It is a well-known fact that the European banking sector is faced with a high volume of non-performing loans (NPL(s)). A NPL is defined as the sum of borrowed money upon which the debtor has not yet made his scheduled payment over a period of more than ninety (90) days. A NPL could either be one in default or close to defaulting.
The European Central Bank (ECB) has recently published its final guidance notes (Guidance), an important step to tackle the problem.
The high level of NPLs is deemed to be a big threat for the overall banking sector for three (3) main reasons:
- NPLs tie up bank’s capital without providing return;
- They reduce profitability and threaten business models and projections; and
- They erode a bank’s liquidity.
As a consequence, the entire banking sector would be weakened with less liquidity and adequate resources to issue further loans, essential weakening its position within the European economy. After approximately one year of analysis and consultations the ECB has published a thorough Guidance to banks on NPLs with the main objective of driving a strategical and operational focus on the reduction of NPLs as well as providing further harmonisation and common definitions of NPLs, forbearance (defined as the temporary postponement of mortgage payments in lieu of forcing a property into foreclosure ) and collateral valuation of immovable property.
The Guidance is addressed to credit institutions directly supervised by the ECB. Although the Guidance is not a binding document, non-compliance may trigger supervisory measures. As yet these are not further specified either by the ECB or the issued Guidance.
The Guidance also provides best practice examples following a NPL management lifecycle. Some of the key features are outlined below:
The ECB expects from credit institutions a complete and detailed roadmap for their NPL – management, especially regarding:
- Strategy assumptions and self-assessment:
- Assessment and reporting of internal/external capabilities, inclusion in the ICAAP ( defined as the Internal Capital Adequacy Assessment process , whereby the Board receives insights related to the ongoing assessment of the bank’s risks, the mitigation measures put in place and the future capital that has to be allocated for mitigating purposes ) and Risk Appetite Framework (RAF), sustainable clean-up of NPLs from the balance sheet for banks with low capital and profitability; and Strategy development and implementation;
- Analysis of available strategic options, comparison and benchmarking with international and/or historical values, establishment of sustainable portfolio targets and term targets for NPL reduction.
- NPL Governance and Operations
The Guidance requires a thorough and separate monitoring during all NPL management processes concerning to:
- Decision-making, strategy approval, oversight, and internal controls;
- NPL operating model: separate and dedicated NPL workout units for different phases of the entire cycle and clear hand-over triggers;
- Control framework: Definition of roles and responsibilities (3 lines of defence model);
- NPL monitoring: KPI framework to monitor the workout progress; and
- Early warning system to be implemented.
As mentioned above the Guidance also aims to enhance the harmonisation of NPL definitions among European players through:
- Consistent application of the regulatory Non-Performing Exposure (NPE) definition;
- Alignment of regulatory and accounting definitions; and
- Public disclosure also including a reconciliation from deviations between accounting and regulatory exposures and disclosure of assumptions underlying the definition of impaired financial assets.
Given the potentially large impact for some European banks, it is important to understand the perception and reaction of the market towards the ECB’s Guidance. Furthermore, it shall be important to understand the extent that the Guidance may further harmonise the cross-border differences in European NPLs. This would help the European banking sector tackle the challenges it is facing.
Further information in relation to the ECB’s Guidance may be found through the following URL: https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/npl/npl_guidance.en.pdf