European banking supervision pays close attention to the quality of banks’ assets, as low asset quality affects banks’ capital and therefore their soundness.
“Delayed recognition and poor management of deteriorating asset quality could easily clog up bank balance sheets with non-performing loans for a fairly long period of time, making it more difficult for the banks to support viable customers and underpin a faster economic recovery.”
- Andrea Enria, Chair of the Supervisory Board
Loans granted to businesses and households are assets for banks. The interest banks earn on these assets is a key component of their income and profit, and the risk of the loans not being paid back is their main risk. The higher this credit risk, the lower the quality of the loan, or “asset quality”. When their asset quality decreases, banks must hold more capital to cover the related credit risk and book higher provisions to prepare for the expected losses.
In an economic crisis, asset quality is a key concern as many borrowers default on their loans and the volume of non-performing loans increases. To mitigate losses and the impact on banks’ soundness and capacity to lend, banks must follow solid lending criteria at all times, actively monitor asset quality, and proactively tackle non-performing loans.
Banks must classify a loan as non-performing when it has been past due for 90 days, or if they deem the borrower to be unlikely to pay back the loan. Non-performing loans are a major issue that banks and supervisors must tackle.
Supervisors assess banks’ risks to capital every year as part of the supervisory review and evaluation process (SREP). Credit risk is a key element of this assessment. See last year’s assessment of credit risk.