Minimum provisioning requirements for NPL

In spring 2018, news on prudential provisioning backstops for non-performing loans or exposures snowballed (the terms NPLs and NPEs are used synonymously). The point of departure was the draft of an addendum to the ECB guidance to banks on non-performing loans in October 2017 followed by the EU Commission’s consultation document a month later.

In March 2018, European banks were then confronted with fleshing out the measures discussed within a short space of time. The ECB finalised its addendum to the NPL guidance and the EU Commission published the relevant proposed legislations. Although the majority of the regulatory publications initially looks convoluted, the fundamental characteristics of the EU Commission and ECB’s measures are coherent. The purpose of the backstops is to ensure that banks make adequate provisioning for NPLs in order to avoid deductions from their common equity tier 1 capital (CET1).

EBA report and EU Commission’s package of measures

The European Banking Authority (EBA) kicked off the wave of publications with the EBA Report on Statutory Prudential Backstops on 14 March 2018 as a response to the initial draft by the EU Commission. The EBA advocates using the prudential provisioning backstops for NPLs as required by the regulatory authorities and presents a detailed summary and analysis of the method suggested.

The following components are quoted as suitable for fulfilling the minimum requirements for provisioning:

1. Specific credit risk adjustments,
2. Additional value adjustments pursuant to article 34 and 110 of the CRR,
3. Other own funds reductions,
4. For banks calculating risk-weighted exposure amounts based on the Internal Ratings Based Approach (IRBA): negative amounts resulting from the calculation of the expected losses as stated in articles 158 and 159 CRR

If the total of the components stated is lower than the minimum coverage requirements, banks have to deduct the difference from their common equity tier 1 capital.

According to the EU Commission drafts and EBA report, establishing the minimum coverage requirements can either be achieved via the deduction approach (option 1 no scalar factor [baseline], option 2a with a linear or option 2b with a progressive scalar factor) or the haircut approach (option 3). Full provisioning must be created as regards all approaches for unsecured NPEs after two and for secured NPEs after six to eight years, whereby full provisioning in option 1 must be created at the relevant juncture (cliff effects) and in options 2a/2b so that it gradually increases until it reaches the full amount. For secured NPEs, the haircut approach distinguishes between the minimum coverage requirements depending on credit protection (e.g. financial collateral, immovable property) as well as the number of years in default (vintage). In addition to an initial haircut level, further haircut levels are added for each year in arrears until the full provisioning is achieved after six to eight years.

On 14 March, the EU Commission also published a four-part package of measures to reduce NPLs in the banking sector, for instance with the publication of the draft for CRR amendments to introduce the prudential provisioning backstops explained above.

The actual amendment proposals are in line with the prudential provisioning backstops defined in the consultation document and the principles of the prudential provisioning backstops prepared by the EBA in its report and are to apply to new loans or ones whose exposure has been exposure enhancing modified after 14 March 2018. Based on the results of the impact study, the deduction approach with progressive scalar factor (option 2b) has transpired to be a good way of determining the minimum coverage requirements. Compared with option 1, no scalar factor (baseline), there are no cliff effects. The progressive scalar factor also makes it easier for banks to enforce their credit protection during the first five years or recover loans in comparison with a linear scalar factor (option 2a). Compared with the haircut approach (option 3), the preferred approach is now considered less complex and time-consuming in operational terms. The new article 47c in the CRR outlines the calculation of the sum to subtract from the common equity tier 1 capital by comparing the minimum coverage requirements (listing the multiplication factors to be applied for unsecured and secured parts of the NPEs in each case) and the components available for fulfilling provisioning.

Furthermore, article 47 c CRR-E empowers the EBA to analyse market practices for secured NPEs and publish guidance on specifying a general method for the regulatory measurement of approved funded or unfunded credit protection in particular regarding assumptions on recoverability and enforceability.

Final addendum to the ECB’s NPL guidance

On 15 March, the ECB published its final addendum to the NPL guidance in order, on the one hand, to specify the ECB’s expectations regarding the level of provisioning on the part of the banks and, on the other, to create a basis for a dialogue between the banks and the Joint Supervisory Team (JST). The regulations apply to the NPLs that were newly classified based on the EBA definition after 1 April 2018. In terms of the quantitative requirements of provisioning, the ECB defines annual NPE periods of time (vintage), differentiates between partially or fully secured and unsecured exposures and takes into account immovable property collateral as well as other eligible collateral and credit risk protection based on section 3, title II, chapter 3 and 4 of the CRR.

Similarly to the EU Commission’s proposal, full provisioning for unsecured NPEs must be created after two and secured NPES after seven years. In the case of secured NPEs, provisioning that increases linearly must be provided for from year three to avoid cliff effects.

The specifications from the ECB addendum on the NPL guidance are directed at significant banks directly monitored by the ECB. They don’t have any legislative force, but sanctions for non-compliance can be applied in the SREP process (pillar 2). On the other hand, the CRR amendments proposed (pillar 1) are legally binding once they come into force for all banks operating in the EU and could accelerate the introduction of minimum requirements for NPL provisioning. Whether the simultaneous initiatives by the various institutions are expedient is questionable - any different regulations might cause confusion on the market.

However, the implementation of the new regulations will definitely require complex implementation measures. Banks with high levels of NPLs in particular could be confronted by major challenges due to the new requirements. For banks facing high costs of provisioning due to these measures, the EU Commission is encouraging the development of the secondary market for NPLs as part of its four-part package of measures (cf. draft of guidance for loan providers, loan purchasers) and accelerating out-of-court realisation of collateral.