Posted: 05 Jun. 2020 7 min. read

Credit Underwriting & Monitoring

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”.  

Figure 1: Framework of the EU Council’s Action Plan
Figure 1: Framework of the EU Council’s Action Plan

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.

Figure 2: EBA Guidelines - Three-Phase Implementation Period
Figure 2: EBA Guidelines - Three-Phase Implementation Period

Main objectives of EBA Guidelines on loan origination and monitoring

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:

  • Adoption from the Bank of robust and practical approaches to credit risk taking, management & monitoring.
  • Preparation for the upcoming challenges in the EU banking sector (Sustainability, Fintech etc.)
  • Improvement of profitability ensuring that the loans that institutions newly originate remain of high quality while respecting and protecting the interests of consumers.
Figure 3: EBA Guidelines Main Objectives
Figure 3: EBA Guidelines Main Objectives

EBA guidelines on loan origination and monitoring

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.

More specifically:

Governance

  • Define Credit Risk Appetite Framework linked to the credit risk strategy and Bank’s business model.
  • Set out criteria for credit lending specific to product type/client segments.
  • State the supervisory expectations for institutions, when their lending activities involve leveraged transactions, technology-enabled innovations, use of automated models in creditworthiness assessments and credit decision-making (Fintech), an approach to ESG factors and environmentally sustainable lending, and their data infrastructure.
  • Set out of the anti-money laundering (AML) and countering the financing of terrorism (CFT) requirements in the context of credit granting.
  • Define the credit decision making process, highlighting the principle of independence between different (e.g. business and risk) functions in decision-making.
  • Set out the requirements for robust and effective credit risk management and internal control frameworks, as part of the institutions’ overall risk management and control frameworks.
  • Set out general remuneration requirements to credit risk granting, with a view to mitigating excessive risk taking in lending activities.

Loan Origination Procedure

  • Specify the handling and use of documentation of information and data from borrowers for the creditworthiness assessment.
  • Specify the assessment of borrowers’ creditworthiness. An effective assessment of a borrower’s creditworthiness at the point of loan origination is essential, both from the institution and consumers’ protection perspective; for instance, a borrower’s failure to meet their financial obligation, could affect overall the financial stability. Hence, the EBA objectives include both prudential and financial stability as well as consumer protection.  Given this fact, it is ensured that there is a comprehensive set of guidelines and requirements covering the creditworthiness assessment from prudential and consumer protection angles, across different types of institutions, asset classes and loan products.
  • Set out requirements for credit decisions and loan agreement proving specific requirements for lending to micro & small enterprises, medium-sized and large enterprises, including both secured and unsecured lending.
Figure 4: Interaction of prudential and consumer protection framework
Figure 4: Interaction of prudential and consumer protection framework

Pricing

  • Align pricing framework to the credit risk appetite and business strategies, including expected overall profitability as well as Bank’s definition of Significant Increase in Credit Risk (SICR).
  • Account for risk-adjusted performance measures, such as RORAC, RAROC, EVA, RORWA, ROTA, driven by Bank’s Risk Appetite.

Monitoring Framework

  • Manage and monitor credit risk exposures in line with Bank’s credit risk appetite, strategy, policies and procedures.
  • Develop early warning triggers and introduce specific key indicators at a cluster customer level.

Collateral Valuation

  • Detailed guidance on setting out the approach to the collateral evaluation from origination to the end of valuation (reference to both movable and immovable property).
  • Set out expectations for independent valuers and conditions that allow advanced statistical models to be used by institutions for the valuation, monitoring and revaluation of various forms of immovable property collateral.
Table 1: Use of advanced statistical models for the purpose of valuation of immovable property collateral (Source EBA)

Impact Analysis

Figure 5: Indicative impact areas of the EBA guidelines
Figure 5: Indicative impact areas of the EBA guidelines

ECB’s review on credit underwriting

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:

Coverage

  • Granularity of data for both existing and new loans from 2016 to 2018.
  • Granularity of data by asset class as follows: RRE, CRE, SME, Corporates, Large Corporate, Consumer credit.

Key Risk Indicators

  • Collection and aggregation of quantitative and qualitative key risk metrics such as: Loan to Value (LTV), Loan to Income (LTI), Loan Service to Income (LSTI), Debt Service to Income (DSTI), Debt Service Coverage Ratio, (DSCR).

