In line with the European Council’s Action Plan on non-performing loans, EU banking supervisors have considerably increased their focus towards credit standards throughout the lending lifecycle. Regulators are faced with widely reported reductions in banks' credit underwriting standards - such as higher loan-to-value (LTV) ratios and weaker loan covenants – leading them to pay increasing attention to this important driver of banking strength and stability. Although this is not the first time that credit underwriting standards are being addressed at European level, it is a strong reinforcement of the required standards and it will have a direct impact on banks' governance, internal processes, and IT infrastructure.
The European Central Bank (ECB) has already taken action on credit standards. In May 2019, the ECB launched a credit underwriting exercise, requiring some directly supervised banks to complete several data templates by 1 July 2019. This phase was followed by a quality assurance review. The ECB will now conduct a deep dive analysis during the second half of 2019, perhaps supplemented by requests for more granular data. In addition to its value as a review of credit standards, the exercise has helped the ECB to gauge banks' implementation of BCBS 239, which sets out principles for the effective governance, aggregation, and reporting of risk data.
Meanwhile, the European Banking Authority (EBA) has also identified loan origination as a priority for 2019, and on 19 June 2019 published a consultation paper on loan origination and monitoring. In contrast to the ECB’s credit underwriting exercise, these guidelines are applicable to all credit institutions in Europe and impact all existing credit facilities - including their refinancing - as well as new credit facilities. The guidelines introduce best practices for robust and prudent standards for credit risk taking, management, and monitoring, in addition to ensuring adequate practices in areas such as consumer protection, anti-money laundering (AML) and environmental, social and governance factors. The consultation period was open until the 30 September 2019 (with public hearing on 20 September in Paris). The guidelines are proposed to take effect from 30 June 2020.
The planned guidelines take a pro-active approach to addressing the European Council's Action Plan on non-performing loans to promote improved underwriting standards for new loans. They not only set expectations for the initial decision-making involved in granting credit, but also call for the regular monitoring of credit risks throughout the life of a loan. And as well as focusing on the creditworthiness of borrowers, they also cover risk mitigation, such as the evolving value of collateral. The draft guidelines aim to ensure that credit is being granted to borrowers who, based on the institution's best knowledge at the time of granting the credit, will be able to fulfil the terms and conditions of the credit agreement and are secured by sufficient and appropriate collateral.
In short, both developments pose challenges for banks in terms of the availability, aggregation, calculation, calibration, reconciliation and quality control of credit data. The EBA's proposed guidelines require banks to collect and store many of the same metrics as those demanded by the ECB's exercise, which already turned out to be challenging for the participating banks.
Credit institutions in Europe are advised to start looking closely at the implications of this increased regulatory focus on quality of credit underwriting, as this is expected to have important implications for institutions of all sizes. This also has to be considered in the broader context of the “end-to-end” credit lifecycle. Regulators are moving away from firefighting non-performing loans and towards expecting banks to have well embedded and integrated governance, processes and control mechanisms from the loan origination stage up to the resolution of distressed exposures.
A first recommended step is to perform a gap analysis of the practices in place in the institution compared to the new EBA Guidelines, to identify potential gaps and pitfalls to develop remediation plans and prepare interactions with the supervisor.
KPMG has extensive credit management and regulatory experience and can support banks with performing regulatory gap analysis, developing remediation plans and supporting the implementation of change programs. Please do not hesitate to contact us