Defaults, Non-Performing Loans (NPL) and provisioning
The following blog post is part of the overview of supervisory measures in reaction to the Corona crisis:Supervisory measures in reaction to the Corona crisis – Overview.
Since banks fear a massive wave of counterparty defaults in the course of the Corona crisis, various supervisory authorities refer to the flexibility of the current NPL framework. For example, the ECB allows banks to benefit from guarantees and moratoriums put in place by public authorities to tackle the upcoming distress in the following manner:
- Supervisors will grant flexibility regarding the classification of debtors as defaulted due to “unlikeliness to pay” when banks call on public guarantees issued in the context of the Corona crisis. Further flexibility will be exercised regarding loans under Covid-19 related public moratoriums.
- Loans which become non-performing and are under public guarantees will benefit from preferential prudential treatment in terms of supervisory expectations about loss provisioning (i.e. 0% coverage rate for the first seven years of the vintage count when determining the NPL backstop. However, the NPL backstop itself is not going to be suspended according to current discussions).
- Supervisors will deploy full flexibility when discussing with banks the implementation of NPL reduction strategies, taking into account the extraordinary nature of current market conditions.
The picture below provides an overview of the mechanism of the NPL backstop in times of the COVID-19 crisis:(please click to enlarge)
The following sub-chapters summarise the most recent publications and statements of the various authorities (especially BCBS, ECB, EBA) with regard to the prudential framework for defaulted and forborne exposures including related considerations on the provisioning according to IFRS 9.
Application of the prudential framework regarding Default, Forbearance and IFRS 9 in light of COVID-19 measures
EBA statement and guidelines on the treatment of moratoria
In the light of the COVID-19 crisis, EBA published on March 25, 2020, a statement on how to apply the rules on the definition of default (DoD), forbearance (FB) and the accounting treatment under IFRS 9 (ECL). The main principle behind DoD, FB and ECL is to ensure a sound identification of credit-impaired assets. It is crucial that these rules must be applied consistently and comparably, even if the capabilities of banks in the current crisis might be limited. EBA emphasizes that all the flexibility of the prudential framework should be used and gives some guidelines on how the rules should be applied. It is important to mention, that GL of the EBA must be adopted by the competent authorities. This adoption might be 100% or with necessary changes. If a competent authority does not follow the guidelines, it is expected to be published and justified. We observed, that the moratoria across EU countries can vary significantly. It is to be expected that national competent authority adjust the EBA GL is a way that their national moratorium is covered.
Concerning public or private moratoria, EBA states that these measures do not necessarily lead to a classification of default or forbearance. In addition to that, the EBA published on April 2, 2020, new guidelines on the treatment of general payment moratoria that were launched in response to the COVID-19 pandemic. As these moratoria in practice are adopted in various forms across jurisdictions, EBA deemed it to be necessary to clarify the application of the definition of default and classification of forbearance in the context of these various measures. In general, the guidelines clarify which legislative and non-legislative moratoria do not trigger forbearance classification and the assessment of distressed restructuring (and therefore would lead to a default. In all other cases, the assessment must be done on a case-by-case basis. In particular, the EBA provides the following conditions that general legislative and non-legislative moratoria need to fulfill, for not being considered forbearance and distressed restructuring: (please click to enlarge)
Where a general payment moratorium meets these conditions and applies to all of the exposures of an institution within the scope of the moratoria, such measures should not change the classification of exposures under the definition of forbearance or change whether they are treated as distressed restructuring. Consequently, the application of the general payment moratorium in itself should not lead to a reclassification of the exposure as forborne (either performing or non-performing) unless an exposure has already been classified as forborne at the moment of the application of the moratorium. Furthermore, the EBA clarifies that where a general payment moratorium meets these conditions, institutions should count the days past due for both the definition of default and the application of the NPE backstop based on the revised schedule of payments.
