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Evolving credit standards

Credit Underwriting and Loan Origination

The ECB's credit underwriting exercise and the EBA's consultation on loan origination herald growing supervisory scrutiny on credit standards - throughout the lending lifecycle. They also show an increasingly forward-looking approach to credit supervision. Banks can learn from their experience of the review by ensuring they're ready for enhanced future scrutiny of their credit data.

Faced with widely reported reductions in banks' credit underwriting standards - such as higher LTV ratios and weaker loan covenants - European regulators and supervisors are paying 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 a European level, it is a strong reinforcement of the required standards and it will have a direct impact on banks' internal processes, IT infrastructure and governance.

As leading banks are well aware, the ECB is already taking action on credit standards. In May 2019 it launched a credit underwriting exercise, requiring some directly supervised banks to complete a data template by 1 July. This phase will be followed by a quality assurance review. It is then expected that the ECB will 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 will have helped the ECB to gauge banks' implementation of BCBS 239, which sets out principles for the effective governance, aggregation and reporting of risk data.

Although the template only requests portfolio level data, KPMG expects that many banks will have found some aspects of the exercise hard to fulfil. Reporting timelines were tight, allowing only eight weeks, and the template covered a wide range of credit metrics at origination, across multiple domestic lending categories, for both existing and new loans from 2016 to 2018 inclusive. Cross-border activity was also requested, if exposures in a determined country exceeded a 2% threshold of institution's total performing exposures. The template included a number of metrics that many banks have had difficulties in collecting and aggregating (LTV, LTI, LSTI, DSTI, ICR, DSCR, etc.). These include IFRS9 risk parameters for periods before 2018; classification of business volume based on 1-year PDs and on LGD, metrics definitions across a number of different portfolios; and information on the performance of past loans origination and evolution of portfolio stock, such as migration effects and reclassifications to non-performing status.

The ECB is not alone in its focus on credit underwriting. The EBA has also identified loan origination as a priority for 2019, and on 19 June published a consultation paper on loan origination and monitoring.

The planned guidelines take a notably 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 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. In fact, the EBA's proposed guidelines require banks to collect many of the same metrics as those demanded by the ECB's exercise.

The ECB's exercise and the EBA's consultation paper take a more forward-looking, pro-active view of credit standards than previous supervisory initiatives have done. As such, they underline the growing desire of Europe's supervisory bodies to understand and monitor credit quality throughout the lifecycle of a loan, from initial analysis right through to maturity. These similarities mean that banks' experience of the recent ECB exercise should help them to understand the difficulties they are likely to encounter in complying with the EBA's coming guidelines. Banks need to reinforce their data infrastructures, ensuring they have timely access to credit underwriting and monitoring data at sufficient levels of quality and granularity to meet the supervisory requirements of the future.

Once the Guidelines have been implemented, the ECB is likely to test the resilience of banks internal processes and policies to ensure adequate governance, processes and robust infrastructure regarding loan origination. This will be part of their wider long-term efforts to reduce non-performing loan stock across Europe and ensure that new loans are of higher quality based on borrower's repayment capabilities.

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