What’s at stake with the ECB draft guidance to banks on non-performing loans?

The European Central Bank (“ECB”) recently launched public consultation on guidance to banks on non-performing loans (“NPL”). Consultation periods runs until 15 of November 2016.

As NPL harms the profitability, funding and capital of banks and more globally the real economy, the ECB issued this guidance, aiming to achieve common practices for how to handle NPLs across Europe.

These guidelines are addressed to all significant institutions, including their international subsidiaries, that are supervised directly under the Single Supervisory Mechanism. However, it is very likely that similar practices would be expected as well from non-significant institutions in the coming years.

The scope of the guidance is comprehensive, covering strategic, governance, operational, disclosure and technical aspects of the NPL management processes. The banks would be required to comply with the following requirements in the short term, the guidance being applicable from now.

1. The bank would be expected to assess its operating environment to develop an effective and realistic NPL strategy. This assessment covers both a self-assessment (analysis of the NPL portfolio, processes and policies, IT system) and external conditions (macroeconomic environment, tax, regulatory and legal framework, risk appetite of investors for non-performing assets…).

2. The diagnostic would assist the bank in defining realistic NPL strategies options to reduce its exposure such as hold/forbearance strategy, active portfolio reductions, change of exposure type. Targets for reducing the NPL by time horizons, by portfolios and by elected options would need to be included in the strategy.

3. The bank should adapt its organisation to ensure the effectiveness of the NPL strategy.

• The NPL strategy should be embedded in the business strategy and the risk appetite.
• A specific NPL operating model should be designed to monitor, control, implement and disclose on the NPL strategy. This would cover the creation of a workout non-performing unit, the implementation of a three lines of defence and the update of processes, procedures and accounting policies to include the new NPL arrangements.
• NPL metrics should be set-up to monitor and measure both the performance of the NPL strategy and the management performance.
• The supervisory reporting around the NPL will need to incorporate details on the strategy, targets, progress to date and operating process in place.

4. In addition, the forbearance and impairment measurement practice of the bank should be reviewed and enhanced to be in line with the best practices observed across Europe.

To conclude, the essence of these guidelines is to channel banks enhancing their management of non-performing loans, and ultimately reducing their credit risk. The successful implementation of this guidance would be another significant achievement for the ECB in ensuring standardized practices across Europe to promote a sustainable banking sector.