Non-performing exposures and forbearance

Financial resilience during stressed times

The 2008 financial crisis resulted in an increase in non-performing exposures (NPEs) on bank balance sheets. Regulators responded by introducing stricter rules and guidelines for allowed exposure. As a result, banks have to increase their capital when NPEs rise. But this, in turn, reduces their liquidity. The Dutch government made emergency funding available for businesses facing financial problems during the pandemic. But this funding has now come to an end and the debts built up over the past two years mean businesses’ financial resilience has become even more critical. The challenge for banks is to continue providing financial support, while minimising non-performing exposures. It is therefore vital to understand how non-performing loans are defined and calculated, and the various nuances.

This blog outlines the various options available within the realm of performing and non-performing loans (NPLs) and briefly explains the difficulties banks face when determining and structuring these loans.

Eight categories of performing and non-performing exposures

Regarding loans and obligors, a few concepts and definitions first need to be clarified:

Performing - A loan is performing if there is no default trigger and the counterparty is less than 30 days past due on its payments.

Non-performing - A loan is non-performing if a counterparty fails to meet agreed repayments for more than 90 days or is deemed unlikely to pay. The few exceptions to this rule are discussed below (see probation period).

Past due - Assets qualify as past due if a counterparty fails to make a contractually agreed payment.

Forbearance – This status applies if a counterparty’s financial difficulties lead to the loan being refinanced or to an existing agreement being revised.

Watchlist - A counterparty is placed on the watchlist if increased credit risk exposure requires action to avoid default status.

Default – A counterparty is considered to be in default if it is more than 90 days past due on its payments or is deemed unlikely to pay.

Loans are assessed on this basis and assigned to one of the eight categories shown in figure 1:
1 – Solely a performing counterparty;
2 – A loan that is performing, but also forborne;
3 – A loan that is performing and on the watchlist;
4 – A loan that is performing, forborne and on the watchlist;
5 – A non-performing loan that is forborne and on the watchlist, but not in default;
6 – A non-performing loan that is on the watchlist, but not in default;
7 – A non-performing loan that is forborne, on the watchlist and in default;
8 – A non-performing loan that is on the watchlist and in default.

Moving between categories

Loans are divided into categories, based, for example, on their payment history and credit status. However, these categories are not static, and loans may move between categories. Moving from performing to non-performing happens when repayments are material and past due for a specific period. Moving back to performing is also possible, but any such moves are subject to rules and conditions (see probation period below).

As soon as a performing loan involves forbearance measures, a minimum 2-year probation period starts. If, by then, the contract is (a) performing and (b) no more than 30 days past due, and (c) regular significant payments are being made, the contract ceases to be forborne. Visually, this means moving from category 1 or 3 to 2 or 4, and back.

Once a loan is non-performing, but no forbearance measures apply, it can return to performing status when the exposure is no longer in default and the obligor’s credit situation has improved to such an extent that full repayment is plausible. In the event, however, of forbearance measures, additional requirements apply before the loan can return to performing status. These include: (a) no additional default triggers, (b) no past-due amounts, and (c) at least one year since the forbearance measure was applied or the loan classified as non-performing. The period referred to in (c) is called the cure period.

Main problems

Categorising loans and obligors into the above categories are tasks that banks have to deal with on a regular basis. A centralised policy department is usually responsible for embedding loans in the various categories and keeping track of changing policies. The EBA has issued guidance on this, including policies on NPL management, NPL disclosure, COVID moratoria, IFRS 9 and the new definition of default. The difficulty, however, is to ensure that loans are properly monitored in the correct systems. Keeping track of changing statuses and correctly automating them in a bank’s IT landscape can prove challenging. Close collaboration between delivery and policy is therefore vital for any compliant financial institution, especially during the current turbulent times.

The Center of Excellence for Regulatory Reporting (CoE) is a virtual team centralising Deloitte’s Regulatory Reporting knowledge and helping clients to act responsibly by assisting them with their regulatory reporting. In order to effectively support our banking clients in this complex regulatory environment, the CoE has been tasked to (i) stay on top of new developments in regulatory reporting so as to support timely and appropriate data-driven reporting solutions for financial institutions, (ii) support financial institutions by leveraging expert views from our international network on ad hoc queries regarding regulatory reporting data and processes; and (iii) combine professionals’ expert knowledge on regulatory reporting with strong data and implementation skills to ensure fit-for-purpose teams.

For more information, please contact us via COERegulatoryReporting@deloitte.nl.