The European Banking Authority has published its Guidelines on loan origination and monitoring with focus on the development of robust and prudent standards to ensure the proper assessment of the newly originated loans.
Over the past financial crises, it has been observed that NPLs can reach levels high enough to become a real problem for banks’ business activities, financial stability and lending to the real economy. The EU, along with the supervisory authorities have set as a top priority on the agenda the quality of the credit underwriting and monitoring process. The COVID-19 pandemic enhanced the necessity of maintaining good credit risk management and monitoring standards to support lending to the economy.
The increased scrutiny to credit underwriting and monitoring can be interpreted as part of the wider response to tackle the high-level volumes of NPEs at EU level, and a shift towards more pro-active actions in order to prevent new NPE flows in the future with a focus on new production.
In fact, in accordance with SSM priorities and within the framework of the EU Council’s Action Plan to attenuate the NPEs’ exposure (Figure 1), the EBA published on 29 May 2020 the final “Guidelines on loan origination and monitoring”.
The main difference from the previous published consultation papers is the fact that those guidelines have been developed in order to ensure that institutions have prudential loan origination standards in place, in order to prevent newly originated performing loans from becoming non-performing in the future. Moreover, these guidelines reflect recent supervisory priorities and policy developments related to credit granting, including the integration of Environmental, Social & Governance (ESG) -related factors, anti-money laundering and countering terrorist financing, technology-based innovation and the imminent effects of the COVID-19 pandemic.
The scope of these guidelines is to apply to all existing loans of the financial institutions, their refinancing and their newly originated loans.
Taking into consideration the need for banks to focus on core operations today and to strengthen future lending and the unprecedented time of the COVID-19 pandemic, a three-phase implementation period is being offered by the EBA, covering a period up to June 2024. As depicted in Figure 2, the guidelines will apply from 30 June 2021.
The EBA final guidelines on loan origination and monitoring aim to improve the financial stability and resilience of the EU financial system. For achieving this, EBA focus on the below objectives:
In line with the Supervisory priorities 2020, the EBA guidelines highlight the regulatory expectations on the credit risk-taking, management and monitoring. Strong governance, internal controls and mechanisms on the credit risk-taking, management and monitoring are just a few examples of those expectations.
Loan Origination Procedure
Key components of the reporting template requested by the ECB are higher granularity of data, calculation of a broad set of Key Risk Indicators (KRIs) and portfolio statistics based on the IFRS 9 framework. More analytically:
Key Risk Indicators
Rating and Pool Stats
Risk and business strategy
Loan Origination and Credit Approval Process
Linkage with IFRS 9 requirements
The introduction of IFRS 9 and Expected Credit Loss (ECL) model revealed the need for higher granularity on credit risk data as well as business implications on lending practices including pricing considerations, product design, and monitoring of credit risk.
The introduction of specific metrics based on IFRS 9 – Point in Time – parameters, as required by the ECB’s credit underwriting exercise, might change the perception over optimal lending growth and overall strategy depending on priorities set and time horizon. Advantages and disadvantages of IFRS 9 PiT parameters must be taken into consideration.
One the one hand, standard risk costs and equity costs are more precise when they move with an expected credit loss model over the next 12m, more likely resulting in an accurate estimate of expected and unexpected losses. Moreover, the use of IFRS 9 PDs will enhance viability and foster common understanding among the organization since risk and business will have a single point of reference when discussing credit risk.
One the other hand, the loan approval process may decline or drive away viable business, for example, higher risk profile clients who have a long-standing relationship with the Bank and may overall be a steady source of risk-adjusted return. Furthermore, standard risk and equity costs will become more volatile based on IFRS 9 PiT risk metrics, creating unpredictability and uncertainty in the lending strategy.
Action plan for decision makers
In this evolving landscape, decision makers should act timely and strategically by considering not only how to meet regulatory requirements but also how to address the business implications behind them in order to achieve possible synergies with other initiatives currently in place and take advantage over their peers. Proposed steps for an accurate and proper implementation of the guidelines include but are not limited to the following:
1. Assessment of current state and gap analysis:
2. Prioritisation of actions for remediation:
3. Business & other functions support:
Both the EBA’s guidelines and ECB’s review on underwriting standards represent a fundamental shift towards an era where the focus is being put back to the very core activity of commercial Banking business (i.e. lending) and as such this can be viewed as an opportunity for Greek Banks to start changing their agendas back again to the re-assessment of their business models and lending strategies for the first time after the financial crisis. As it is evident from the 2020 SSM priorities published on 7 October 2019, as well as from the EBA Guidelines issued to address gaps in reporting data and public information in the context of COVID-19, regulatory focus is expected to remain high on the area for next years in order to strengthen future resilience and as such timely and persuasive responses from Banking institutions are vital in order to get things right at the first time and ensure that sound mechanisms are in place in order to prevent problems in the future.
Spyridon is the Partner responsible for the development and delivery of Financial Risk Management (FRM) propositions. He has extensive professional experience of over 14 years in the Financial Services sector which includes a significant number of consulting and advisory projects across all three lines of defense plus statutory audit. Indicative recent experience and Engagement Leader includes large scale advisory projects in the context of C&E risks integration into risk management frameworks, credit risk modelling and validation at A-IRB Banks in Greece and abroad, IFRS 9 implementation, Capital Management and Stress Testing support, as well as management consulting projects focusing on regulatory and strategic issues within the Banking sector. He holds an M.Sc. degree in International Accounting and Finance from the University of Strathclyde Business School, UK and is a member of the Association of Certified Chartered Accountants (ACCA) in the UK. He is a member of Deloitte’s Banking Union Center in Frankfurt (BUCF), as well as, Basel III, IFRS 9, and Capital Management & Stress Testing Working Groups at Deloitte North South Europe (NSE).
Chara joined Deloitte’s Financial Risk Management as a Manager after spending more than 7 years at Deloitte UK in London. Chara specializes in Credit Risk Transformation including Target Operating Model (TOM) and Automation of Credit Underwriting Processes. Other areas of expertise include IRB assessment, IFRS 9 key processes design and process flows optimization, and Risk Appetite Framework.