A combination of supervisory initiatives over non-performing loans leaves banks facing a confusing `calendar of provisioning' framework. Institutions understand the importance of this issue, but are struggling to reconcile the practical short-term implications with the need for a clear - and clearly communicated - NPL strategy that can deliver long-term improvements.

It's nearly two years since the Council of the EU announced its action plan for tackling non-performing loans (NPLs). This reflected serious concerns about the potential impact of Europe's NPL overhang on the strength and stability of banks, the success of the Banking Union and European economic prospects.

Fast forward to today, and the ECB has identified NPLs as a supervisory priority for the third year running. There could hardly be a more compelling sign of the size and persistence of Europe's NPL problem.
Out of the raft of initiatives from the ECB, EBA and the European Commission (EC), the most notable requirements for European banks to take into account are:

• The ECB's Guidance to banks on NPLs, issued in March 2017 (ECB NPL Guidance (PDF 1.98 MB));
• The ECB's Addendum to its NPL Guidance, proposing supervisory expectations for `prudential provisioning' of new non-performing exposures (NPEs) classified as such from 1 April 2018, issued in March 2018 (ECB NPL Addendum (PDF 458 KB));
• The supervisory expectations for NPL provisioning set out in the ECB's 2018 Supervisory Review and Evaluation Process (SREP) letters (ECB NPL SREP Expectations);
• The upcoming regulation amending the Capital Requirements Regulation (CRR) to introduce common minimum loss coverage levels (Statutory Backstops (PDF 411 KB)) for newly originated loans that become non-performing; and
• The EBA's Guidelines on the management of non-performing and forborne exposures, issued in October 2018 (EBA/GL/2018/06, EBA NPE Guidelines (PDF 1.41 MB)).

A recent KPMG survey of 14 banks in six EU member states shows that banks are in no doubt of the need to treat NPLs as a serious priority - not just in compliance terms, but also at an operational and strategic level. The survey makes it equally clear that most banks are uncertain how they should implement the differing requirements in practical terms - let alone manage the implications for profitability and capital.

Banks must understand and implement a variety of initiatives, all of which require potentially far-reaching changes to strategies, business models, operations and infrastructure. One example is the shift from an `originate-to-hold' business model to one of `originate-to-sell' - something that could require an automated mechanism for disposing of unsecured NPLs before they reach two years' vintage.

Furthermore, the different initiatives are not fully aligned in terms of their detailed timings and provisioning requirements. For instance, many banks seem to have been surprised by the ECB NPL SREP Expectations. A number of institutions feel that these are not always aligned with the expectations set out in the ECB NPL Addendum. And there is further uncertainty over the Statutory Backstop and how it will align with existing initiatives in practical terms.

That leaves banks facing a complicated and challenging `calendar of provisioning' framework. This poses a number of obvious difficulties including:

• Preparing for and meeting supervisory requests. Banks face the possible threat of Pillar 2 supervisory measures should they fail to meet the ECB's expectations. Our survey suggests that Joint Supervisory Teams (JSTs) are conducting extremely thorough analyses in the field of credit risk, with data requests at a comparable level of detail to those of the Asset Quality Review. As an example, the ECB expects to conduct between 25 and 40 On-Site Inspections (OSIs) focusing on residential mortgages during 2019. Additional OSIs looking at commercial real estate and leveraged finance exposures are also anticipated.
• Setting and communicating an NPL strategy. Three provisioning calendar not only make it very hard to execute implementation efficiently, effectively and at low cost. It also poses challenges for banks as they seek to devise a clear strategic approach to NPLs, as well as communicating it to external stakeholders including investors, shareholders and rating agencies.
• Reconciling provisioning with other regulatory changes. The multi-tiered supervisory requirements around NPLs complicate the process of reconciling changing provisioning practices with the implementation of IFRS 9, the new Definition of Default and the EBA NPE Guidelines.

In short, banks not only face overlapping calendars of short-term provisioning requirements; they also need to take into account the longer-term implications for credit processes, management information systems, financial reporting and many other operational activities. Banks need a strategy that allows them to address compliance targets while building NPL management practices that will allow them to stay competitive and profitable into the future.