Three new publications have already been introduced in 2018 to address NPLs. Now banks are faced with unravelling the individual requirements.
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:
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.
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:
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:
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.
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”.
|Application:||All significant institutions directly supervised by ECB.|
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:
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.
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.
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:
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.
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