpose: Central Accuracy vs. Prudential Conservatism

At the heart of IFRS 9 lies the requirement to produce an unbiased, forward-looking central estimate of expected credit losses (ECL). Overlays (or underlays) are applied when model outputs fail to capture all relevant risks or systematically overstate them. Their purpose is corrective — to bring the model output closer to the true central view.

By contrast, CRR Ill explicitly requires conservatism in IRB parameter estimation. A Margin of Conservatism is applied not to achieve central accuracy, but to ensure prudence in the face of model uncertainty. The objective is to bias estimates upward (more conservative) so that capital requirements remain safe under stress and data limitations.

In short: overlays correct toward neutrality; MoCs adjust toward prudence.

2. Direction: Two-Sided vs. One-Sided

An important practical distinction lies in directionality.

•  IFRS 9 overlays are two-sided. If models understate risk, overlays can increase ECL; if they overstate risk, overlays can reduce it ("underlays"). The key is that the final adjusted number must still represent a central, unbiased estimate.

• CRR Ill Mocs are one-sided. They only ever increase risk parameters or capital requirements. The philosophy is that model uncertainty should never lead to undercapitalization.

This asymmetry explains why overlays and MoCs cannot be treated as equivalent, even if they are sometimes triggered by the same missing data or risk factor.

3. Governance and Removal: Flexible vs. Persistent

Governance requirements add another layer of divergence:

• Overlays are temporary and flexible. Once the missing factor is integrated into the IFRS 9 model, the overlay should be reduced or removed. Auditors expect overlays to be short-lived and transparent.

• Mocs are sticky and persistent. Removal requires strong quantitative evidence and regulatory approval. Supervisors want to see that data limitations have been fully addressed before a MoC is lifted.

This creates different institutional dynamics. Finance functions may update overlays quarterly, while risk functions may carry MoCs for years until supervisory comfort is achieved.

4. The Practical Overlap: Same Triggers, Different Treatments

Despite these differences, both overlays and MoCs are often triggered by the same issues:

• Missing or incomplete data on drawdown behaviour.

• Macroeconomic uncertainty not captured in model calibration.

• Portfolio shifts that challenge representativeness of historical data.

This is where confusion arises. Practitioners may use similar information sets to justify both adjustments, leading to the perception of "double counting." While conceptually they are independent, in practice banks must work hard to ensure they are applied in distinct, well-governed ways.

5. Implications for Banks

The interplay between overlays and MoCs creates three key challenges:

• Avoiding Redundancy: Without coordination, banks risk layering conservatism twice, constraining both provisions and capital.

• Cross-Functional Governance: Finance and risk functions must develop joint governance forums to ensure clarity on when and how adjustments are applied.

• Regulatory and Audit Transparency: Supervisors and auditors expect clear articulation of the different objectives and governance of overlays vs. MoCs.

Conclusion:

Overlays and MoCs may look similar, but they are not interchangeable. One aims at unbiased accounting, the other at prudential conservatism. One is two-sided, the other one-sided. One is flexible, the other persistent.

The real challenge for banks is managing their interaction. Without proper governance, the same uncertainty can generate two separate adjustments, amplifying prudence in ways not always intended.

By recognizing both the similarities and differences, banks can avoid unnecessary capital strain while maintaining credibility with both supervisors and auditors.

The message is clear: overlays and MoCs are not the same tool - but they are two faces of prudence that must be managed together.

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Ozan Çağlar

is a senior risk management leader specializing in IFRS 9, credit risk modelling, and regulatory frameworks. With experience at ENBD DenizBank, Deloitte, UniCredit, Yapı Kredi, and Kuveyt Türk, he has led major projects across model audit, IFRS 9 implementation, portfolio monitoring, and capital adequacy. He brings nearly two decades of expertise in driving risk strategy and ensuring regulatory compliance across international banking groups.

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