Regulatory update on NPLs

European authorities have been busy in March in terms of regulatory updates on Non-Performing Loans (NPLs). This alert provides an overview of three recent regulatory developments in relation to NPLs with the release of:

the European Commission’s (EC) update on the NPL action plan
the Final Addendum to the European Central Bank (ECB) Guidance to banks on NPLs: supervisory expectations for prudential provisioning of NPEs
the European Banking Authority (EBA) Draft Guidelines on management of non-performing and forborne exposures

1. European Commission’s update on the NPL action plan

On 14 March 2018 the EC published a series of measures and proposals designed to tackle NPLs which follows on from the Action Plan on reducing NPLs agreed by Europe’s finance ministers in July 2017. This package outlines a comprehensive approach including policy actions that target three key areas for banks:

(a) Ensuring sufficient loss coverage by banks for future NPLs

The EC has proposed amending the Capital Requirements Regulation (CRR) with the aim of introducing minimum provisioning levels for newly originated loans that become Non-Performing (“statutory prudential backstop”). This is currently only a proposal and not yet in force, with no explicit planned date of finalisation. This proposal was supported by the outcome of the impact assessment performed by the EBA on the use of prudential backstops to prevent the building up of new NPLs.

Since this measure would apply to newly originated loans that become NPLs, it is designed to address the risk of the accumulation of NPLs on the balance sheet, as well as the risk of not having enough funds to cover future NPL losses.

New calendar provisions will apply as follows:

	Minimum coverage level (in %)
After year	1	2	3	4	5	6	7	8
Secured	5	10	17.5	27.5	40	55	75	100
Unsecured	35	100

This provisioning schedule is in line with expectations of non-linearity (i.e. provisions would get steadily larger as time progresses), thereby allowing banks to look for other options to solve the NPL issue, such as via secondary markets, or out of court settlements. Non-compliance would dictate deductions from banks’ own funds (de facto a Pillar 1 measure).

The EBA’s quantitative analysis, which was based on a “very conservative methodology”, concludes that the backstop may lead to a cumulative (negative) impact on CET1 capital ratio of 56 basis point for the average bank over the first seven years.

This provisioning backstop accompanies the publication of the Addendum to the ECB guidance to banks on NPLs (discussed below).

(b) Developing a secondary market for NPLs and facilitating out-of-court collateral enforcement

The EC has published a proposal for a directive which is designed to:

a. Foster the development of a secondary market for NPLs, introducing;
- i. a common set of new rules for credit servicers to operate cross-border within the Union (”EU passporting”),
- ii. specific market entry conditions for loan servicers, and
- iii. conditions for borrower rights protection.
b. Enable accelerated out-of-court enforcement of loans secured by collateral, introducing for secured creditors a more efficient method of value recovery from secured loans through an accelerated extrajudicial collateral enforcement (i.e. out-of-court measures).

This is currently only a legislative proposal to the Council and European Parliament for approval, with no immediate implications for banks and no indication of when it is likely to take effect.

(c) A technical blueprint for how to set up national Asset Management Companies (AMCs)

The Action Plan, agreed in July 2017, outlined that the EC should provide guidance or a “blueprint” for member states to set up an AMC in their market, in order to better address the ongoing NPL issue. The EC has now published its final AMC blueprint which is non-binding and contains a number of suggestions for common principles on all aspects of such AMCs, including their setup, governance and operations. Drawing on best practices, the blueprint is heavily inspired by the lessons learned from SAREB and NAMA.

2. Final Addendum to the ECB Guidance to banks on NPLs: supervisory expectations for prudential provisioning of NPEs

The ECB published the final Addendum to the ECB Guidance to banks on NPLs on 15 March 2018.

During the consultation period on the draft Addendum (October to December 2017), the ECB received 35 responses with over 500 individual comments. The EC and EU Parliament also raised fundamental questions relating to the essence of the text and the risk of overreaching the ECB’s mandate.

