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Banks’ credit underwriting

Banks’ credit underwriting

Banks’ credit underwriting

Niamh Lambe

niamh.lambe@kpmg.ie

Director, KPMG in Ireland

In line with the 2019 EU regulatory priorities for credit risk, the EU regulators have considerably increased their focus towards enhancing the robustness of credit underwriting practices in Europe. The aim is to improve credit quality and prevent new flows of non-performing exposures (NPEs) in the European banking system, in order to avoid similar issues as faced in the previous crisis.

Recent developments

New measures recently introduced:

  • The European Banking Authority (EBA) published on 19 June 2019 its draft Guidelines on loan origination and monitoring (PDF, 851KB) . 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 and AML. The consultation period is open until the 30 September 2019 (with public hearing on 20 September in Paris). The Guidelines will apply from 30 June 2020.
  • The European Central Bank (ECB) has requested all European Significant Institutions (SIs) it supervises to complete detailed templates on their credit underwriting practices. The first submission was 1 July 2019, with Q&A and resubmission process until the final templates by end September 2019. Following the data assurance process, it is expected that the ECB will perform deep dive analyses of the data in Q3/Q4 2019. The purpose of this exercise is for the ECB to assess the quality and consistency of lending practices and management across banks and jurisdictions in Europe, ultimately to identify and close gaps. 

Timeline Loan origination guidelines and monitoring/Credit Underwriting Exercise

Timeline Loan origination guidelines and monitoring/Credit Underwriting Exercise

EBA draft Guidelines on loan origination and monitoring (the “Guidelines”)

The EBA has developed these Guidelines in response to the European Council Action Plan (PDF, 463KB) on tackling the high level of non-performing exposures.  

The objective of the Guidelines is to:

1)     Improve institutions’ practices and associated governance arrangements, processes and mechanisms in relation to credit granting.

2)     Build on statutory objectives to include both prudential and financial stability as well as consumer protection and to ensure that the institutions’ practices are aligned with consumer protection rules and respect fair treatment of consumers.

3)     Ensure that institutions have in place prudential loan origination standards in order to prevent newly originated performing loans from becoming non-performing in the future.

Content of the guidelines

The Guidelines cover a broad range of topics from the granting of the credit to the subsequent monitoring. These topics include: internal governance and control framework; loan origination (including data and information requirements); risk-based pricing; approaches to valuation (immovable and movable collaterals); and ongoing monitoring.

Chapters overview

4. Governance
Claify internal governance and control framework for credit granting and credit decision making-process.

5. Loan origination
Set out requirements for information and data collection from borrowers, documentation, and requirements for the borrowers' creditworthiness assessment for loan originated after the application date or where terms are renegotiated or requires specific actions triggered by the regular credit review after the application date.

6. Pricing
Set out supervisory expectations for the risk-based pricing of loans.

7. Valuation
Provide guidance on the approaches to the valuation of immovable and movable property collateral at the point of credit granting, monitoring and review of the value of such collateral.

8. Monitoring
Specify the ongoing monitoring of credit risk and credit exposures, including regular credit reviews of professional borrowers.

Non-exhaustive highlights of the content of the draft EBA Guidelines:

Internal governance and control:

  • The internal governance and control frameworks for the credit granting and decision-making process should build on the requirements of the EBA Guidelines on internal governance (PDF, 800KB), including the setting of a credit risk culture as part of the overall risk culture.
  • The Guidelines place a particular emphasis on the role of the second line of defence as part of a comprehensive credit risk management and internal control framework.
  • The credit risk appetite, credit risk strategy and the overall credit risk policy should be aligned to the overall Risk Appetite Framework (RAF). The credit risk appetite should consider both top-down and bottom-up perspectives, both supported by a budgeting process.