Rating and Pool Stats

  • Reporting IFRS 9 credit risk parameters; classification of business volumes based on 12m PDs and on LGD, metrics definitions across a number of different portfolios and asset classes; and linkage of PDs to pricing information: Probability of Default (PD), Exposure at Default (EAD), Loss Given Default (LGD), Pricing.
Figure 6: Set of quantitative and qualitative KRIs request by European Central Bank
Figure 6: Set of quantitative and qualitative KRIs request by European Central Bank

Business implications

Risk and business strategy

  • The Bank should ensure that its credit risk strategy is in line with the overall Bank’s risk strategy and with the institution’s Risk Appetite Framework, the capital and liquidity planning, their  internal capital adequacy assessment process (ICAAP) and their internal liquidity adequacy assessment process (ILAAP).
  • The institution’s credit risk appetite should specify the scope and focus of the institution’s credit risk strategy, the composition of the credit portfolio through a combination of backward-looking and forward-looking indicators. These indicators include Banks’ concentration, and diversification objectives in relation to business lines, geographies, economic sectors and products. Credit risk appetite should be cascaded down to the organization’s business lines. A mix of top-down and bottom-up approach is appropriate in order to define credit risk appetite and provide the rationale for inclusion or exclusion of risks and risk classes into the Risk Appetite Framework.
  • The institution should develop a credit risk culture that will be part of the overall risk culture through specific developed policies, continued communication and staff trainings.
  • The Bank’s credit risk policies and procedures should promote a proactive approach to monitoring credit quality, identifying deteriorating credit early and managing the overall credit quality and associated risk profile of the portfolio, including through new credit granting activities. Credit risk policies and procedures should cover all lending activities, asset classes, client segments, products and specific credit facilities, credit risk management practices, and associated responsibilities and controls.
  • The Bank’s credit risk policies and procedures should be also align with the EBA’s supervisory expectations for institutions, when their lending activities involve leveraged transactions, technology-enabled innovations, use of automated models in creditworthiness assessments and credit decision-making, an approach to ESG factors and environmentally sustainable lending, and their data infrastructure.
Figure 7: Business Implication – Risk & Business Strategy
Figure 7: Business Implication – Risk & Business Strategy

Loan Origination and Credit Approval Process

  • Granularity of quantitative and qualitative information, including but not limited to affordability assessment and ESG factors, as well as their proper management and verification of these are required for the purposes of creditworthiness assessment.
  • Use of automated models in the creditworthiness assessment and credit decision-making processes in a way that is appropriate to the size, nature and complexity of the credit facility and the types of borrowers.

Pricing Considerations

  • Risk, operating and capital costs are main components to be considered in order to develop and implement a comprehensive pricing framework.
  • Lifetime effects, expected loss, profit expectations, provisions and RWA calculations should be considered as part of your pricing methodology in order to drive greater long term profitability.
Figure 8: Pricing through risk adjustment measures
Figure 8: Pricing through risk adjustment measures

Monitoring

  • Back-tested leading metrics, covenant compliance and other monitoring activities will result in the embedding of early warning indicators in processes, building the link between the ongoing monitoring and early detection of loans with deteriorating credit quality.
Figure 9: Monitoring process and early warning indicators
Figure 9: Monitoring process and early warning indicators

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.

Figure 10: Indicative example of Bank A shifting lending focus to large revenue, high ROE, low RWA clients
Figure 10: Indicative example of Bank A shifting lending focus to large revenue, high ROE, low RWA clients

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:

  • Identification of the main areas of analysis with a focus on governance, strategies, processes, technology / innovation (e.g FinTech) and systems.
  • Group areas for assessment in line with the regulatory guidelines.
  • Gap analysis between ‘as-is’ state and regulatory requirements.

2.       Prioritisation of actions for remediation:

  • Prioritisation of identified gaps based on complexity and priority.
  • Identification of actions set out in guidelines for the design and implementation of the processes, to ensure the requirements alignment and credit processes optimization.

3.    Business & other functions support:

  • Data Infrastructure solution requirements gathering based on the gap analysis undertaken to support the estimation of cost & effort required.
  • User requirements gathering based on the gap analysis undertaken to support the estimation of cost & effort required for business implementation.
  • Identification of the business functions to be involved in the implementation.

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.  

Get in touch

Spyridon Bisisidis

Spyridon Bisisidis

Principal

Spyridon has extensive professional experience of over 10 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. Recent experience as team leader includes large scale advisory projects in the context of IFRS 9 implementation at A-IRB Banks in Greece and abroad, participation at statutory audits of systemically important financial institutions as impairment methodologies subject matter expert, IRB and IFRS 9 credit risk models development and validation as well as Management Consulting Projects focusing on regulatory and strategic issues.

Chara Stamou

Chara Stamou

Manager

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.