Managing an increase in bank credit risk

Managing an increase in bank credit risk

Wed 14 Apr 2021

While 2020 went relatively smoothly for the banking sector, uncertainties remain on the potential effects of Covid-19 on the real economy. Any negative impact could lead to heavy losses for the sector, especially when support measures are gradually phased out.

These measures have not only contained the anticipated increase in credit risks, but have also maintained strong solvency ratios, often higher than they were at the start of the crisis. In order to address the expected increase in credit risks in 2021, banks must put in place all the existing regulatory tools in order to anticipate the potential difficulties of their borrowers when the support measures cease to have effect.  In a letter to the CEOs of Significant Institutions in December 2020, the ECB issued a formal reminder that ‘it is becoming increasingly important […] to ensure that risk is adequately assessed, classified and measured on their balance sheets’.

Widely varying practices identified

Despite its previous recommendations, the ECB has identified widely varying practices among Significant Institutions in terms of reporting asset quality deterioration and the resulting levels of provisioning. Some banks have mistakenly assumed that concessions to their borrowers under EBA moratoria guidelines exempted them from any analysis of the quality of the renegotiated asset. In addition, the ECB has had to remind banks that any exposure subject to a concession outside the moratoria must be classified as forborne. More generally, banks must not only rely on quantitative indicators to detect a significant increase in credit risk, but also on new approaches to characterise unlikeliness to pay (UTP).

The EBA risk dashboard for Q3 2020 suggests that there has been massive take-up of these support measures in the EU: EUR 289bn in loans under public guarantee schemes, and close to EUR 587bn in loans under moratoria.

An updated action plan for non-performing loans (NPLs)

Concerned by the expected deterioration in banking asset quality and the resulting credit crunch risk, the Commission has relaunched its NPL action plan. Although the average ratio of NPLs in the EU was down slightly to 2.8% in Q3 2020, the situation is still uneven across the Member States and the risk of a significant increase in the coming months is not negligible.

In the interests of transparency in the NPL markets, a central NPL data hub should be created and the reporting by banks of their new NPLs will be boosted by the now-mandatory use of the EBA’s NPL data templates. Finally, the securitisation of NPLs will be possible in future, since the draft document published in July 2020 as part of the Capital Markets Recovery Package (cf. Mazars LR #26) received inter-institutional agreement in December.

Enhancing practices for loan origination and monitoring

Beyond the management of current or future risks, banking institutions will have to put in place good practices for credit facilities throughout their lifecycle. The definitive guidelines on loan origination and monitoring, published in May 2020, are intended not only to harmonise loan origination processes, but also to take account of the concept of sustainability in the context of financing the transition to a low-carbon economy. As well as strengthened governance for risk management, the guidelines seek to harmonise practices for assessing the solvency of the borrower and the valuation of collateral, including real estate. Significant Institutions should bring themselves into compliance with these guidelines by 30 June 2021.