Credit risk policies and procedures:

  • Emphasis on minimising the risk of internal or external fraud in the credit granting process and that money laundering and terrorist financing (ML/TF) risks are well understood and addressed.
  • Need for a clear scope and definition for leveraged transactions as well as the institution’s appetite and strategy.
  • Provide specification on technology-enabled innovation for credit granting, including to capture, manage and control the associated risks and manage the potential for bias in the credit decision-making process. The management body should also understand how the technology-enabled innovation is used and impacts credit granting.
  • Require institutions to incorporate environmental, social and governance (ESG) considerations into their policies and procedures and develop specific green lending policies and procedures for the granting and monitoring of such facilities where relevant.

Remuneration:

  • Provide specification on remuneration, including for the need of policies and practices for staff involved in granting, administration and monitoring of credits to promote prudent credit growth and appropriate risk-taking behaviour.

Data:

  • Emphasis on data and information to be of adequate depth, breadth, accuracy, integrity, reliability, consistency, timeliness and traceability.
  • Data and information should be sufficiently detailed and granular to capture specific loan-by-loan information and linking to borrower and relevant collaterals. 
  • Data collection and management are expected to consider the relevant data fields necessary for potential future NPL management, using the EBA NPL transaction templates.

Credit risk monitoring framework: 

  • Should allow the gathering and automatic compilation of credit risk data without delay and with limited manual interface.
  • Should enable a single aggregated consistent and comprehensive customer view.
  • Should allow tracking of the credit decision-making process and escalations and include necessary key risk indicators (KRIs) at asset type or portfolio level.
  • Particular focus on quantitative and qualitative early warning indicators (EWIs), including defined trigger levels with assigned escalation procedures and assigned responsibilities for the follow-up actions.
  • Must allow the generation of granular risk data, including for the needs of prudential and statistical reporting, stress testing and crisis management purposes. 

Loan origination

  • Define the types and extend of information to collect for loan origination for consumers and professional borrowers, including the need to verify the authenticity and assess the plausibility of any information and data provided by the borrower.
  • Define series of minimum credit granting criteria (in Annex 1).

Borrowers’ creditworthiness:

  • Requirements for assessing the creditworthiness of different types of borrowers and for various types of lending, before concluding a new loan agreement or amending an existing one.  
  • Include the need for sensitivity analysis, reflecting potential negative scenarios in the future.
  • The Guidelines will replace the existing EBA Guidelines on creditworthiness assessments under the Mortgage Credit Directive (MCD) (EBA/GL/2015/11 PDF, 419KB).

Pricing framework:

  • Require to establish a comprehensive pricing framework related to loan pricing principles, consistent with risk appetite and business strategies and considering the profitability perspective.
  • Loan pricing is expected to consider costs items such as related to capital, funding, operation and administration, credit risk and any other real costs associated with the loan.

Collateral valuation:

  • In addition to immovable collateral valuation, the guidelines provide specific requirements for movable collaterals valuation, including:
    • To be assessed by an independent qualified valuer or appropriate advanced statistical models.
    • To specify internal thresholds and limits for when such individual valuations are needed at origination.
    • To have adequate IT processes and systems in place and accurate and sufficient data available necessary for statistical valuation.

Stress testing in monitoring process:

  • Should conduct regular stress testing of their credit portfolios (aggregate and relevant sub-portfolios) and individual exposures when appropriate (in line with the EBA Guidelines on stress testing PDF, 427KB.)

Indicative impact areas of the Draft EBA guidelines

Indicative impact areas of the Draft EBA guidelines

Key considerations

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, as the regulators are now moving away from NPL firefight 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 pitfall to develop remediation plans and better prepare interactions with the regulator.

Get in touch

KPMG has extensive credit management and regulatory experienced and can support banks with performing regulatory gap analysis, developing remediation plans and supporting implementation of change programs. Please do not hesitate to contact us, via this form, for any question and/or if you require any support to navigate these changes. 

We also invite you to visit our KPMG ECB Office website and/or contact Allan Folly Darlis for further information on the ECB supervisory approach to credit risk.

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