(revised on 15 March 2018)
The ECB aims to avoid the piling-up of new NPLs by fostering timely provisioning practices for new non-performing loans (NPLs) in the future. The addendum sets out supervisory expectations as a starting point for the supervisory dialogue. It supplements the NPL Guidance published by the ECB in March 2017, which focused on qualitative aspects.
It is the ECB Banking Supervision’s obligation to address key vulnerabilities in banks in a consistent manner that ensures fair and equal treatment. Among other things, the existing prudential framework requires supervisors to assess and decide whether banks’ provisions are adequate and timely from a prudential perspective. It is important to note that the addendum is not in itself a Pillar 2 measure and does not seek to impose obligations on banks. The addendum simply indicates what the ECB expects from the banks when they assess their risk exposures and serves as a starting point for a discussion with each individual bank on whether it has made adequate and timely provisions for NPLs.
The addendum is relevant for the NPLs of all significant institutions and is non-binding. It addresses loans classified as NPLs after 1 April 2018. In fact, the addendum sets out an expectation that, as of 1 April 2018, new unsecured NPLs will be fully covered after a period of two years from the date of their classification as NPLs. For example, the supervisor would expect a loan that is classified as an unsecured NPL on 1 May 2018 to be fully provisioned for by May 2020.
For new secured NPLs, a certain level of provisioning is expected after three years of classification as an NPL, or “NPL vintage”, which then increases over time until year seven. In this case, if a secured loan were classified as an NPL on 1 May 2018, the supervisor would expect this NPL to be at least 40% provisioned for by May 2021, and totally provisioned by May 2025.
During the supervisory dialogue, the ECB will discuss with each bank divergences from the prudential provisioning expectations laid out in the addendum.
The result of this dialogue will be incorporated, for the first time, in the 2021 Supervisory Review and Evaluation Process (SREP).
Banks should prepare themselves and use the next two years to review their credit underwriting policies and criteria with a view to reducing the emergence of new NPLs, particularly given the current benign economic conditions. A suitably gradual path towards provisioning is also important, starting from the moment of NPL classification.
The accounting provisions of a bank serve as a basis for the supervisory dialogue in determining whether these provisions are sufficiently prudent. Therefore, accounting provisions will be taken fully into account when analysing the banks’ individual circumstances with regard to the prudential provisioning expectations, including potential increases in provisions as a result of IFRS 9 coming into force in 2018. If banks make use of the IFRS 9 transitional arrangements, this will also be taken fully into account in determining whether risks are adequately covered.
The addendum serves as a starting point for the supervisory dialogue with banks.
The impact of the supervisory expectations will depend on the outcome of supervisory dialogues with individual banks. Furthermore, since the supervisory expectations apply only to new NPLs, the consequences in terms of additional risk coverage also depend on future NPL inflows.
Regarding the potential impact of the addendum on secondary NPL market activities, the expectations address the net exposure of NPLs, i.e. the supervisor is not encouraging banks to sell their NPLs but expects NPLs to be sufficiently covered. Furthermore, the NPL Guidance published on 20 March 2017 refers to NPL sales as only one of a number of possible tools to address high levels of NPLs. Others can include workout, restructures and foreclosures.
Through the Joint Supervisory Teams, ECB Banking Supervision is assessing the credibility and ambition of the strategies of significant institutions for reducing the existing stock of NPLs. It should be noted that we have seen a reduction in the significant banks’ NPL stock, which fell from €950 billion in the first quarter of 2016 to €759 billion in the third quarter of 2017. Supervisors will continue to monitor bank-specific progress in NPL reductions.
A range of considerations underpin the final calibration of the addendum. These include supervisory judgement, international best practice regarding provisioning and the speed of resolution processes across the EU, including recent related improvements. ECB Banking Supervision considers that the addendum provides a balanced approach to assessing whether banks’ provisioning practices are timely and adequate.
The addendum specifies supervisory expectations for new NPLs, not for foreclosed assets. However, the ECB is closely monitoring developments related to foreclosed assets. If banks reduce NPLs only by means of foreclosure, without being able to dispose of related foreclosed assets, resulting in the risks not being fully covered, supervisory measures may follow. In this context, the ECB NPL Guidance also invites banks to apply reasonable haircuts in the valuation of such assets.
The addendum is complementary to any future EU legislation based on the European Commission’s proposal to address NPLs under the Pillar 1 rules, i.e. the mandatory prudential requirements in the Capital Requirements Regulation.
In fact, in line with CRD IV, supervisors have to assess and address institution-specific risks which are not already covered or which are insufficiently covered by Pillar 1 rules.
In the ECB’s view, it is important to assess risks related to NPLs not covered by Pillar 1 on the basis of the addendum. Where supervisors ascertain on a case-by-case basis that, despite the application of the Pillar 1 backstop, the NPLs of a specific bank are not sufficiently covered, they may make use of their supervisory powers under the Pillar 2 framework.
The minimum coverage levels required under the future Pillar 1 rule will provide for a backstop against under-provisioning on an EU-wide basis and apply to all institutions.
By contrast, the addendum sets out supervisory expectations as a starting point for a supervisory dialogue to assess all risks to which an individual institution is, or might be, exposed and which go beyond the risks already covered by Pillar 1 minimum requirements. Hence, by construction, automatic minimum requirements and supervisory expectations differ in terms of calibration.
The supervisory expectations outlined in the addendum are generic. Specific situations that might lead to different magnitudes of risk will be taken on board during the supervisory dialogue. In certain “unlikely to pay” cases, banks will be able to provide evidence of regular repayments of a significant portion of the exposure, which may make the 100% provisioning expectations inappropriate for a specific portfolio/exposure.