Your chosen topic for today’s exchange of views – credit risk and the potential surge in non-performing loans (NPLs) as a result of the pandemic shock – is very timely and important. I am happy to provide you with my views on this subject, which is one of our top priorities.
Before
presenting our current credit risk strategy and addressing the specific
issues mentioned in your invitation, namely the prudential definition
of default and the provisioning calendar for NPLs, let me recall that
NPL reduction has been an ongoing priority of European banking
supervision since its inception. Thanks in part to continued supervisory
pressure in this area, banks entered the COVID-19 crisis with more
resilient balance sheets than in the past, making them better able to
support distressed clients during the downturn and better equipped to
absorb any future pandemic-related losses. The progress achieved in NPL
reduction as a result of our supervisory pressure has so far prevented
any need for additional direct public support to the banking sector. A
fundamental lesson from the great financial crisis, to which I will
return later on, is that delayed NPL recognition and resolution lead to
an excessive pile-up of bad loans, which clog up banks’ balance sheets
and hamper both the banking sector’s profitability and its ability to
support the economic recovery.
That is why the driving aim behind
our response to the COVID-19 pandemic was to mitigate the impact of the
shock by ensuring that viable households, small businesses and
corporates continued to have access to credit, while at the same time
inducing banks to strengthen their credit risk management practices and
to swiftly adapt them to the specificities of this shock.
Overview of ECB Banking Supervision’s credit risk strategy
To
tackle this potential increase in NPLs proactively, we devised a
dedicated credit risk strategy, building upon the work we had carried
out last year, including the sound practice letters setting out our
supervisory expectations that we sent to the CEOs of the banks we
supervise.
Following up on these letters, we launched an in-depth
assessment and benchmarking exercise of banks’ credit management
practices, examining where banks deviated from our supervisory
expectations. While most banks are fully or broadly in line with our
expectations, certain banks, including some that now have fairly low
levels of credit risk, need to address significant gaps in their risk
control frameworks, which are the most important safeguard against a
significant deterioration in asset quality in the future. The main areas
of attention are the classification of loans, especially when there is a
significant increase in credit risk (Stage 2 under IFRS 9), the proper
flagging of forbearance measures and the timely and adequate assessment
of borrowers’ unlikeliness to pay.
Banks need to accurately
reflect credit risk in their financial and regulatory statements. They
should have adequate processes in place to assess the extent to which
borrowers are unlikely to pay, so that NPL classifications are not
solely based on the number of days past due. The latter is a lagged,
backward-looking measure of loan performance which fails to adequately
capture the specific risk situation arising from the pandemic, where
support measures such as moratoria may have made traditional early
warning indicators – focused on the timeliness of payments – less
useful.
We have also identified highly diverse practices under
IFRS 9 accounting standards, with differences across banks relating to
the transfer of loans to Stage 2 –
signalling a significant increase in credit risk – and the level of
credit loss provisions associated with such loans. We observed that some
of these practices systematically delay the identification of loans in
this category, especially for riskier portfolios. This appears to be
aimed at smoothening the recognition of IFRS 9 provisions over time.
We
have shared our findings with the relevant banks and asked for
remediation plans. Our assessments have also been fully integrated into
this year’s Supervisory Review and Evaluation Process. Taking proactive
steps to resolve weaknesses in credit risk management practices should
actually dampen procyclicality, helping to mitigate the build-up of bad
loans and promote more sustainable credit availability over the full
credit cycle.
Definition of default
The rules on the
definition of default are a key component of the regulatory overhaul
undertaken in the aftermath of the great financial crisis, which aimed
to better prepare the banking sector for future crises, in line with
international best practices. In my previous role at the European
Banking Authority (EBA), I witnessed first-hand how important that piece
of regulation has been in the context of the EU’s single rulebook.
Credit risk practices and definitions have historically differed widely
across banks and Member States, not only resulting in an unlevel playing
field across banks, but also making it difficult for supervisors and
market participants to compare outcomes and monitor credit risk
dynamics.
The scheduled application date of the new rules falls
within a delicate and important phase of the incipient recovery from the
pandemic. I think it is crucial, now more than ever, that banks
correctly monitor and recognise credit risk deterioration as it occurs.
Postponing or otherwise watering down the rules we have set ourselves –
however exceptional this crisis may seem – would be harmful for banks’
balance sheets and their ability to provide credit, would impinge on our
capacity to rigorously follow credit risk developments, and would risk
undermining the credibility of the single rulebook.
In response
to the shock, loan moratoria and loan guarantees provided borrowers and
banks alike with the necessary breathing space, and successfully
prevented excessive procyclical dynamics in credit availability.
Regulators and supervisors acknowledged the extraordinary nature of the
events and accompanied those measures with the necessary flexibility and
forward guidance, including on the treatment of broad-based forbearance
measures and the automatic reclassification of loans. However, the
borrower relief measures have made identifying credit risk events a more
complex job, not only for banks, but also for supervisors, investors,
analysts and the wider market, making banks’ balance sheets somewhat
more opaque. As I have said previously, underlying credit quality
worsened in the course of 2020, while bankruptcies and NPL levels kept
falling.
When banks’ balance sheets become opaque, it increases
uncertainty for investors and creates the risk that banks will have to
pay higher refinancing costs on debt and equity markets, thereby
reducing their capacity to lend to the real economy. Moreover, opaque
balance sheets expose banks to sudden cliff effects in their ability to
support lending. Both outcomes represent a threat to a smooth recovery
process and risk making banks part of the problem rather than part of
the solution.