Key clarifications have been made to the final addendum, which are outlined below. Overall, it’s clearer that these are supervisory expectations with no legal effects and the provisioning calendar is slightly less constrained (i.e. longer period before first provisioning). The Addendum also states that the “quantitative prudential expectations may go beyond, but not stand in contradiction to, accounting rules”.

Area	Current Version
Application:	All significant institutions directly supervised by ECB.
Scope:	At a minimum, all exposures newly classified as non-performing (in line with the EBA definition) as of 1 April 2018. Banks are asked to inform the ECB of any differences between their practices and the prudential provisioning expectations as part of the SREP supervisory dialogue from early 2021 onwards (for year end 2020).
Prudential provisioning backstops	During the supervisory dialogue, the ECB will take into account the following quantitative expectations: After two years of NPE vintage - 100% unsecured part After three years of NPE vintage - 40% secured part After four years of NPE vintage - 55% secured part After five years of NPE vintage -70% secured part After six years of NPE vintage - 85% secured part After seven years of NPE vintage - 100% secured part The secured exposures (i.e. fully secured or secured balance of a partially secured exposures) will be expected to be secured according to the calendar starting from year three. This will allow banks to explore other options for resolving their NPL (workout, selling to third party buyers, out-of-court settlement, etc.). In addition, any partial write-offs made since the most recent NPE classification can be considered as provisioning and contribute to the coverage ratio of the bank. For the unsecured exposure (i.e. fully unsecured or unsecured balance of partially secured exposures), there is 100% write off after two years with no step up after one year.
Supervisory dialogue	Banks will be required to inform the ECB of any deviations to the prudential provisioning expectations from early 2021 onwards, as part of the SREP supervisory dialogue. The supervisory process might include off-site activities (e.g. deep dives by the JST), on-site examinations or both. Any divergences from the prudential provisioning expectations will be discussed and portfolio-specific "robust evidence" can be used to inform the dialogue. The outcome of the ECB assessment will be taken into account in the SREP.
Pillar 2 potential implications	The addendum clarified it is not intended to produce legal effects on banks (i.e. it is not a Pillar 1 measure). If the ECB concludes that the prudential provisions do not adequately cover the expected credit risk, a supervisory measure under Pillar 2 framework might be adopted on a case by case basis.

It is noted that the provisioning schedules do not fully align with the proposed amendments to the CRR from the EC. However, the amendments to the CRR by the EC are still at the proposal stage with no finalisation date yet, leaving time for the two to align.

3. EBA Draft Guidelines on management of non-performing and forborne exposures

Also in line with the EC’s NPL Action Plan, on 8 March 2018 the EBA issued a consultation paper on its draft guidelines for credit institutions on how to effectively manage non-performing exposures (NPEs) and forborne exposures (FBEs). Some of the key elements are highlighted below.

The EBA guidelines have a legal basis (and are therefore compulsory) and were developed on the basis of the EBA's Pillar 2 mandates in the CRD IV. They closely mirror the content of the ECB Guidance to Banks on NPL Management, published in March 2017 and cover expectations in terms of NPL strategy, governance and operations, control and monitoring, early warning and collateral valuation (although valuation is expected to also cover immovable).

The main differences introduced by the EBA Guidelines are that they:

Apply to all regulated European credit institutions, while the ECB Guidance is only for Significant Institutions supervised by the SSM;
Cater for consumer conducts requirements in accordance with the EBA’s consumer mandate;
Set a threshold NPL ratio of 5% in order to establish a NPE strategy and related governance and operational arrangements rather than applying the ECB concept of “High NPL” banks
Define the concept of proportionality, according to the size and complexity of the credit institutions (this is however not precisely defined and left for interpretation by supervisors).
Set out requirements for competent authorities' assessment of application as part of the Supervisory Review and Evaluation Process (SREP)

The public consultation period will end 8 June 2018, with a public hearing to be held on 25 April 2018 from 11:00 to 12:30 GMT at the EBA premises. Final publication is expected for summer 2018, with monitoring of implementation as of 1 January 2019.