In September 2018, German publication Risikomanager published an article written by White & Case partner Dennis Heuer and associate Claire-Marie Mallad. With permission from Risikomanager, the Firm has republished the article in its entirety below.
On March 14, 2018, the European Commission (the Commission) published a package of legislative measures aimed at reducing the current stock of non-performing loans (NPLs) held by European banks. These measures are the Commission's response to the European Council´s Action Plan, published in July 2017, demanding a reduction of the current stock of NPLs in the European banking sector. In addition, the European Central Bank (the ECB) published separate guidelines on minimum regulatory provision levels for NPLs through an addendum to their 2017 NPL Guidance.
"Non-performing loans" refers to loans where the respective borrower is not able to make scheduled interest and principal repayments. When the payments are more than 90 days past due, or the loan is assessed as unlikely to be repaid by the borrower, it is classified as an NPL.
NPLs do not only affect the bank's company result, but also its clients: NPLs in balance sheets tie up the regulatory capital required to grant new loans, leaving banks with limited lending capacities to households and companies. Therefore, NPLs not only harm the bank itself but also the real economy.
In order to counter this misery, some European banks have already taken a number of initiatives to reduce NPL stocks. This approach seems to be successful. The progress report of the Commission, published in March of 2018, shows the continuing decline of NPL stocks in Europe.
Nevertheless, the current stock of NPLs of European banks is still one of the main obstacles to a full economic recovery in some EU Member States. According to the Commission, the total volume of NPLs in the EU is currently €910 billion. The Commission considers that the high stock of NPLs requires standardised, EU-wide approaches. Although the main responsibility for reducing the high stock of NPLs remains with banks and Member States, there is also a clear interest at the EU level in reducing the current stock, given the interconnectedness of the banking system in the EU and in particular in the euro area. In addition, the various measures taken by the ECB and the Commission aim to prevent the future emergence of such loans. This article provides an overview of the measures of the EU on NPLs and discusses the potential conflict of IFRS 9 rules with the requirements of the ECB Addendum.
1) Measures by the Commission
a. Regulation amending the Capital Requirements Regulation (CRR) regarding minimum loss coverage for non-performing exposures
The proposed regulation amending the Capital Requirements Regulation (CRR) introduces uniform minimum levels of coverage to ensure that banks have sufficient loan-loss coverage for future NPLs. The prudential backstop would therefore only apply to new NPLs, i.e., to exposures originated after March 14, 2018, or to NPLs that have been subsequently modified by the institute. Hence, exposure values of the current stock, which are subsequently increased, are treated as new NPLs.
On the one hand, the proposal establishes the requirement for institutions to cover the incurred and expected losses on newly originated loans once such loans become non-performing ("minimum coverage requirement") up to common minimum levels.
On the other hand, in case the minimum coverage requirement is not met, there is an obligation for institutions to deduct the difference between the actual coverage and the minimum coverage from CET1.
The backstop is a minimum requirement (Pillar 1) that directly applies to all banks subject to the CRR. In addition, under the current regulatory framework, supervisory authorities enjoy discretionary powers and can therefore decide with regard to the specific institution whether the bank's provision is sufficient for its NPL stock.
Higher provisions may therefore be required as part of institution-related decisions (Pillar 2). The minimum coverage requirement increases gradually, depending on how long the NPL has been classified as non-performing. The increase is not linear, but gradually higher. This reflects the fact that the longer the risk position is non-performing, the less likely it is that the amounts owed will still be recoverable. Furthermore, a distinction must be made between secured and unsecured NPLs. Unsecured NPLs are considered to be riskier and require the creditor bank to provide provisions earlier in order to fulfill the minimum coverage. Therefore, the highest minimum coverage requirement already applies from the second year onwards. For secured NPLs, the minimum level of coverage is gradually increased over time. Only if the bank is unable to realise the granted loan collateral within eight years, then the collateral would be deemed ineffective and the bank would be required to fully cover the NPLs.
b. Proposed Directive on credit servicers, credit purchasers and the recovery of collateral
The proposal for a directive on credit servicers, credit purchasers and the recovery of collateral of 14 March 2018 aims to assist banks in reducing their NPL stocks through appropriate distribution channels and more flexible ways of realising collateral. The directive provides for the facilitation of the security recovery of collateralised corporate loans by accelerating their out-of-court enforcement. Banks and borrowers have to agree in advance on such an accelerated mechanism.
In addition, the development of secondary markets for NPLs will be enhanced. Therefore, the requirements for the authorisation of credit service providers should be simplified and harmonised, enabling EU-wide action by credit service providers (EU passporting). This should create an EU internal market for credit services.
The removal of national entry barriers should make the market more competitive through increasing demand, which should have a positive impact on banks´ sale proceeds. As a result, selling NPLs will be more attractive overall, which should accelerate the reduction of NPL stocks from banks' balance sheets.
c. Blueprint on asset management companies (AMCs)
The blueprint on AMCs, also published in March of 2018, provides non-binding guidelines on how Member States can set up national AMCs in full compliance with EU banking and state aid rules. The blueprint provides practical guidelines for the structure and establishment of national AMCs. In addition, it outlines alternative relief measures for impaired assets that do not constitute state aid. The recourse to state aid for AMCs should be an exception. Taking this into consideration, the blueprint aims to clarify which concepts for such AMCs are permitted and fully compatible with EU law and state aid rules. The blueprint is based on best practices and past experiences that some Member States already have made with regard to AMCs. The establishment of pan-European AMCs had also been discussed. However, this idea was rejected, as the Member States did not want a transfer union effect with regard to NPLs.
