21 December 2020
When granting loans to their clients, banks always expose themselves to credit risk – the risk that the borrower may not pay back the loan. When this happens, the loan is said to become non-performing. A loan becomes non-performing when the bank considers that the borrower is unlikely to repay, or when the borrower is 90 days late on a payment.
Non-performing loans (NPLs) reduce banks’ earnings and cause losses, which weighs on their soundness. Banks with high levels of non-performing loans are unable to lend to households and companies. This is harmful to the economy as a whole.
Every bank has to prepare for making a loss on its loans. To offset this credit risk, the bank estimates the expected future loss on the loan and books a corresponding provision. Booking a provision means that the bank recognises a loss on the loan ahead of time. Banks use their capital to absorb these losses: by booking a provision the bank takes a loss and hence reduces its capital by the amount of money that it will not be able to collect from the client.
Banks do not have to book provisions for the full value of a non-performing loan, because they might still receive some repayments from the client. They might also be able to recover part of the loan amount by selling the assets or property the client has given as collateral. Only the net loss that is expected should be covered. The portion of the non-performing loans covered by provisions is called the bank’s NPL coverage. It shows to what extent the bank has already recognised losses it expects from non-performing loans.
Example: a bank has non-performing loans worth €100 and it expects the net loss on them to be €40. It covers this loss by booking provisions for €40, so its NPL coverage ratio is 40%.
To ensure that banks book sufficient provisions, EU law sets a minimum coverage ratio that banks are required to maintain. If a bank has not booked enough provisions to cover its new non-performing loans, it must correct the shortfall by deducting the missing amount from its capital. This can potentially spell trouble for a bank if it does not have sufficient capital cushions on top of the minimum requirements to operate safely.
Banks should not delay the coverage of non-performing loans too much. Many tools and mechanisms have been put in place to ensure that banks’ loss provisions are not only sufficient but also timely. One of them is a pre-defined provisioning calendar that works as a backstop for insufficient NPL coverage.
How does this work? The calendar determines the required level of coverage at different points in time, starting from the date on which the loan becomes non-performing. The longer a loan has been non-performing, the less likely it is to become performing again and the higher the provision should be. The required coverage therefore gradually increases with time until it reaches 100%.
The required timeline depends on whether the loan is secured (in other words backed by collateral or property) or not. If the loan is not secured, the bank must fully cover it within three years at the latest. Secured loans must be fully covered within seven to nine years.
The backstop for loss provisioning helps to ensure that banks are properly harnessed against credit losses. But the backstop only applies to loans that banks have classified as non-performing. Banks therefore need to keep a close eye on the loans they have granted, promptly identify those loans that are at risk of becoming non-performing and classify them accordingly.
The coverage requirement stemming from EU law (“Pillar 1 backstop”) is binding for all banks in the European Union and applies to loans granted from 26 April 2019 onwards. Loans granted before that date are subject to non-binding expectations stemming from ECB Banking Supervision (“Pillar 2 expectations”), which follow a similar logic. For more details on the interaction between the binding requirements and the non-binding supervisory expectations, see August 2019 communication on supervisory coverage expectations.
Communication on supervisory coverage expectations for NPEs