Hence, in its new guidelines, the EBA closely connects the definition of forbearance with the need to assess the status of distressed restructuring for DoD purposes: If the moratorium fulfils the specific EBA requirements, it is not treated as a trigger for the forbearance classification and the assessment of distressed restructuring. That means, however, that the specific features of each moratorium need to be assessed carefully in light of the new EBA requirements. In particular, according to the EBA guidelines, the moratorium should not affect any conditions of the loan other than the payment schedule. There is only one exemption in the case that such a change only serves for compensation to avoid losses which an institution otherwise would have due to the delayed payment schedule. This means that without the change under the moratorium, there would be a negative impact on the net present value. In all other cases, amendments that lead to a (significant) change in the net present value of the credit obligation (e.g. a zero interest rate for a specific period without capitalization of the suspended interest payments) does not fulfil the EBA requirements, i.e. a forbearance classification and an assessment of distressed restructuring would have to be considered.(please click to enlarge)
Furthermore, the EBA clarifies that institutions should still assess the potential unlikeliness to pay of obligors subject to the moratorium in accordance with policies and practices that usually apply to such assessments. Any form of credit risk mitigation such as guarantees provided by third parties to institutions should not exempt institutions from assessing the potential unlikeliness to pay of the obligor or affect the results of such an assessment.
Wherever institutions apply a non-legislative general payment moratorium, they should notify their national competent authorities and provide a range of detailed information (e.g.the number of obligors and exposure amount within the scope of the moratorium and the conditions offered based on the moratorium including the duration of the moratorium). Further, institutions should collect and have readily available detailed information about the moratoria, including:
- clear identification of the exposures or obligors for which the moratorium was offered and to which the moratorium was applied
- the amounts that were suspended, postponed or reduced because of the application of the moratorium;
- any economic loss resulting from the application of the moratorium on individual exposures and the associated impairment charges.
In addition to the additional notification requirements, it is already announced that the EBA will identify any necessary short-term supervisory reporting and disclosure requirements to monitor the implementation of the measures introduced against COVID-19 and loans that fall under the scope of the new guidelines. The EBA will provide specific requirements on public disclosures and reporting separately at a later point in time.
EBA statement on additional supervisory measures in the COVID-19 pandemic focusing on securitisations
In its publication from April 22, 2020 EBA also clarifies some uncertainties concerning the application of payment moratoria on securitisations. This clarification especially focuses on the EBA guideline EBA/GL/2020/02 of 02 April 2020 (Guidelines on COVID-19).
The regulation of COVID-19 in relation to moratoria should be applied on securitised exposure in case of traditional securitisations if the underlying exposure remains on the originator institution’s balance sheet or which is not excluded from the calculation of risk-weighted exposure. In case of synthetic securitisations institutions have to apply those regulations for any underlying exposure whose risk is transferred to third parties via credit derivatives or guarantees and whose securitised exposure remains on the originators balance sheet.
Just like with other exposures the moratorium leads to a shift of the day past due calculation. However, it is required to distinguish between legislative and non-legislative moratoria when assessing the treatment of pools of securitised assets.
With focus on the calculation of regulatory capital requirements EBA underlines the necessity to classify the underlying securitised exposures in accordance to Guidelines on COVID-19 being subject to a general payment moratorium. This also includes the approach to continue to assess the potential unlikeliness to pay of obligors as appropriate.
The EBA publication also includes information on how to asses possible implicit support under Article 250 CRR. Cases like suspending, postponing or reducing payments due under securitised assets or granting new loans under a general payment moratorium are for example not regarded as prohibited implicit support under Article 250 CRR.
In addition, EBA clarifies further cases not automatically be regarded as prohibited implicit support. This covers for example cases like not making a claim during the moratorium period against protection provider as well as where permitted replacing securitised assets in the pool being subject to a moratorium.
Under any circumstances, institutions are obligated to inform competent authorities.
BCBS statement on the treatment of moratoria
In line with the new EBA guidelines, the BCBS stated in its latest paper as of April 3, 2020, that the framework on defaulted, non-performing and forborne exposures should be applied in a flexible manner to support the measures introduced by the respective jurisdictions to alleviate the financial and economic impact of the COVID-19 crisis (e.g. moratoria, payment holidays). In particular, the BCBS agreed on the following:
- Payment moratorium periods (public or granted by banks on a voluntary basis) relating to the COVID-19 outbreak can be excluded by banks from the counting of days past due.