2) ECB addendum
a. Main contents
The requirements of the ECB addendum with regard to the NPL Guidance only address significant credit institutions that are subject to the direct supervision of the ECB. The ECB addendum complements the NPL Guidance published in March of 2017 and provides quantitative guidelines to ensure timely implementation of risk protection measures for NPLs. The requirements of the ECB addendum will only apply to exposures classified as NPLs as from 1 April 2018. Nevertheless, the ECB is currently considering whether to extend its future expectations to the current stock as well.
The addendum is intended to serve as a starting point for the dialogue between the respective supervisory authorities and the affected banks. The addendum itself does not constitute a Pillar 2 measure and does not impose any obligations on the banks. It only sets out the ECB's expectations referring to the valuation of NPLs. On this basis, the goal is to open a discussion with regard to the extent to which appropriate risk protection is carried out for NPLs with regard to the specific institution. Afterwards, the result of the dialogue becomes incorporated into the SREP quote. The approach taken by the ECB is similar to the Commission's proposal for a regulation. However, there are also some differences that are explained in the table below.
b. Correlation between the ECB addendum and IFRS 9 accounting principles
The question arises as to how the ECB addendum relates to IFRS 9 accounting principles. First of all, it should be stressed that while the quantitative regulatory expectations towards risk provisioning may go beyond those of accounting principles, they should not contradict each other. This is because the regulatory expectations are the sum of the following two components:
- All valuation adjustments made in accordance with applicable accounting principles, including any potential new valuation adjustments, and
- The negative difference between the valuation adjustments and the expected loss for the respective non-performing risk exposure in accordance with articles 158 and 159 CRR, as well as other capital deductions from the Common Equity Tier 1 capital (CET1) in relation to these risk exposures
To put it simply, the financial valuation adjustments should form the basis for regulatory risk provisioning. In addition, expected regulatory losses that exceed the valuation adjustments must further be taken into account, as well as deductions already made from CET1 for each non-performing risk exposure in accordance with article 3 CRR. In order to comply with regulatory requirements, this sum then needs to be compared to the quantitative provisions under paragraph 4.2 of the ECB addendum. Three scenarios are possible here, which are typically applied in the following sequence:
- Excess of financial risk provisioning
- Consistency between financial and regulatory risk provisioning and
- Financial shortfall with respect to the regulatory expectations
This sequence results from the fact that IFRS 9 has been in full force since 1 January 2018, while the ECB addendum envisages quantitative provisions with a phase-in of two to seven years from the date of classification of a risk exposure as NPL. Only when the quantitative provisions exceed the financial risk provisioning, institutions will have to deduct the delta that exceeds the maximum financial risk provisioning from CET1 on their own initiative in order to comply with the regulatory expectations.
However, IFRS 9 already has an impact on the regulatory capital. Compared to IAS39, the implementation of IFRS requires higher and earlier risk positioning that partially goes beyond the regulatory expected losses and therefore results in a so-called valuation adjustment excess. This discrepancy between financial risk positioning and regulatory expected losses arises from the fact that IFRS 9 and CRR each rely on a different underlying definition of expected losses.1 Any valuation adjustment excess has to be formed with a P&L impact and needs to be deducted from CET1. This effect can be mitigated by the transitional provisions under Article 437a CRR. Accordingly, institutions may add part of the IFRS 9 risk positioning to their CET1 until the end of the transition period.2
The battle for the reduction of NPLs on European bank balance sheets has entered the next round. The urgency of this topic does not only result from the unprofitability of European banks and from necessary, but so far lacking, consolidation measures ("too small to succeed"), but also from other political objectives, such as the plans for the implementation of the European Deposit Insurance Scheme (EDIS). Hope remains that the legislator and the relevant supervisory authorities will find appropriate ways and means not to overstrain the banks that already find themselves under tremendous regulatory pressure. Otherwise, the declared intention to develop a thriving banking industry might quickly result in the contrary. In any case, it is therefore advisable for institutions to prepare for these measures and to seek customised solutions for reducing their NPL positions while at the same time maintaining their regulatory capital ratios.
From the legislator's point of view, it remains debatable whether it would not be quicker and indeed more effective to approach the NPL topic through individualised measures (where applicable, with the help of the regulator) in lieu of creating an inflexible and impractical framework, which fails to adequately address individual concerns of European banks.
Click here for the September 2018 issue of Risikomanager; the article runs on page 8-11.
1 CRR assumes a "Through-the-Cycle"" method for expected loss while IFRS 9 follows a "Point-in-Time" model, which is dependent on the current market environment.
2 95% in 2018, 85% in 2019, 70% in 2020, 50% in 2021 and 25% in 2022.
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