Provisions for non-performing loans: how much is enough?
For years the increase in non-performing loans (NPLs) resulting from the financial crisis represented one of the major risk factors for the banking industry in the eurozone. This increase was relatively heterogeneous, with a greater impact on the peripheral countries in Southern Europe.
To address this problem, the Council of the European Union approved an action plan in 2017 aimed at reducing the volume of non-performing loans and averting future occurrences. The plan proposed measures such as the development of secondary NPL markets, a European NPL transactions platform, a general guideline on the management of these assets, and templates of minimal required detailed information.
In addition, the International Financial Reporting Standard (IFRS) 9, in force since 2018, tackled the main issue related to accounting provisions when recognizing impairment losses on loans. It replaced the incurred loss model – which accounts for provisions relatively late in the day, once a loss has already been incurred – with an expected loss model. Furthermore, capital requirements have been defined for expected losses, requiring financial institutions to address those losses that are not covered by accounting mechanisms.
Nevertheless, in March 2018, the ECB published an addendum to its NPL guidance, with which it established additional pillar 2 (supervisory) requirements with respect to NPL volume. As part of what is known as the supervisory dialogue under the framework of the supervisory review and evaluation process (SREP), depending on the age of the exposure and its collateral, more capital may be required, as per the discretion of the supervisor and based on the accounting coverage. This coverage approach applies both to new NPLs and, with an offset specific to each bank, to accumulated NPL stock.
In addition, last April 26, the European Commission proposed the famous NPL backstop, which is similar to the ECB requirements in so far as it raises capital buffer requirements based on the age of the exposure and its type of collateral. The backstop represents a Pilar 1 (capital) requirement and applies only to NPLs that are so deemed after the regulation comes into effect.
In an environment where levels of non-performing loans stand at pre-crisis levels for most EU member states, the existence of two backstops with similar features but with specific nuances and particularities that obligate financial institutions to comply independently with both, seems excessively onerous. This is why coordination between the relevant authorities, with a view to merging both measures in the medium term, is imperative.
It is reasonable for regulatory authorities and supervisors to closely monitor the evolution of non-performing loans, but with industry profitability at historic lows and the emergence of new digital competitors in the market, it is essential that regulation and supervision strike a balance in such a way that regulation preserves financial stability without causing an adverse effect on the sector’s ability to make a profit.
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