Addressing future non-performing loans

In parts of Europe, banks still carry high volumes of non-performing loans (NPLs) on their balance sheets. That is a problem.

Balance sheets that are congested by non-performing loans are a huge burden for banks. Non-performing loans are a drag on profits; they might hurt trust in the banks; and they keep banks from lending to the economy.

Against this background, addressing asset quality has been one of the key priorities of ECB Banking Supervision since its inception. The approach adopted by supervisors under the Single Supervisory Mechanism (SSM) is a genuinely European one that is designed to achieve a level playing field across the banking union.

As a first step, the ECB’s qualitative NPL guidance was published in March 2017. In line with this guidance, which sets out supervisory expectations, banks were encouraged to implement their own ambitious, yet realistic, strategies and operational plans to tackle and reduce NPLs. The plans are, however, subject to scrutiny in the context of the supervisory dialogue to ensure banks are making purposeful and determined progress on dealing with NPLs. The supervisory initiatives have started to bear fruit. Over the last year considerable efforts have been made by significant institutions to reduce the stock of NPLs across euro area Member States. This has led to a decrease of €141.76 billion between the second quarter of 2016 and the same period in 2017, bringing the total down to €794.91 billion. However, in many cases further work is required.

In line with its mandate, the ECB applies a forward-looking approach in proactively addressing risks, while also learning from past experience. Since publishing the guidance to banks on NPLs, European banking supervision has continued to work on further measures to address the NPL issue. The draft addendum to the NPL guidance, which was published for consultation on 4 October, aims to foster more timely provisioning practice for new NPLs from 2018 onwards in order to avoid a renewed build-up of NPLs in the future.

The draft provides credit institutions with the ECB’s supervisory expectations for addressing new NPLs and aims to provide transparency and a level playing field. More precisely, the general expectation is that unsecured loans should be 100% covered by prudential provisioning after 2 years of being classified as non-performing. For secured loans, the 100% coverage should be in place after 7 years.

The addendum also clarifies the ECB’s considerations when assessing the levels of prudential provisions expected for non-performing exposures. A bank’s accounting allowances serve as a starting point for supervisory dialogue in determining whether these allowances adequately cover expected credit risk losses. The accounting allowances are then compared against the supervisory expectations set out in the draft addendum. Unlike Pillar 1 rules, which trigger automatic actions, these supervisory expectations are not binding requirements.

During the supervisory dialogue banks are expected to provide evidence to explain any deviations from the general supervisory expectations. The ECB will then consider – on a case-by-case basis and after a thorough analysis – whether a bank-specific supervisory measure is needed. This process does not include any automaticity. The mechanism is nothing new. Since its inception, ECB Banking Supervision has clarified its supervisory expectations on various topics.

The draft addendum is consistent with the current regulatory framework. In the interest of transparency at all levels and of attaining a level playing field in euro area Member States, it clarifies what the ECB expects from banks as they comply with existing provisions.

The draft addendum is also complementary to the NPL action plan of the European Commission’s ECOFIN Council. The Council has stressed that incentives for banks to deal with NPLs should be enhanced, and the consultation goes precisely in that direction. Moreover, the NPL report by the Financial Services Committee (FSC) of the Council of the European Union and the European Commission’s Report on the Single Supervisory Mechanism, published on 11 October 2017, both encourage the ECB, where necessary, to apply the relevant Pillar 2 measures.

In the interest of transparency and to gather input from stakeholders the ECB has launched a public consultation on the draft addendum. The consultation will run until 8 December 2017 and before finalising the draft addendum the ECB will carefully consider all comments received.