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, the ECB refers to the flexibility of the current NPL framework. In particular, 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). Please see below for an overview of the mechanism of the NPL backstop in times of the COVID-19 crisis.S
- 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.(please click to enlarge)
Statement of EBA on the application of the prudential framework regarding Default, Forbearance and IFRS 9 in light of COVID-19 measures (March 25, 2020)
In the light of the COVID-19 crisis, EBA published on March 25 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.
Concerning public or private moratoria, EBA states that these measures do not necessarily lead to a classification of default or forbearance. Both the definition of default and forbearance are borrower specific. As long as the moratorium is applied to a broad range of customers, products or portfolios, the definition of default or forbearance is not triggered. Nevertheless, banks will still have to assess the individual credit quality of customers.
Definition of default
One important trigger of the DoD is the 90 days past due criteria. It is important that bank calculate the days past due according to the EBA guidelines considering the correct thresholds for individuals or corporate customers.
If loans are renegotiated in the light of the COVID-19 crisis, only in the case of distressed restructuring the default trigger must be considered (See also earlies announcement of Bafin). Only in the case that the net present values of the position decreases by more than 1% after the renegotiation, the DoD applies.
In the case of public or private moratoria, the calculation of days past due must be based on the new payment plan considering the moratoria. If a customer anyways fails to pay according to the new payment plan and the 90 days past due threshold is breached, the DoD is triggered.
EBA does not consider yet the combination of the two default triggers 90 days past due under moratorium and distressed restructuring. In reality it can be possible that the 90 days past due trigger considering the moratorium does not apply, but due to the change in the payment plan the difference between the NPV of the position before and after the change of the payment plan triggers the definition of distressed restructuring. It is important that EBA clarifies that the capitalisation of interest will be still ongoing during the moratorium and that only the payments are deferred.
EBA acknowledges that there might be operational difficulties in the individual monitoring of the DoD in the case of a moratorium. EBA advised to apply a risk-based approach in the individual assessment and should focus on exposures with a high impact on the institution in the case of default. Banks should especially pay attention to the time after the moratorium and monitor if customers can meet the required payment obligations according to the revised payment plan.
Similar to the DoD, in the case of a moratorium, the definition of forbearance is not automatically triggered. Forbearance is a customer or exposure specific definition and therefore does not apply in the case of a moratorium where a broad range of exposure are affected. A moratorium addresses systemic risks rather than individual risks.
Considerations on IFRS9
EBA and ESMA (European Securities and Markets Authority) published a statement on financial reporting aspects related to IFRS9. Both statements deal with the evaluation of the significant increase of credit risk within the framework of IFRS9.
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 out of 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 IFRS9 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 IFRS9 on capital requirements and the banks evaluation process for credit risk changes.
Statement of Bafin on Definition of default
Regarding the definition of default, no concrete reliefs are discussed yet. While the Bank of England, for example, has announced a deferral of the implementation deadline for the new definition of default, the ECB is still silent in that regard. The German NCA (BaFin) used the possibility to clarify 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 leads to a diminished financial obligation that exceeds the 1% threshold (see paragraph 51 of EBA Guidelines 2016/07 on the definition of default)..(please click to enlarge)
As a result, the measures taken by the ECB and the discussions around the treatment of payment holidays make it necessary to re-assess the current definition of default and its technical implementation. Furthermore, banks should prepare themselves for upcoming discussion with the supervisory authorities regarding the announced but not yet specified “flexibility” that will be exercised within the NPL framework.
Loan loss provisions under IFRS 9
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. To alleviate the corresponding impact on the banks’ CET1 and to avoid pro-cyclical effect on the lending behaviour of the banks applying IFRS 9, the ECB recommends making use of the transitional provisions according to Art. 473 (a) CRR for taking into account the IFRS 9 implementation effects. Besides, 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.
COVID 19 Abmilderungsgesetz
In Germany, a new draft of the Ministry of Justice to soften the impact of the Corona crisis (“COVID 19 Abmilderungsgesetz”) has been circulated. A comprehensive overview of the different elements of the draft can be found here. For banks, the most important part of the new law is a moratorium on consumer loans to natural persons (and possibly micro-enterprises) for loans granted before March 15th, 2020 if the borrower is unable to make payments due to the effects of the Corona virus. In this case, payments due between April and June 2020 can be deferred by three month (and possibly until end-of-September 2020). During this time, the loan can not be terminated by the lending institution.
According to the statements from BaFin and EBA (see above), the 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 to perform the 1% net present value test to determine whether the loan is to be treated as defaulted.
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.