- The assessment of the unlikeliness to pay criterion should be based on the rescheduled payments. That is, for borrowers that are not making payments as permitted by a payment moratorium, the assessment should be based on likelihood of payment of amounts due after the moratorium period ends.
- When borrowers accept the terms of a payment moratorium (public or granted by banks on a voluntary basis) or have access to other relief measures such as public guarantees, this should not automatically lead to the loan being categorised as forborne.
Further NCA statements
Some weeks ago, the German NCA (BaFin) already clarified in its Q&A section that a payment holiday is in general not to be deemed as a default according to Art. 178 CRR as long as there is no “distressed restructuring” which is basically in line with the EBA and BCBS statements. After the EBA published their new guidelines on the treatment of general moratoria (see above), the BaFin declared to adopt these guidelines (“comply”) for the LSIs in Germany. However, the BaFin seems to slightly deviates on their interpretation of a general moratorium according to the EBA guidelines.
In its FAQ section, the BaFin states that even a financial concession (e.g. agreeing of new interest rates or temporarily new interest rates) that leads to a decrease of the NPV of more than 1% does not harm the classification of a general moratorium and hence should not lead to trigger the forbearance classification and the assessment of distressed restructuring. To the contrary, you could read the underlying EBA interpretation a bit different: According to the criterion to be classified as general moratoria laid down in paragraph 10 c) of the EBA guidelines and the respective background and rationale (see paragraph 24 in this section of the EBA guidelines), the moratorium should only affect the schedule of payments and not any other conditions of the loan, in particular the interest rate. Otherwise, this could lead to a significant change in the NPV of the credit obligation and in such a case, the EBA assumes that a forbearance classification would have to be considered. So while the EBA is obviously of the opinion that a significant NPV decrease due to financial concessions may contradict the classification as a general moratorium, the BaFin does not take the NPV test into consideration when classifying a moratorium as a general moratorium. This might reflect the German moratorium (see below), that allows changes in the interest rate.
According to the EBA guidelines and the BaFin statements (see above), a general payment moratorium is to be treated as a restructuring of the original payment schedule and therefore not leading to the 90 days past due criterion of default being violated. However, it is necessary for the moratorium to fulfil the EBA criteria listed above, including the requirement that the moratorium only changes the schedule of payments. If this is not the case, the 1% net present value test to determine whether the loan is to be treated as defaulted needs to be performed.
Other changes envisaged by the draft law that may be of importance to banks are restrictions on a lender’s ability to terminate residential or commercial rental contracts if the tenant’s ability to pay suffers from Corona-related effects; this may influence property values. Also under Corona-related circumstances, enterprises may avoid having to report their insolvency. If the creditors file for bankruptcy, certain limitations are to be observed as well. However, this should only marginally avoid or delay having to report said enterprises as defaults, as the default definition does not only focus on insolvency proceedings but takes account of several other factors as well.
Banks have now more clarity on how the various types of moratoria will affect regulatory reporting and capital requirements. However, this means that detailed assessments of the moratoria that were launched in the respective jurisdictions are necessary. Furthermore, the impact on the current implementation of the definition of forbearance and default needs to be analyzed. And finally, preparations are to be made with regard to the additional notification requirements, i.e. banks need to ensure that they collect all necessary information and data on an ongoing basis.
Considerations on IFRS 9 with respect to regulatory capital
IFRS 9 as a potential driver for severe CET1 hits during crisis
Applying the accounting standards for provisioning according to IFRS 9 based on an Expected Credit Loss (ECL) model is expected to lead to a significant and sudden increase in loan loss provisions and adverse P&L effects respectively during this unprecedented time of stress. This is especially due to the fact that banks need to take into account a significant increase in credit risk over the total expected lifetime of the exposure and consider forward looking information in their ECL models.
Therefore, EBA and ESMA (European Securities and Markets Authority) published a statement on financial reporting aspects related to IFRS 9. Both statements deal with the evaluation of the significant increase of credit risk within the framework of IFRS 9.
Based on quantitative and qualitative triggers institutions have to make an assessment of whether there has been a significant increase in credit risk over the total expected life of the exposure. EBA points out that the use of private and public moratoria in response to the COVID-19 pandemic should not be seen as a standalone indication of increased credit risk.
