Forbearance: banks need to gear up

17 May 2023

As part of its supervisory priorities, the ECB began carrying out in-depth assessments of banks’ forbearance processes over the past year. Forbearance involves granting concessions to borrowers who are unlikely to be able to repay their loans under the current terms and conditions. Forbearance measures can take the form of refinancing or restructuring the loan, or modifying the terms and conditions (including the interest rate and maturity). Such measures should be flagged as forbearance regardless of whether the financial difficulties are structural, such as solvency, or temporary, such as liquidity constraints.

Forbearance measures aim to return borrowers to a sustainable repayment path. Therefore, banks’ forbearance processes should clearly focus on providing sustainable solutions to viable distressed clients. Consecutive non-sustainable solutions or measures targeting non-viable debtors should be avoided as they only delay taking appropriate action and ultimately lead to higher-than-necessary losses for banks and the economy. In 2017 the ECB published its “Guidance to banks on non-performing loans” which includes supervisory expectations on the management of forborne exposures. Similar provisions were communicated in 2018 by the European Banking Authority (EBA) in its “Guidelines on management of non-performing and forborne exposures”. These expectations were reiterated in the two letters sent to banks in July and December 2020.

The ECB’s most recent forbearance analyses focused particularly on risk management aspects and banks’ preparedness for dealing with an increase in distressed debtors and refinancing risk. The analyses have revealed that banks need to improve three areas in particular: how they identify a client in financial difficulties, how they ensure that clients are granted the most appropriate measures, and how they monitor forbearance measures, both at individual and portfolio level.

First, banks can only properly identify those clients facing financial difficulties by checking all modification or refinancing requests for signs of financial distress. They need to ensure this analysis is performed consistently and proactively, based on clear quantitative and qualitative criteria and building on effective early warning systems.

Second, the processes for granting forbearance should ensure that clients are granted only measures that are sustainable and the most appropriate, resulting in maximum recovery values for the banks. Our analyses show this is not always the case and improvements are necessary. In particular, the following elements are essential yet often missing:

• Banks should check whether the customer faces financial difficulties and, if so, investigate their root cause before granting any forbearance measure. This would also ensure that the assessment and approval of forbearance measures occurs in line with forbearance policies and not through business-as-usual processes.
• Banks should maintain a complete forbearance toolkit that describes the different available measures and the circumstances in which each of them should be used, considering both the portfolio and root cause of the financial distress.
• To ensure that clients can repay the loan under the new terms and conditions, affordability assessments should consider the client’s projected financial situation under different scenarios and also the payment schedule of potential measures.
• Further, banks should establish robust processes for choosing between the available measures included in their toolkit, such as decision trees for less complex exposures and comparing the net present value of available options.

Third, the supervisory review revealed that banks’ processes for the regular and enhanced monitoring of forborne exposures should be improved so that banks can proactively and promptly react if the client does not meet the forbearance conditions or if the client’s situation deteriorates further than initially assumed when granting the measure. This monitoring needs to be based on client-specific targets and milestones. Banks also need to establish a regular granular monitoring of the effectiveness and efficiency of the forbearance processes which should feed into the regular update of their forbearance policies and procedures. In this way banks can ensure that any inefficiencies identified are addressed in a timely manner and recovery values remain at maximum.

Forbearance is about much more than identifying forborne exposures for regulatory purposes – it is an integral part of credit risk management. In economically favourable times, suboptimal forbearance processes might not produce significant negative consequences. However, in the current economic environment, characterised by inflationary pressures, rising interest rates and an uncertain outlook, it is essential that banks prepare their processes for a potential increase in distressed debt and refinancing risk. Effective forbearance frameworks and efficient processes will not only support viable distressed debtors, they will also shield both banks and the economy from higher-than-necessary losses.