ECB Offers Further Guidance on Management of Credit Risk Amid Pandemic

The ECB letter with additional guidance on management of credit risk highlights that significant institutions should strike the right balance between avoiding excessive procyclicality and ensuring that the risks they are facing (or will face) due to the pandemic are adequately reflected in their internal risk measurement and management processes, financial statements, and regulatory reporting. Significant institutions should use well-structured and sound creditworthiness assessment procedures so they can differentiate, in a timely and effective manner and on a case-by-case basis where appropriate, viable from non-viable debtors. Furthermore, from a prudential perspective, to properly manage and cover credit risk, it is important for significant institutions to allocate exposures to the appropriate IFRS 9 stages and use all relevant information to determine expected credit losses. The letter sets out the following sound credit risk management policies and procedures:

• Significant institutions should ensure that they have enhanced their procedures so that all contract modifications that qualify as concessions and are provided to distressed borrowers, in line with Article 47b of the Capital Requirements Regulation or CRR, are correctly classified as “forborne” in their systems.
• Significant institutions are expected to perform a regular assessment of borrowers’ unlikeliness to pay, including exposures with general payment moratoria, using all relevant and available information. When the assessments are performed manually, banks are expected to follow a risk-based approach. 
• From a risk management perspective and to set appropriate provisions for prudential purposes, ECB advocates that significant institutions should identify and record any significant increase in credit risk at an early stage. Significant institutions should not rely solely on days past due as a trigger for a significant increase in credit risk.
• From a prudential perspective, to ensure the sound measurement, management, and coverage of credit risk, ECB considers it essential that significant institutions correctly estimate their provisions using realistic parameters and assumptions which are appropriate for the current environment. In this regard, significant institutions are recommended to continue anchoring their IFRS 9 baseline scenarios using the forecasts of ECB in an unbiased manner.
• ECB expects the management bodies of significant institutions to exercise adequate oversight over the critical elements of credit risk management. In addition, significant institutions should also ensure there is segregation of duties across loan origination, risk monitoring and the collection and restructuring processes, as well as adequate internal and external reporting of the relief measures.
• As a part of strategic and business planning, ECB expects significant institutions to forecast the most likely impact of the crisis in terms of stage allocations, provisioning, and capital.

ECB also published two letters from Andrea Enria, the Chair of the Supervisory Board of ECB. One of the letters discusses ECB stance with respect to the nonperforming loans. The letter highlights that, so far, banks have not experienced any material increase in nonperforming loans or NPLs. However, ECB expects nonperforming loans to rise and is, therefore, monitoring the development of nonperforming loans ratios very closely. As already communicated in the frequently asked questions on supervisory measures in response to pandemic, mitigation measures of ECB do not focus on the stock of nonperforming loans accumulated prior to the outbreak. However, ECB is fully aware that current market conditions may make the agreed reduction targets difficult to attain. Thus, the Joint Supervisory Teams will show a large degree of flexibility when discussing the implementation of nonperforming loans strategies on a case-by-case basis. The letter also pointed out that the rule to classify loans 90 days past due as “in default” is set out in the CRR and ECB is, therefore, not competent to temporarily adjust this rule. The other letter from Mr. Enria highlights that, later this month, ECB will review whether its recommendation to banks to refrain from paying dividends is still necessary. The review will also take into account the latest macroeconomic projections of ECB that are expected to be published on December 10, 2020. 

Related Links

• Letter on Credit Risk Management (PDF)
• Article by Elizabeth McCaul of ECB
• Letter on Dividend Distribution (PDF)
• Letter on Nonperforming Loans (PDF)

Keywords: Europe, EU, Banking, COVID-19, Credit Risk, CRR, IFRS 9, NPLs, Dividend Distribution, Procyclicality, Basel, ECB