On March 20, the ECB published its final guidance to banks on non-performing loans (NPLs).
The guidance, published as a draft in September last year (see our article), was subject to a two month consultation phase and a public hearing (see the webcast). According to the ECB, the guidance should be applied starting with its date of publication, meaning that it has effectively entered into force. From our meetings with banks over the last couple of weeks, we expect the quick entry into force will come as a surprise, as many expected an explicit transitional period.
The final guidance contains further clarifications on its applicability, effectively broadening this beyond the ‘usual’ suspects on the NPL topic. As an example, the ECB clarified in the accompanying feedback statement, that even for a ‘low NPL bank’ the sections on NPL Strategy and Governance and Operations (and the respective annexes) can be applicable to certain parts of the business such as sectoral/regional portfolios or subsidiaries higher NPL levels if deemed appropriate by the JST.
This relativizes the previous discretionary distinction between high (and low) NPL banks, by shifting the debate from bank-level towards portfolio-level application. The ECB also clarified that not only NPLs but also foreclosed assets or watch lists could trigger banks being classified as a high NPL bank. Furthermore, the ECB clarified that all significant institutions are expected to implement effective early warning mechanism as suggested in the Guidance. Taken together, these changes shift the emphasis further towards universal application for all significant institutions.
Compared to the consultation draft and as expected (see our article from February), the final draft includes overall few changes. In the final version of the guidance, the ECB clarified that an assessment of banks’ NPL-management will be part of the annual SREP cycle, implying indirectly Pillar 2 requirements for non-compliance. Apart from that, the ECB also clarified that the NPL disclosure expectations described in the guidance should be implemented beginning with 2018 reference dates onwards. With regard to each chapter, the number of effective changes due to the comments received varies (see table 1). As an example, all comments received for the chapters on NPL Strategy, Forbearance and NPL Recognition resulted in changes of the guidance, while not all comments received on other chapters resulted in changes of the final version. The latter therefore appear to have been discussed more controversy between the ECB and the banking sector.
As expected (see February article), the final draft includes overall few changes. In the final version, the ECB clarified that an assessment of banks’ NPL-management will be part of the annual SREP cycle, implying indirectly Pillar 2 requirements for non-compliance. The ECB also clarified that the NPL disclosure expectations described in the guidance should be implemented beginning with 2018 reference dates onwards. With regards to each chapter, the number of effective changes due to the comments received varies (see table 1). As an example, all comments received for the chapters on NPL Strategy, Forbearance and NPL Recognition resulted in changes of the guidance, while not all comments received on other chapters resulted in final version changes.
Table 1: Overview on comments received and effective changes of the draft guidance by chapter. Source: ECB.
In the following, we shortly highlight selected changes for each chapter of the guidance:
In total, the ECB received 44 responses during the consultation phase. Compared to other consultations (see table 2), the number received for the NPL Guidance is the highest – an indication of its impact on the sector, and on multiple stakeholders within each SSM supervised bank.
Table 2: Overview on comments received during consultation phases (non-exhaustive).
Not surprisingly, the ECB also defended the notion of ‘conservatism’ and ‘prudence’ used in the NPL guidance, which are sometimes regarded by market participants as being incompatible with accounting standards (general requirement for neutrality under the IFRS Framework). In response to that, the ECB is “firmly of the view that in areas of uncertainty requiring management judgement a management bias exists and, therefore, a level of conservatism is required to ensure that a neutral view is attained”. We understand the ECB will want to see this logic applied in particular to NPL provisioning in ‘areas of uncertainty’.
The NPL guidance has de facto entered into force. Significant institutions are now expected to comply with the principles and expectations laid down in the guidance, subject to the proportionate judgement of their Joint Supervisory Team (JST). Banks with NPLs in their portfolios are therefore well advised to analyze potential gaps of their NPL management compared to ECB’s guidance; they should also immediately develop action plans to be prepared for the discussion with their JST and the next Supervisory Review and Evaluation Process (SREP) cycle.
Our KPMG gap analysis tool on ECB’s NPL guidance allows banks to quickly identify potential areas of non-compliance and helps to develop an action plan to ensure compliance over time. From banks’ perspective, it is now also crucial to clearly identify interdependencies with current implementation projects (e.g. IFRS 9, CRR default definition, BCBS 239), optimize necessary implementation costs and align their project activities needed to ensure compliance with the guidance.