Apart from this, institutions should include all reasonable and supportable information available to assess the credit risk of an exposure and also include forward looking information. In particular, this means assessing possible upcoming effects arising out of the current shock and any sudden changes in the short-term economic outlook influencing the exposures credit risk beside the scarcity of available and reliable information.
The assessment therefore also covers the distinction between two sorts of obligors: obligors whose credit standing is not significantly affected by the current situation and obligors whose credit worthiness is unlikely to be restored.
Furthermore, the institutions have to analyse the impact on their income statements resulting from the recognition of the expected credit losses, the eligibility of provided collaterals or public guarantees. Current exceptional circumstances should also be considered by competent authorities within the application of IFRS 9 transitional arrangements.
EBA also emphasizes that they will continue to monitor banks‘ current practices within the framework of IFRS 9 benchmarking in order to better understand the potential impact of IFRS 9 on capital requirements and the banks evaluation process for credit risk changes.
ECB and BCBS provide guidance and recommendations on applying IFRS 9
To alleviate the IFRS 9 impact on the banks’ CET1 and to avoid procyclical effect on the lending behaviour of the banks applying IFRS 9, the ECB recommends IFRS 9 banks to account for the new relief measures granted by public authorities in their ECL model forecasts and announced to support banks with their macroeconomic scenarios to reduce procyclicality and high volatility in provisioning. In its latest letter to significant institutions as of April 1, 2020, the ECB expressed its support to all of the initiatives of European authorities and international bodies that were issuing guidance on the use of IFRS 9 in the context of the COVID-19 outbreak. Thereby, the ECB provided further detailed guidance about the essential implementation choices that the banks would have when it comes to the interpretation of the key assumption and discretionary electives. Those initiatives in general provide clarity on the room for the prudential judgement that all significant institutions have to take into account while implementing the IFRS 9 and all the relief measures such as payment moratoriums, guarantees and other debtor support initiatives what should be factored in when assessing the SICR, the application of the scenarios and other estimation procedures related to the estimation of the ECL for the institutions credit portfolios.
In this respect, one important question was what would be the emphasis for the institutions while monitoring the economic recession effects of the COVID-19 outbreak, and several institutions were having second thoughts how to reflect their expectations onto their scenarios. Here, the ECB circular clearly stipulates the use of specific scenarios that have been as well published last week and gave very detailed explanations about the interpretation of the macro economic conditions’ changes and expected downturn impact for the coming quarters of 2020 and 2021. There is ample input parameter level guidance to enable any significant institution how to react to the various impact analyses requirements for the ECL calculation. Obviously, the scenarios might take a different shape and form depending on the course of the pandemic outbreak and its implications, and needless to say, for certain industries the prospects might look still very bleak however for other industries or regions the outcome might be not felt in a much lesser magnitude. However, banks should bear in mind that these economic forecasts are set out as of the end of March and might be respectfully changed in the coming weeks and months.
With regard to the assessment of whether there has been a significant increase in credit risk, also the BCBS stated in its publication as of April 3, 2020, that relief measures to respond to the adverse economic impact of COVID-19 such as public guarantees or payment moratoriums (granted either by public authorities or by banks on a voluntary basis) should not automatically result in a significant increase in credit risk and thus in exposures moving from a 12-month ECL to a lifetime ECL measurement. Furthermore, the BCBS expressed its expectation that ECL estimates should reflect the mitigating effect of the significant economic support and payment relief measures put in place by public authorities and the banking sector. While estimating ECL, banks should not apply the standard mechanistically and should use the flexibility inherent in IFRS 9, for example to give due weight to long-term economic trends.
Transitional arrangements to account for IFRS 9 effects within regulatory capital
In its various statements, the BCBS and the ECB recommend banks to make use of the transitional provisions for taking into account the IFRS 9 implementation effects. In the EU, these transitional provisions according to Art. 473a CRR initially entered into force in 2018 when the IFRS 9 effects on regulatory capital arose for the first time. Back then, banks were obliged to decide whether or not they will make use of the transitional provisions and notify their competent authority. Due to several operational and technical challenges in applying these provisions, many banks decided to not apply them. However, this might now be different due to the potential serious P&L hits banks are going to face when applying IFRS 9 for loan loss provisioning. Time to shed again some light on the technical details of Art. 473a CRR.
