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COVID-19: gaps in credit risk management identified

19 May 2021

COVID-19: gaps in credit risk management identified

As part of its coordinated coronavirus (COVID-19) credit risk strategy, ECB Banking Supervision launched a number of complementary projects to get a full picture of how banks are measuring and managing credit risk during the pandemic. This is the first article in our related series.

 

“Unlike in the 2008 financial crisis, banks are not the source of the problem this time. But we need to ensure that they can be part of the solution.” This statement by Supervisory Board Chair Andrea Enria is as true now as it was when the COVID-19 pandemic first struck. Banks can only be part of the solution if they have enough capital to absorb losses, but an increase in credit risk could put pressure on their capital positions. Such an increase could arise from the uncertain economic situation caused by the pandemic, which could leave debtors struggling to pay back their loans. To ensure a sustained recovery from the pandemic, banks need to keep lending to the economy and provide support to viable distressed borrowers as soon as they show any signs of financial difficulty. Clogging banks’ balance sheets with high amounts of non-performing loans would undermine the economic recovery, so proactive and strong credit risk management practices are vital.

ECB Banking Supervision has taken a number of actions to ensure the banking system remains resilient to pandemic-induced shocks. As part of this effort, the Joint Supervisory Teams examined whether banks are operationally prepared to deal with an increase of distressed debtors by assessing their compliance with the supervisory expectations communicated to banks in July 2020. Initially, supervisors carefully assessed critical elements of banks’ credit risk management, including their IT infrastructure, management reporting, risk segmentation, early warning systems and strategy, as well as their resources and expertise. Based on the outcome of the initial review, around 30 banks were selected for a follow-up exercise which scrutinised further potential gaps in their compliance with the July guidance. ECB Banking Supervision found that not all banks have sufficiently strengthened their credit risk management to face the expected increase in this risk. The following issues are of particular note:

  1. A strong data infrastructure is vital as it underpins a bank’s ability to understand the risks it is facing. Data should be readily available and easily aggregated. But some banks struggle with data aggregation, which is hindering their ability to obtain a comprehensive view of credit risk. These weaknesses also result in poor management information, which in turn makes it difficult for executives to make informed decisions.
  2. Banks should have a strategy in place to engage with borrowers as soon as they show signs of distress, and any issues should be adequately addressed. Good strategies can only be developed if banks are able to differentiate between viable, non-viable, and viable but distressed debtors at a granular level, grouping borrowers with similar characteristics and resolving them in a comparable way. However, not all banks were able to achieve adequate borrower segmentation. In some cases, this led to the underlying risk not being sufficiently detailed and addressed in the strategy. In other cases, banks did not provide a realistic assessment of the operating environment, which would weaken any strategy and, in turn, limit the amount a bank could recover should a large number of borrowers ultimately default.
  3. Borrowers in distress should be identified early so that viable borrowers can be provided with sustainable solutions in a timely manner. This would partly mitigate the economic impact of the pandemic for debtors and banks alike. To achieve this, banks need an effective early warning system (EWS) that monitors borrower-specific signs of distress. This would need to be supported by sound borrower segmentation, as explained above. Several banks established good practices in this regard: they proactively prioritised and reached out to their riskier borrowers and updated their EWS, tailoring it to the current crisis, for example by introducing new indicators. They also report frequently to management bodies and committees. However, some other banks did not update their systems to reflect the current situation or did not adapt their approach to address the impact of various support measures provided to borrowers. For example, when moratoria (i.e. temporary suspensions of capital or interest payments) are granted to borrowers, some indicators may temporarily suggest that a borrower has improved their financial position because the loan shows that all required payments are up to date. However, the borrower will need to repay the suspended instalments at a later stage. Additionally, the money “saved” from the temporary suspension of payments may temporarily improve the cash position of the borrower in their current or savings accounts. In this case, banks should review their EWSs to identify those indicators that might be presenting a misleading picture of a borrower’s financial position and adjust them if necessary. Banks that had failed to implement such updates appeared to be slower to identify those borrowers that are in distress and thus potentially less likely to pay.
  4. Banks need to ensure that they have forbearance procedures that are clear, detailed and fit for purpose in the current environment. Banks can only appropriately measure the risks they face if they classify distressed borrowers correctly. Ineffective procedures could result in banks underestimating the risks. The biggest challenge in this respect is how banks can determine if a borrower has (or will soon have) financial difficulties. While some banks had updated their procedures or policies to reflect COVID-19 risks, others had documentation that was outdated or was not sufficiently detailed.
  5. Sufficient resources and the right expertise are essential for effective risk management. But to ensure adequate resources, banks need to have realistic projections of how credit risk will evolve over a meaningful time frame. While banks have made progress in this regard, a significant number of banks lacked a monitoring framework to ensure that resources are being used effectively. A monitoring framework is important for banks to be able to identify any increased strain on resources so that they can address issues quickly.

In the light of these findings and the continued economic uncertainty caused by the COVID-19 pandemic, ECB Banking Supervision expects banks to continue to carefully monitor how the credit risk situation develops. In particular, banks should maintain a comprehensive toolkit to effectively manage distressed debtors as early as possible and provide financial support to viable businesses that may have come under temporary stress during the pandemic. The Joint Supervisory Teams will continue to monitor banks’ implementation of the necessary remedial actions to ensure that the supervisory expectations are met.

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