FAQ on the draft ECB Guideline on the supervisory approach by NCAs to coverage of NPEs held by LSIs
What is the ECB consulting on and why?
The ECB is consulting on a draft guideline for national competent authorities (NCAs). Developed jointly by the ECB and the NCAs, the Guideline lays down a harmonised supervisory approach to the coverage of legacy non-performing exposures (NPEs) held by less significant supervised entities (LSIs). The Guideline sets out supervisory coverage expectations which NCAs will apply on a case-by-case basis to those LSIs particularly exposed to risks from legacy NPEs that were originated before 26 April 2019. These NPEs fall outside the scope of the deduction requirement under the Capital Requirements Regulation (CRR) applicable to NPEs originated after that date. NCAs are expected to assess whether LSIs cover potential credit losses on those NPEs via provisions or other risk mitigants. Given that average recoverable amounts decrease materially over time, NCAs will consider the NPE’s vintage, i.e. the number of years since the exposure was classified as non-performing.
By consulting on and publishing this draft Guideline, the ECB aims to ensure transparency regarding the harmonisation of supervisory practices and the consistent application of high supervisory standards for banks under the Single Supervisory Mechanism (SSM).
Why is the ECB now establishing a common supervisory approach to the coverage of NPEs held by LSIs?
While NPE ratios have, on average, decreased significantly since the launch of European banking supervision, some LSIs have shown slower progress in managing their stocks of legacy NPEs. This is reflected in NPE stocks which exhibit higher vintages and lower coverage ratios than those held by significant institutions (SIs). As those stocks constitute lasting sources of potential further losses and restrict banks’ capacity for new lending, ensuring that banks make progress in reducing them, or in mitigating the associated risks, is pivotal to supervisory efforts to enhance LSIs’ resilience.
Large stocks of NPEs can pose a significant risk to banks and financial stability more generally. Ensuring that banks adequately manage their NPE portfolios and maintain sufficient coverage of NPEs has therefore long been an important supervisory priority. The successful reduction of NPEs by SIs over the past decade was supported by a common SSM-wide approach which included supervisory coverage expectations.[1] Up to now, LSIs in most countries participating in the SSM have not been subject to those expectations.
How does this initiative target the relevant risks? How does it compare with other ways of reducing or mitigating them?
Since supervisory coverage expectations for NPEs were first used within European banking supervision for larger banks, they have proven to be a transparent and effective tool and have contributed significantly to NPE reduction and risk mitigation. These expectations are not rigid rules, but rather provide a clear basis for a supervisory dialogue in which additional factors brought forward by the banks, backed by specific evidence, are assessed.
While complementary instruments like NPE reduction strategies and specialised workout processes developed by banks have also produced positive outcomes, smaller banks have faced greater challenges in their practical implementation due to factors like resource constraints and lack of investor demand for small-scale NPE sales. Against this background, European banking supervision considers that harmonised supervisory coverage expectations, targeted to the relevant LSIs via risk-based criteria, now offer a simple, tried-and-tested way of ensuring that risks related to NPEs are adequately addressed.
To which banks will this common supervisory approach apply?
The approach is risk-based and designed to ensure proportionality while avoiding undue distortive effects. In principle, it applies to all LSIs, but NCAs can exclude banks or cohorts of exposures where risks are assessed as low, or where applying the approach would lead to unwarranted differences in supervisory outcomes. More specifically, the Guideline includes the following conditions for the potential exclusion of LSIs from the scope of application:
- NPL ratio is below 5%
- NPEs in scope of the common supervisory approach constitute an insignificant share of the LSI’s total NPEs
- LSI is subject to an orderly wind-down process
- LSI is subject to an ongoing merger with, or acquisition by, another supervised entity
- LSI is a ”specialised debt restructurer” as defined in the CRR
- LSI is subject to specific and factual circumstances that, in the view of the relevant NCA, make the application of the common approach inappropriate
Based on these criteria, NCAs will assess annually whether a given LSI is subject to the common approach. If so, NCAs should ensure that potential coverage gaps identified under the common approach are addressed in quantitative terms during their Pillar 2 review, after duly considering the specific circumstances presented by the LSI.
What exposures are in scope? How does this relate to the deduction requirement for NPEs enshrined in the CRR?
The common supervisory approach applies to exposures that were originated prior to 26 April 2019 and therefore fall outside the scope of the deduction requirement for NPEs under Pillar 1. The level of the supervisory coverage expectations set out in the Guideline is quantitatively aligned with the coverage rules enshrined in the Pillar 1 deduction requirement. This ensures that all NPEs held by the LSIs in scope are subject to consistent coverage expectations once they reach a given vintage, irrespective of their date of origination. However, unlike the deduction requirement under CRR which applies automatically, the NCAs will assess the coverage of NPEs of LSIs on a case-by-case basis considering specificities of each individual bank. The Guideline does not substitute or supersede any applicable regulatory or accounting requirements.
How is this approach expected to affect the banks in scope?
While the final impact will depend on the outcome of NCAs’ supervisory dialogues with the identified banks, the impact of the common approach on LSIs is expected to be manageable. When developing the common approach, SSM supervisors conducted a detailed impact study to gauge its effects. This study concluded that the impact in terms of capital requirements will be overall manageable given that banks have made progress in reducing NPEs overall and have healthy capital levels bolstered by improved profitability over recent years. To provide banks with sufficient time to prepare, the common approach will be phased in gradually: the supervisory coverage expectations will only apply in full from 31 December 2028 onwards. For prior reporting periods, they are set at lower levels that will gradually increase year by year.
Does the common approach imply significant additional reporting?
NCAs will require LSIs in scope to submit dedicated annual reporting, which will be based on a concise core template. The latter is closely aligned with existing reporting for the CRR deduction requirement, which all banks under European banking supervision have been submitting as part of quarterly common reporting (COREP) since 2021. This alignment means that well-established concepts and calculations are used.
What are the roles of the ECB and the NCAs in implementing the common supervisory approach established by the draft Guideline?
The draft Guideline addresses NCAs in their role as direct supervisors of LSIs. NCAs have primary responsibility for reviewing the arrangements, processes, mechanisms and strategies implemented by LSIs to ensure sound management and coverage of their risks, including their provisioning policies and treatment of assets in terms of own funds requirements. The ECB promotes the consistent application of high supervisory standards in the execution of such reviews, in line with its broader responsibility for the effective and consistent functioning of the SSM as part of its oversight role. Within this framework, the ECB and the NCAs will collaborate in the implementation of the Guideline, for example through the exchange of information and benchmarking. Several features of the approach established by the draft Guideline provide NCAs with an appropriate degree of supervisory discretion, thereby ensuring operational feasibility in local contexts.
What are the next steps for the banks in scope once the draft Guideline has been adopted?
The LSIs in scope of the first annual application of the common supervisory approach will be informed by the respective NCAs on a timely basis and receive the relevant reporting templates and instructions.