ECB published a report that examines the credit underwriting standards of banks. The report highlights some weaknesses in the way banks granted and priced new loans in recent years. The report showed several cases where loan pricing did not cover expected losses and costs, revealed that banks with high nonperforming loan levels tended to grant housing loans more conservatively than others, and found no evidence that banks using internal models applied better risk-based pricing. The report contains the industry-wide findings of a project launched in May 2019 to collect data from 95 significant banks in the euro area on new loans granted during 2016-18 for different lending portfolios.
The unique quantitative dataset on credit underwriting standards presented in this report offered valuable insights. In particular, the analysis focuses on six different portfolios. These cover, on the one hand, loans to private households, with a breakdown by residential real estate (RRE) loans and credit for consumption (CRDCN), and, on the other hand, loans to the non-financial corporate sector, encompassing commercial real estate (CRE) loans, loans to small and medium-size enterprises (SME), loans to corporates, and loans to large corporates. For these portfolios, the objective was to assess the adequacy of lending standards and the trends over time, to identify specific characteristics of individual loan segments and countries and to analyze the application of risk-based loan pricing. The analyses indicated relevant trends across different portfolios and in risk-based pricing, with the following key findings:
- Banks with high levels of non-performing loans tended to grant housing loans more conservatively than other banks. The dataset showed significant differences in the way high non-performing loan banks granted new loans (compared with other banks) during 2016-2018, particularly in RRE. In the RRE and CRDCN portfolios, income-based key risk indicators deteriorated while pricing spreads also declined.
- On average, banks lowered their lending standards for loans to households, over this period. They took more risks, while working with tighter margins resulting from narrower pricing spreads (interest rate charged minus funding costs).
- Not all banks paid sufficient attention to risk-based pricing, particularly to ensure that loan pricing at least covered expected losses and costs.
- No evidence was found that banks using internal models to calculate capital requirements applied better risk-based pricing. Risk-based pricing deserves further attention, as the positive relationship between expected loss rate and pricing spread does not always hold within portfolios and for higher-risk loans.
- New loans granted to non-financial corporations showed a mixed picture in terms of bank risk-taking, combined with mostly decreasing pricing spreads. Most non-financial corporate portfolios were characterized by improving KRIs, riskier loan structures, and decreasing pricing spreads.
The goal of the credit underwriting data collection was to examine the quality of lending practices of banks, to mitigate a potential build-up of excessive credit risk. ECB Banking Supervision considers proper credit underwriting to be a key element of the stability of significant institutions in the euro area. In the past, inadequate loan origination practices have contributed to an accumulation of non-performing loans on the balance sheets of banks. The supervisory efforts that started in 2016 as a Single Supervisory Mechanism (SSM) priority to reduce non-performing loans have been aimed at strengthening bank resilience and ensuring trust in the banking sector. The present work on credit underwriting complements the strategic efforts to tackle the existing non-performing loans. It also gives an unparalleled insight into the underwriting processes in European Economic Area, with the aim of preventing the build-up of new non-performing loans. This is the first time that harmonized quantitative data including a detailed breakdown of new loans have been available for banks. In times of economic downturn or stress such as the current crisis caused by COVID-19, adequate lending standards and risk-based pricing become even more important as losses materialize.
Keywords: Europe, EU, Banking, Credit Underwriting, Credit Risk, COVID-19, NPLs, RRE, SSM, Lending Practices, CRE, Basel, Expected Credit Loss, ECB
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