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The latest on NPLs: how do the newly published regulatory requirements fit together?

Regulatory update on Non-Performing Loans

Three new publications have already been introduced in 2018 to address NPLs. Now banks are faced with unravelling the individual requirements.

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At the end of 2017, we predicted that EU banks would need to face a new normal, with NPLs becoming much more costly and demanding over the next few years for banks to hold. Regulators have continued to enforce this message across Europe, with new measures already being introduced in 2018 to address the NPL overhang.

In March, we saw the publishing of:

  • The European Commission's (EC) update to the NPL action plan
  • The final Addendum to the ECB Guidance on NPLs 
  • The EBA draft guidelines on management of non-performing and forborne exposures

All of these new publications are expected to raise numerous questions and uncertainty from the banks as they begin to unpick the individual requirements. Banks need to clearly understand how they intertwine and fit together (or where they misalign), how to interpret the overall regulatory expectations and how to prepare efficiently and cost effectively. In this article, we highlight the main components of each publication and how we anticipate they will work in practice.

European Commission's update on the NPL action plan

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

  1. 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 has no planned date of finalisation. It 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:

This provisioning schedule is non-linear (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 7 years.

        2. 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:

  • Foster the development of a secondary markets for NPLs, introducing;
  1. a common set of new rules for credit servicers to operate cross-border within the Union (”EU passporting”),
  2. specific market entry conditions for loan servicers, and
  3. conditions for borrower rights protection.
  • 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 this would take effect.

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

The Action Plan agreed in July 2017 invited the EC to propose a guidance (“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 (PDF 1.46 MB) which is non-binding and contains a number of suggestions for common principles on all aspects of AMCs, including the setup, governance and operations. Drawing on best practices, the blueprint is heavily inspired by the lessons learned from SAREB and NAMA.

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

Accompanying the EC's update on the NPL action plan is the publication of the Addendum to the ECB guidance to banks on NPLs. The ECB published the final Addendum on 15 March 2018.

The consultation period on the draft Addendum (PDF 458 KB) ran from October to December 2017 and received 35 responses with over 500 individual comments. It also raised fundamental questions around the risk of the addendum overreaching the ECB's mandate. Since then, clarifications have been made and overall, it's clearer that these are supervisory expectations with no legal effects and the provisioning calendar is slightly less constraining (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:

  Unsecured part Secured part
After two years of NPE vintage 100%  
After three years of NPE vintage   40%
After four years of NPE vintage 55%
After five years of NPE vintage 70%
After six years of NPE vintage 85%
After seven years of NPE vintage 100%

The secured exposures (i.e. fully secured or secured balance of a partially secured exposures ) are 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 might be adopted on a case by case basis.

 

Currently, the provisioning schedules do not fully align between the proposed amendments to the CRR from the EC and the Addendum from the ECB. Although the proposed amendment to the CRR is not in force at the moment and has no planned date for finalisation, leaving time for the two to align.

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

Also in line with the NPL action plan of the EC, the European Banking Authority (EBA) issued on Thursday 8 March 2018 a consultation paper on its draft guidelines for credit institutions on how to effectively manage non-performing exposures (NPEs) and forborne exposures (FBEs).

The EBA guidelines have a legal basis (thus 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 on NPL strategy, governance and operations, control and monitoring, early warning and collateral valuation (although valuation is expected to also cover immovable).

The main differences the EBA Guidelines introduce are:

  • Applicable to all regulated European credit institutions, while the ECB Guidance is only to Significant Institutions supervised by the SSM.
  • Catered for consumer conduct requirements due to the EBA's consumer mandate.
  • Doesn't have the ECB concept of “High NPL” banks but instead sets a threshold NPL ratio of 5% from which credit institutions should establish a NPE strategy and related governance and operational arrangements. 
  • Defines the concept of proportionality for the application of the text, according to the size and complexity of the credit institutions (this is however not precisely defined and left for interpretation by supervisors).
  • Sets out requirements for competent authorities' assessment of application as part of the Supervisory Review and Evaluation Process (SREP)

Action plan - what banks should do now

With all of these new regulatory measures being introduced, ongoing and yet to come, banks are advised to ensure they have a thorough understanding of where they are lacking in meeting the requirements and the significance of these gaps. This includes grasping the subtleties and links between all three publications, and identifiyng the common pressure points. Banks are also required to anticipate, as best as possible, the impacts of future regulatory changes to ensure that any curative measures taken by the bank are necessary.

Such an understanding starts with ensuring adequate NPL data (see our article on NPL data), a deep knowledge of NPL portfolios and its underlying risks, and the development of credible and implementable NPL strategies. Only then can the bank provide evidence of compliance to the regulators and develop sound arguments to potential deviations from supervisory expectations.

To discuss how we can help you or for any questions regarding NPLs, please contact us at mailto: eric.cloutier@kpmg.co.uk.

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