I understand that the new thresholds in the
definition of default, which sanction the distressed restructuring of an
exposure, and therefore default on that exposure, have come under the
spotlight. But suspending these thresholds, even in the current
environment, would be tantamount to incentivising loan evergreening
practices. In other words, this would effectively incentivise
unsustainable forms of borrower support which mask actual credit risk
deterioration and aggravate the already existing problem of private debt
overhang.
ECB analysis tells us that pandemic-related public
support may have increased the number of what are known as “zombie
firms”, which are a legacy of the great financial crisis and sovereign
debt crisis. Those borrowers are a drag on the economy’s productivity
and expose the banking sector to disruptive adjustments. Giving up on
parts of the prudential framework would see banks feed into this
problem, instead of helping to tackle it. As also recognised by the G30,
the only way to manage the recovery phase is to ensure that resources
are channelled to viable firms and projects while avoiding adverse
selection and moral hazard.
I
am confident that all banks under our supervision are now ready to
implement the new credit risk rules. The final EBA guidelines
on this topic were published in 2016 and have only recently become
applicable – five years later. EU banks have had a very long time to
prepare their models, infrastructures and governance to comply with the
new framework. And a large number of banks have in fact already updated
their systems and are fully compliant with the new legal framework, so a revision of the rules would also create a serious level playing field issue.
Calendar provisioning
Let
me now turn to the topic of calendar provisioning. I strongly believe
it is a critical tool for timely NPL solutions. As I said, a key lesson
from the past crisis was that delaying NPL recognition and resolution is
not good for economic growth and financial stability.
High NPL
stocks weigh on banks’ profitability and their ability to provide new
credit, and may indicate that deeper corporate viability issues are
present in the economy – which in turn act as a drag on investment and
growth. Empirical studies based on both euro area and global data concur
in establishing that reducing NPLs is associated with faster economic
growth, higher corporate investment and lower unemployment.
And the links go both ways, in that weak banks are more likely to delay
the restructuring of their weak corporate customers, while lending to
such distressed customers can hamper banks’ financial viability.
In fact, timely restructuring is in the interest of not only banks and
the wider economy but also the distressed customers themselves. While
simply delaying the payments of customers may provide them with some
immediate relief, in some cases it is not a sustainable long-term
solution. Instead, it would be preferable for banks and their customers
to discuss how to restructure the loan in order to restore the
borrower’s ability to pay. This would protect customers from
over-indebtedness and help break the debt spiral to preserve the
viability of businesses and individual borrowers alike.
Furthermore,
banks with materially impaired balance sheets do not adjust their loan
pricing in response to policy rate changes, which undermines the
effectiveness of the monetary policy transmission mechanism.
In its action plan to tackle non-performing loans in Europe,
the European Council emphasised the need for a comprehensive set of
measures to address legacy NPLs and prevent new NPLs building up in the
future. Of these measures, calendar provisioning was deemed instrumental
in preventing a repeat of the mistakes of the past. The Council placed
so much importance on this that, with the prudential backstop regulation
in 2019, it turned what used to be a tool of sound discretionary Pillar
2 supervisory policy into directly applicable Pillar 1 EU law.
But
why is calendar provisioning so important? First, it ensures that banks
build up sufficient levels of provisioning buffers to be able to
resolve NPLs, including through write-offs or sales on the secondary
market. And second, it provides banks with a strong incentive to work
out NPLs in a timely manner.
The ECB was among the first
authorities at the global level to issue supervisory relief measures
once the COVID-19 pandemic began. This included significant flexibility
in the application of supervisory policies in the area of NPL
management. Let me remind you that, as the pandemic hit, the ECB
extended to all pandemic-related government-guaranteed NPLs the same
preferential treatment, in terms of calendar provisioning rules, as
applied to NPLs insured by official export credit agencies. With a
legislative amendment, the legislator followed suit in relation to the
remit of the prudential backstop regulation. This concretely ensures
that, for all NPLs with a pandemic-related public guarantee, no calendar
provisioning will apply during the first seven years of vintage. In the
same emergency context, the ECB also decided to deploy flexibility in
the supervision of the pre-agreed NPL reduction plans of banks with high
levels of NPLs.
But I am not at all convinced that postponing
calendar provisioning rules now, with the recovery just beginning, is
the right choice. It is important to put things in perspective. The time
windows envisaged in EU legislation – the prudential backstop
regulation – on calendar provisioning are fairly long (three years for
unsecured, seven years for secured and nine years for real
estate-secured). Postponing or watering down these rules would mean
accepting that the EU banking sector may remain clogged with
pandemic-related secured NPLs for longer than a decade, leaving it
unprepared to face the next recession.
Time is of the essence
here. I believe that this is also why, in other jurisdictions such as
the United States, the rules impose significantly shorter timeframes for
banks to fully write off impaired loans when there is no prospect of
recovering them.
Conclusion
This crisis has been
characterised by exceptional levels of prompt fiscal support, both at
the national level and – most importantly and for the first time – at
the European level. This is different from previous crises and has
helped mitigate the immediate impact of the crisis. The positive
economic outlook confirmed in all recent macroeconomic projections
indicates that our most pessimistic expectations on the possible
deterioration of bank asset quality are not likely to materialise. That
being said, we don’t know how severe the delayed NPL build-up will be or
the precise timeline over which it will materialise. What is clear,
however, is that by adhering to sound credit risk management practices
and timely provisioning, we will help ensure the integrity of bank
balance sheets and lending practices. In turn, this will support more
sustainable growth over the medium to long term. This is the only way to
address the private sector debt overhang and ensure there is no drag on
the economic recovery.
SSM
© ECB - European Central Bank
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