The new Definition of Default and its challenges | Deloitte Netherlands


The new Definition of Default and its challenges

The impact on IFRS9, NPE and loan monitoring

The banking industry is currently in the midst of implementing the new guidelines on the Definition of Default. This article will provide a brief overview of its challenges compared to other regulation, such as IFRS9 and Non-Performing Loans.

The new Definition of Default

It has been more than two and a half years since the EBA published its Guidelines on the new Definition of Default (‘DoD’) (EBA/GL/2016/07). The implementation of these guidelines has been a challenge across all institutions with less than one year ahead until the new rules enter force, at the end of 2020. 

The potential consequences of new DoD and its impact on issues such as accounting practices and Non-Performing Loans (‘NPL’) management are technical changes that banks are facing in this final phase of the implementation.

While this is reasonable from a management perspective, implementing those regulations in a harmonized manner and, particularly, the consideration of credit impaired, could entail relevant challenges for banks. Furthermore, DoD regulation requires alignment in regard to default classification (e.g. Stage 3 and default status).

In this article we will also highlight relevant aspects when harmonizing default definition under DoD, IFRS9 and NPL regulations.

Impact on new DoD on IFRS staging

The IFRS9 accounting standard is based on a 3-stage approach:

  • Stage 1: upon initial recognition (with the exception of purchased and originated credit-impaired assets)
  • Stage 2: performing assets with a significant increase in credit risk after initial recognition
  • Stage 3: credit impaired assets.

Paragraphs 36 to 39 of the EBA Guidelines on the application of the DoD under article 178 of Regulation (EU) No 575/2013 (GL/2016/07) set out that where institutions treat an exposure as credit-impaired under IFRS9 (i.e. assigns it to Stage 3), such exposure should be considered as default except for some specific cases.

Additionally, paragraph 89 of EBA/GL/2017/06 states that: ‘IFRS 9, paragraph B5.5.37, does not define default, but requires credit institutions to define default in a manner consistent with that used for internal credit risk management. […] When adopting a definition of default for accounting purposes, credit institutions should be guided by the definition used for regulatory purposes provided in Article 178 of Regulation (EU) 575/2013’.

It would be easy to infer that there are some challenges for institutions to align DoD and credit impaired definition as per IFRS stage 3. In particular, the following three areas of change in the DoD are driving those challenges:

  • Past due criterion in the identification of default: the introduction of a 90 day backstop with specific materiality thresholds could lead to postponing classification into default/stage 3 credit impaired.
  • Specification regarding Unlikeliness to Pay (‘UtP’) definition: DoD defines a number of new UtP events that entities should consider when assessing the identification of default. Taking into account that the documentation of these client assessments are far more profound than in the past, these events could increase the number of default clients.
  • Default exit criteria: A probation period is set out before a defaulted obligor can be classified as performing (90 days or one year, depending on the particular situation of the client). One could expect that due to the probation period exposures will remain in Stage 3 for a longer time. As long as IFRS9 models are not aligned with the probation period conditions, provision levels might be higher.

Although these aspects are not per se disclosed in IFRS9 (paragraph 5.5), it seems reasonable to expect that these changes are agreeable with IFRS9. In the harmonization of default and credit impaired the following aspects might be considered:

  • Past due criterion in the identification of default: UtP events should not postpone default classifications based only on the quantitative backstop. Banks should implement processes and controls to identify, capture and report defaults considering a number of aspects apart from the 90 day past due criterion.
  • Specification regarding UtP definition: UtP events set out by DoD regulation could be considered, in practice, as a materialization of IFRS impairment events. Bank should assess and document in its policies and credit risk manuals how this materialization has been implemented.
  • Default exit criteria: banks should assess whether these probation periods are in line with what IFRS9 is disclosing, and particularly with the borrower’s financial situation. In principle alignment also seems reasonable.

Impact on IFRS staging due to new DoD will determine an impact on loan loss provisioning that constitutes another challenge that banks needs to sort out in the upcoming months.

New Definition of Default and Non-performing Loans

Next to the changed definition of default, the Council of the European Union has created an action plan to tackle non-performing loans (‘NPLs’) within Europe and to decrease the elevated NPL rates in the banking sector. This has led to new regulation and guidelines that should be closely aligned with the new DoD and IFRS9 regulation:

  • The prudential backstop has been introduced (Regulation (EU) 2019/630 of the European Parliament and of the Council of 17 April 2019 amending Regulation (EU) No 575/2013 as regards minimum loss coverage for non-performing exposures) and is a pillar I backstop for newly originated non-performing loans. Providing coverage for unsecured loans would potentially lead to a higher provisioning level under the new regulation. This depends on the provisioning build-up within IFRS and will lead to a higher cost of capital. 
  • The EBA has published Guidelines on management of non-performing and forborne exposures (‘FBEs’). These guidelines specify sound risk management practices for credit institutions for managing NPE and FBE, looking at governance and operations of NPE workout framework, the internal control framework and NPE monitoring, and warning processes. All in all, these guidelines should lead to a better management of non-performing loans with a decreased NPL-ratio as a consequence. 
  • Prevention is better than cure, and that is also the intention of the EBA Draft Guidelines on loan origination and monitoring (EBA/CP/2019/04). These guidelines should limit the stock of NPLs by improving the institutions’ practices around the credit origination process, in order to ensure that institutions have robust and prudent standards for credit risk taking, management and monitoring, and that newly originated loans are of high credit quality.

With a high correlation between default and non-performing, the implementation of this regulation and these guidelines require a sound planning and fine-tuning. Even though the guidelines on management are already applicable as of 30 June 2019, many of the guidelines are not fully implemented yet within banks. Additionally, with the expected implementation date of the guidelines on loan origination of 30 June 2020, a creation of a coherent planning in order to maximize efficiency and consistency in the implementation of both DoD and NPL is highly recommended.

Implementation and monitoring remain challenges

The scrutiny on the loan quality remains high and it requires consistency from many perspectives. In a highly demanding regulatory environment, where the capacity to implement the change within the different teams is already limited, it is vital to align the planning of each individual regulation or guideline into overarching requirements. Take into account that also the necessary data elements from different systems and teams need to be gathered to monitor and to ensure consistency throughout the different elements, one can only foresee the difficulties that will arise with implementation.

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