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    EU Regulators Warn of Fall in Asset Quality and Rise in Credit Risk

    March 31, 2021

    The Joint Committee of ESAs (EBA, EIOPA and ESMA) published the report on risks and vulnerabilities in the financial system in EU. The report highlights how the COVID-19 pandemic continues to weigh heavily on short-term recovery prospects, highlights a number of vulnerabilities in the financial markets, and warns of possible further market corrections. The financial regulators also warn of an expected deterioration of asset quality and recommend policy actions for supervisors and regulated institutions. EBA also published its assessment of risks in the financial system in the form of a dashboard, which points to a rising share of loans that show a significant increase in credit risk (stage 2 loans).

    Macroeconomic conditions improved in the second half of 2020, supported by ongoing fiscal and monetary policy efforts, but the resurgence of the COVID-19 pandemic since the last quarter of 2020 has led to increasing economic uncertainty. The start of the rollout of vaccinations provides a crucial anchor for medium-term expectations, but insufficient production capacities, delays in deliveries, and risks related to mutations of the virus are weighing heavily on short-term recovery prospects. Macroeconomic uncertainty was generally not reflected in asset valuations and market volatility, which have recovered to pre-crisis levels, highlighting a continued risk of decoupling of valuations from economic fundamentals. In light of these risks and uncertainties, ESAs advise national competent authorities, financial institutions and market participants to take the following policy actions:

    • Prepare for an expected deterioration of asset quality. Banks should adjust provisioning models to adequately address the impact of the economic shock of the pandemic and to ensure a timely recognition of adequate levels of provisions, while having an appropriate allocation of financial instruments within the IFRS 9 impairment stages. They should engage at an early stage with struggling borrowers to efficiently restructure overindebted, but viable
      exposure. Provisioning policies of banks should continue to be a point of particular attention for supervisors.
    • Continue to develop further actions to accommodate a “low-for-long” interest rate environment and its risks. While low interest rates are important to support economic activity, they negatively impact banks’ interest income and remain the main risk for the life insurance and pension fund sector. For insurers, it is important that the regulatory framework also reflects the steep fall in interest rates experienced in recent years and the existence of negative interest rates. Proposals to this aim, as well as other proposals aiming to keep the regulatory framework fit for purpose have been sent by EIOPA to EC in its Opinion on the Solvency II 2020 review. Financial institutions should also continue to monitor, and be prepared for, changes in interest rates, especially in light of the recent upward shifts of long-term interest rates and the consequent concerns about re-emerging inflationary pressures.
    • Ensure sound lending practices and adequate pricing of risks. Banks should continue to make thorough risk assessments to ensure that lending remains viable in the future; this should be closely monitored by supervisors. Banks should continue to make thorough risk assessments to ensure that lending remains viable, including after public support measures such as loan moratoria and public guarantee schemes will expire.
    • Follow conservative policies on dividends and share buybacks. Prudence is required to maintain sufficient capitalization as a necessary condition for the continuous financing of the economy. Any distributions should not exceed thresholds of prudency and institutions should ensure that the resulting reduction in the quantity or quality of their own funds remains at levels appropriate to the current and prospective levels of risk.
    • Investment funds should further enhance their preparedness in the face of potential increases in redemptions and valuation shocks. To this end, the alignment of fund investment strategy, liquidity profile, and redemption policy should be supervised, in addition to the funds’ liquidity risk assessment and valuation processes in a context of valuation uncertainty.

     

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    Keywords: Europe, EU, Banking, Insurance, Securities, COVID-19, Asset Quality, NPLs, Credit Risk, IFRS 9, Solvency II, Policy Recommendations, EBA, ESAs

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