A common way forward for legacy loans at small banks

15 September 2025

By Sharon Donnery, Member of the Supervisory Board of the ECB

The significant decline in bad loans on European bank balance sheets over the past decade is the result of the collective efforts of banks, policymakers and supervisors. The reduction in non-performing loans (NPLs) has strengthened the banking system, making it more resilient and boosting its ability to grant loans to new profitable projects in the economy.

However, this overall improvement is uneven across banks. Some smaller banks continue to face challenges stemming from persistent stocks of long-standing NPLs^[1] and maintain less provisions to cover potential losses on bad loans. To address these risks and strengthen the resilience of the banks affected, the ECB and national competent authorities (NCAs) have jointly developed a common approach to supervising the coverage for legacy NPLs at smaller banks. The ECB and NCAs have cooperated closely to produce a draft Guideline addressed to NCAs as the direct supervisors of smaller banks, known as less significant institutions or LSIs. The draft Guideline is risk-sensitive, proportionate and carefully tailored to LSIs. The ECB is inviting comments from banks and other stakeholders on this draft Guideline, which is published today for public consultation. This will ensure that the final version is both effective and balanced.

The draft Guideline builds on the tried-and-tested concept of calendar-based coverage expectations, which link the level of provisions that supervisors expect banks to maintain to the age and type of their NPLs. Where, after duly considering specific circumstances, supervisors find that existing provisions fall short of their expectations, they may require banks to increase their capital to cover those gaps. First used for larger banks^[2], supervisory coverage expectations have proven to be a transparent and effective tool and have contributed significantly to NPL reduction and risk mitigation.

The draft Guideline recognises that effective supervision requires proportionality and therefore permits NCAs to exempt banks, or cohorts of exposures, where risks are assessed as low – for example, because a bank has a very low NPL ratio or only negligible amounts of legacy NPLs. In applying the common approach, NCA supervisors will also consider additional factors brought forward by the banks and backed by specific evidence. The new draft Guideline is another step towards a competitive and resilient banking sector, contributing to a safer, sounder financial system for all.

Risks from legacy loans: reduced but not extinguished

Credit is the lifeblood of the economy and the soundness of bank balance sheets depends on the quality of that credit.^[3] To maintain a resilient banking system we therefore need to keep focusing on the risks related to banks’ NPLs. After years of steady decline, the downward trend in NPL ratios in the European banking industry came to a halt in 2023. And NPL levels at smaller banks even started to rise again in 2024, albeit moderately. While NPLs are linked to the business cycle and are bound to ebb and flow as part of banks’ normal credit activity, it is important that they are closely monitored and adequately provisioned. In today’s uncertain economy, marked by numerous complex risk factors, banks must be ready to tackle challenges unhampered by lingering losses from legacy exposures. We should bear in mind, however, that smaller banks face certain structural disadvantages with respect to NPL reduction:

• low market demand for small-scale NPL transactions makes it much harder for small banks to find buyers for their NPL portfolios;
• resource constraints for smaller banks tend to imply fewer specialised units (such as dedicated loan workout units) available for NPL reduction;
• access to state support schemes which helped larger banks reduce NPLs was not always extended to smaller banks.

Against this backdrop, persistent stocks of high vintage NPLs and low levels of provision coverage, as seen in some LSIs, warrant specific supervisory attention. Although the entities concerned are in the minority, they are the reason for the diverging coverage levels between significant institutions and less significant institutions displayed in Chart 1. Average coverage ratios are naturally influenced by the composition of NPL portfolios. For example, higher shares of secured exposures like mortgages, where the loan is backed by collateral, can explain lower provision coverage to some degree. As the value of real estate used as collateral for mortgages often offers sufficient coverage, the expected recovery rate is higher, which in turn reduces the need for high provisioning. However, when NPLs are held for extended periods of time, realistic expectations on recoverable amounts should be lowered and coverage increased accordingly for all types of NPLs.

Chart 1

NPL vintage versus coverage for less significant institutions and significant institutions

Coverage expectations: a key prudential tool

The basic dynamics of timely provisioning are reflected in calendar-based approaches to NPL coverage, which the ECB has applied to legacy NPLs held by significant institutions since 2018. The same principle is also reflected in the deduction requirement for more recent NPLs included in the Capital Requirements Regulation (CRR), which applies to all European banks. These approaches are different for secured and unsecured NPLs, allowing significantly longer time frames for expected full coverage for secured exposures. If justified by specific evidence-based circumstances, supervisors may decide that supervisory coverage expectations may not be appropriate for certain exposures or portfolios of exposures.

Coverage expectations are one element of the three-pronged approach taken by European banking supervisors when tackling NPL-related risks for significant institutions, in addition to:

• requirements for banks with high NPL ratios to develop and execute dedicated NPL reduction strategies, which have been central to lowering the risks to capital from credit losses;
• supervisory expectations regarding the early identification and management of distressed debtors, forbearance and operational capabilities for dealing with NPLs, which have ensured banks are equipped to prevent the excessive build-up of new NPLs.

The interplay between these three elements is crucial. NPL coverage expectations have supported reduction strategies by ensuring that banks maintain sufficient capital to absorb potential losses. At the same time, because these coverage expectations ensure that the continued holding of such assets directly affects capital, they incentivise banks to resolve problem loans more quickly.

Harmonised supervisory approach for small banks: targeted and risk based

LSIs have also been subject to supervisory requirements for reduction strategies and management of NPLs under the responsibility of the respective NCAs. These measures have supported progress in reducing NPL-related risks, with due regard to proportionality considerations and local circumstances. However, in most countries, supervisory coverage expectations have not been widely used as a tool in this context – until now. Their use in the future will harmonise and enhance the effectiveness of the existing supervisory efforts for LSIs. By introducing these supervisory coverage expectations, we complement the progress already achieved by NCAs in fostering NPL reduction strategies and sound risk management practices, while further aligning with the key pillars of the strategy successfully tested with significant institutions, as outlined above.

A dedicated study has found the expected impact on small banks – in terms of additional reporting and compliance efforts – to be manageable, particularly since the approach will be phased in gradually up until the end of 2028. For LSIs that are not exempt from the supervisory approach set out in the draft Guideline, the annual submission of a limited number of data points on legacy NPL coverage should not pose material challenges. The concepts and calculations involved are well known from the common reporting on the CRR deduction requirement, which all banks have been submitting quarterly since 2021.

We therefore expect the simple, tried-and-tested supervisory instrument at the core of the proposed new European banking supervision-wide approach, which is now open for consultation, to contribute significantly to reducing and mitigating risks related to small banks’ legacy NPL portfolios, while making efficient use of banks’ and supervisors' resources. The consultation process provides an important opportunity for stakeholders to offer feedback on the proposed expectations, helping to ensure they are both effective and proportionate. Addressing legacy NPLs remains essential to ensure a strong and resilient European banking system that can effectively serve the real economy.

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