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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.
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.
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[1], 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[2] 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[3], so a revision of the rules would also create a serious level playing field issue.
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.[4] 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.[5] 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.[6]
In its action plan to tackle non-performing loans in Europe[7], 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[8] 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.
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.