Banks with high non-performing loans should set ambitious targets

Interview with Sharon Donnery, Deputy Governor of the Central Bank of Ireland and Chair of the ECB’s High Level Group on NPLs, published in Supervision Newsletter (Winter 2017) on 15 February 2017

The high level of non-performing loans (NPLs) in some European banks has been an issue of much interest and discussion for investors, analysts and supervisors alike. Sharon Donnery, Deputy Governor of the Central Bank of Ireland and Chair of the ECB’s High Level Group on NPLs, speaks about the task of providing guidance to banks to help them tackle their NPL portfolios in a prudent and sustainable way.

When will the final guide to banks on NPLs be published and what will the ECB’s follow-up work entail?

We are aiming to publish the final guidance to banks in spring 2017. This follows the initial publication of the draft guidance last year and an extensive public consultation process and public hearing. We are pleased to be able to bring such a comprehensive piece of work on a complex issue to a speedy conclusion given that the High Level Group was only established in 2015.

Deliberate and determined action is required. In the first instance, the banks themselves are responsible for implementing adequate strategies to manage their NPL portfolios. Some banks need to move faster to address their NPL problems. They need to work intensively to put in place credible and properly resourced plans to tackle this issue. Therefore, the guidance will work as a basis for the supervisory dialogue with individual banks. Our next steps include engaging with the Joint Supervisory Teams (JSTs) to ensure consistent implementation across the Banking Union. We will regularly track progress made by the banks on implementing the guidance. Furthermore, we aim to ensure that banks with high levels of NPLs will be subject to regular on-site inspections on this issue.

What is the purpose of the guidance to banks? Why is the guidance important for banks?

The purpose of the guidance is to bring a consistent approach to the supervision of banks with high levels of NPLs. It clearly sets out ECB Banking Supervision's expectations on NPL workout and resolution. The guidance follows the life cycle of NPL management, beginning with bank strategy, governance and operations, followed by forbearance treatment, NPL recognition, provisioning and write-off, and collateral valuation. Importantly, it requires banks to implement ambitious and realistic NPL reduction targets.

The guidance is important for banks because high levels of NPLs mean they must hold additional provisions against non-performing loans, thus lowering net income and reducing profitability. Furthermore, NPLs cause uncertainty as to banks’ actual financial position given the inherent judgemental nature of provisioning. This creates profit and loss volatility and vulnerability as provisions are typically connected to the value of the underlying collateral, which can fluctuate. These factors contribute to the cost of funding and negative or volatile investor sentiment. Finally, NPLs tie up bank capital and restrict their ability to undertake new lending. Therefore, the guidance is also of critical importance for the broader economy given that high levels of NPLs can constrain both credit growth and economic activity.

As the guide is not legally binding, what is meant by “banks are expected to apply the guidance”?

Even though the guidance is currently non-binding in nature, we expect the institutions to apply it in full, in line with the scale and severity of the NPL challenges they face. We want banks to manage this issue much more proactively. Banks will need to explain any deviations from the guidance and non-compliance may trigger supervisory measures. What this means in practice is that if supervisory judgement supported by benchmarks concludes that certain NPL strategies are not sufficiently ambitious or are not appropriately implemented, we will consider additional measures on a case-by-case basis. We already have the legal tools available to us if necessary, for example expectations can be turned into binding requirements by implementing them as part of the Supervisory Review and Evaluation Process (SREP). We also expect that market pressure will rise for banks to take action and reduce their stock of NPLs as fast as possible.

All banks will be treated according to the same rules, but of course we will apply the principle of proportionality. In other words, the intrusiveness with which we act will differ depending on the size of the NPL problem. As outlined in the guidance, we see that chapters on establishing an NPL strategy and governance and operations are probably more relevant for high-NPL banks, or for certain portfolios or for subsidiaries of banks that might have high levels of NPLs.

To avoid any potential issues of non-compliance, all significant institutions should thoroughly analyse any existing gaps with respect to the content of the guidance. They should then proactively seek a dialogue with their respective Joint Supervisory Teams to swiftly develop suitable action plans where needed and agree on areas where deviations can be reasonably explained and accepted. Compliance functions will play a key role in this process.

What is the extent of the problem in the euro area and how long will it take to solve it?

The extent of the problem is considerable for the euro area as a whole. However, the depth of the problem is quite heterogeneous across Member States. That is the reason banks need to take a portfolio-by-portfolio approach rather than using generic and general thresholds. In addition, our supervisory work will focus on this by taking a bank-by-bank approach.

We have made a good start in addressing this problem, but there is still much to do. It is important to stress that supervisory powers alone cannot solve this problem. Concerted action from all stakeholders, such as Member State governments, the Commission, the European Systemic Risk Board, and relevant EU fora is also needed to address this issue, including the underlying factors, over the coming years. This will ensure a deliberate and sustained reduction in NPLs.

We are cognisant that economic recovery is an important ingredient for addressing large-scale NPL issues, but it should also be noted that only sound banks that actively address their problems are able to ensure the adequate funding of the economy. The “wait-and-see” or “extend and pretend” approach we have too often observed in the past cannot, and via the guidance will not, continue.

How will the results of the NPL project fit into the regular supervisory assessment in the future?

The results of the guidance are already reflected in the daily work of the JSTs. In addition, we expect the guidance to be integrated fully into the SSM supervisory manual and the SREP in the near future. In essence, it will become business as usual for both banks and supervisors.

Do impediments and obstacles in legal and judicial systems at the national level inhibit the progress banks can make on dealing decisively with NPLs?

As shown in the stocktake report, a number of legal and judicial aspects still pose a considerable challenge for NPL workout and resolution. The stocktake report shows that lengthy legal procedures and insufficient court capacity significantly inhibit banks’ ability to quickly reduce their NPL stock. In this regard, we urge Member States to consider implementing policies to improve the efficiency of their legal and judicial systems.

However, the current state of the legal and judicial systems should not justify a lack of action on the side of banks. We therefore expect banks with high NPLs to set ambitious targets for working out their impaired assets, in line with the guidance.

By when will you require bank to reduce their NPLs to specific percentages? Will the ECB set a maximum NPL percentage or will this be done at peer group level?

The guidance is much broader than the specific targets. It aims to ensure that banks have the operational capacity to work out NPLs. We have explicitly decided not to set a generic NPL threshold for all banks across the euro area. Establishing a generic threshold for NPL reduction would inevitably have resulted in a non-realistic target for a number of banks or would have not been very ambitious, if adapted to suit them all. Moreover, setting a generic NPL reduction strategy would not have allowed supervisors to take into account the existing disparity in the starting points of banks and the specificities of the environment in which they operate.

Rather, individual banks are requested to set ambitious and credible portfolio-specific targets, after having conducted an assessment of the full context in which they operate. These targets will then be embedded in a comprehensive strategy that also includes macro assumptions, targets and monitoring indicators, foreclosed assets, vintages, etc. In turn, we expect the NPL strategies to be fully embedded in banks’ forward-looking business model projections and analysis.

However, allowing for specific targets does not mean that we won’t evaluate banks against their peers via benchmarking. Peer analysis is a critical component and a competitive advantage of the ECB’s Banking Supervision. We will be able to use our monitoring tools to drill down into the strategies and compare granular sets of indicators to obtain a homogenous view on NPL targets. Certain banks will inevitably be more advanced in dealing with specific issues (for example forbearance) than others. Some banks will inevitably be slower. Banks have different issues, and therefore will have different recommendations, and if necessary different remediation plans. But I am optimistic.