Look back: The mechanisms of the transitional arrangements according to CRR
With the application of IFRS 9, banks were expected to face significantly higher risk provisions for financial instruments both on day 1 (static effect) and going forward (dynamic effect), especially resulting from the calculation of lifetime expected losses for financial instruments categorised as stage 2 under IFRS 9. The following picture illustrates the two effects on regulatory capital and on RWA, differentiated between IRB and CR-SA positions: (please click to enlarge)
Therefore, as a transitional provision, the inclusion of these increased risk provisions into CET1 capital can be phased-in over a five year horizon from 2018 (5%) until 2022 (75%). Or to put in other words: the reduction in CET1 capital caused by the increased risk provisions is partly reversed by adding back to the CET1 capital the so called adjustment amount. The adjustment amount is decreasing over the transitional period from 95% (2018) to 25% (2022). Technically, the adjustment amount is calculated as the sum of the following:
- Day one effect, i.e. the difference between the risk provisions according to IFRS 9 as of day one of application (1/1/2018) and the risk provisions according to IAS 39 as of its last day of application (12/31/2017); plus
- Subsequent effect, i.e. the difference between the risk provisions according to IFRS 9 for stage 1 and 2 positions as of the current reporting date (e.g. 3/31/2020) and the respective risk provisions as of the first day of application of IFRS 9 (1/1/2018); minus
- Tax savings, i.e. the increase of CET1 capital that is due to tax deductibility of the higher provisioning according to IFRS 9
For IRB positions, the adjustment amounts are calculated by subtracting the EL from the provisions for the respective positions since the elimination of an existing IRB shortfall due to higher risk provisions offsets the P&L effect and thus reduces the adjustment amounts.
When applying these transitional provisions, banks need to adjust the corresponding effects on Deferred Tax Assets (DTA), Tier 2 capital and the EAD for CR-SA positions accordingly. Furthermore, banks need to meet additional disclosure requirements within their Pillar 3 reports to show the respective CET1 effects.
The following picture illustrates (on a simplified basis) the effects and the mechanism of the transitional provisions. (please click to enlarge)
BCBS agrees on flexible application of the transitional arrangements
From a global perspective, the BCBS also highlights in its latest statement the mitigating effects of the transitional provisions to account for the IFRS 9 impact and agreed on the following to make them applicable in a flexible manner across jurisdictions:
- Jurisdictions may apply the existing transitional arrangements, even if they were not initially implemented when banks first adopted the ECL model.
- Jurisdictions may permit banks to switch from the static approach to the dynamic approach to determine the adjustment amount (even if they have previously switched the approach that they use).
- Jurisdictions may use alternative methodologies that aim to approximate the cumulative difference between provisions under the ECL accounting model and provisions under the prior incurred loss accounting model (e.g. IAS 39).
- Irrespective of when a jurisdiction initially started to apply transitional arrangements, for the two year period comprising the years 2020 and 2021, jurisdictions may even allow banks to add-back up to 100% of the adjustment amount to CET1. The “add-back” amount must then be phased-out on a straight line basis over the subsequent three years. However, jurisdictions that have already implemented the transitional arrangements (as it is the case e.g. for the EU) may choose to add back less than 100% during 2020 and 2021, or take other measures to prevent the add-back including ECL amounts established before the outbreak of COVID-19. This means that only COVID-19 effects can be fully added back to CET1 whereas other static and dynamic effects need to be treated according to the already established arrangements. Within the EU, for example, this change in the existing transitional arrangements would require a CRR amendment and would lead to even more complexity.
To sum up, given the complexity of the transitional arrangements and the various side effects, it is important for banks to reassess the dynamic IFRS 9 impact under the new macroeconomic circumstances (e.g. with different scenarios on provisioning). Since banks are allowed to reverse their decision once, it might be worth discussing again the decision taken in times when IFRS 9 was implemented and banks had only little incentive to apply the complex rules.