Managing credit risk and capital procyclicality in the context of COVID-19.

The COVID-19 pandemic is putting European banks and financial institutions at the heart of a fast-changing crisis.

Initially, the major challenge for banks came from liquidity management – the result of country lockdowns that resulted in deteriorating corporate revenues and drawdowns of credit facilities as well as national measures to ease payment pressures on individuals and businesses. However, as the crisis continues banks and supervisors are shifting their focus to credit quality and loan impairments.

That means that the next priority for banks is to limit the procyclical effects of the crisis and avoid serious repercussions for the real economy. Secondary effects on credit risk capital are already being felt, threatening to hamper the industry’s recovery and reduce the availability of credit. Based on current rules and regulations, the crisis is expected to create a significant increase in credit risk-weighted assets (RWA) and provisioning levels in Europe according to IFRS over the course of the calendar year, especially starting from the second quarter of 2020. U.S. banks have reported record high provisions according to U.S. GAAP in the first quarter in 2020.

The good news is that supervisors and regulators are already taking a range of actions to provide additional guidance to manage procyclical effects on financial systems and the wider economy. This should support the industry with their activities and approaches, but much remains to be done.

On the supervisory side, the ECB has granted some flexibility over implementing its Guidance on NPLs for loans covered by public guarantees. It has relaxed UTP criteria for exposures covered by COVID-19 repayment moratoria and has provided guidance to potentially mitigate volatility in institutions’ regulatory capital and financial statements stemming from IFRS 9 accounting practices in the current context of extraordinary uncertainty. Capital requirements have also been eased, allowing banks to fully use their capital buffers and operate well below the levels previously required and expected by the ECB.

For its part, the EBA has clarified definitions of default relating to public and private repayment moratoria and has granted greater flexibility in implementing its Guidelines on the management of non-performing and deferred exposures. The EBA also notes that banks are expected to use a certain degree of judgement when applying IFRS9 principles, distinguishing those borrowers who will not restore their creditworthiness on a timely basis versus those whose credit standing will not be significantly affected by the current situation in the long term. The EBA highlighted the importance of adequately measuring credit risk, prioritising the individual assessment of obligors' likeliness to pay. Additionally, in line with their recent statements, the EBA recommends banks not to distribute dividends or share buybacks but instead use the capital relief resulting from ECB measures to finance corporate and household sectors.

Finally, governments also hope to reduce the economic shock of the pandemic via payment suspensions or deferrals. While the short-term effects of such moratoria will ease financial pressure on citizens and the industry, the medium to long-term effects have yet to be seen. Banks therefore might expect a significant increase in claims over the coming months, especially from borrowers hoping to restructure short-term debts into medium-term exposures, and the potentially significant impacts on their NPL stocks. The last month has also seen the rapid emergence of governmental ‘loan programs’ and ‘stimulus packages’ to support the economy. Aimed directly at individuals and businesses, these initiatives take various forms including loan guarantees, direct payments, recapitalization measures and the deferral of tax payments.

Managing the effects of the crisis on credit risks and capital levels is now a top priority for every bank. But meeting that goal depends on each institution’s ability to judge the potential impact of COVID-19 over several quarters, perhaps even several years and act accordingly.

The first and most obvious step is for banks to analyse their credit portfolios, identifying the sectors and companies most likely to have viable and sustainable business. When accounting for impairments, banks must comply with accounting standards which have not changed. Given the additional guidance published by the standard setter, regulators and supervisors, banks seem to expect that provisions in the context of COVID-19 crisis might tend to be lower than without the guidance.

Portfolio analysis should also allow banks to identify which debtors are eligible for repayment moratoria. The EBA’s Guidelines related to moratorium (EBA/GL/2020/02 (PDF 847 KB)) have been broadly welcomed by the industry, but it remains difficult to identify a few common schemes broadly applicable and supported by banking associations – within the different European countries. In addition, moratorium period remains unclear therefore more clarity would help banks with their approach.

Banks should also consider how the crisis may be affecting their credit risk monitoring systems, and what enhancements they should make in response. In some cases, banks’ internal frameworks have been adjusted to ensure inter-subjectivity of analysts’ downgrades and guide the analyst to the hot spots with the greatest need for re-rating.

When it comes to ongoing credit monitoring, credit risk departments seem to be focusing on three key actions:

• Identifying the most relevant indicators to monitor;
• Specifying which indicator changes should trigger downgrades; and
• Deciding when downgrades should be applied.

Banks seem to be aware that the CRR requirements still apply. They are conscious of supervisors’ reminders that they still need to carry out proper risk assessments of debtors and exposures. Banks must also tailor their risk assessments to different situations, for example by distinguishing clients applying for moratoria from those applying for government guarantees.

Lastly, it is essential that banks focus on the quality of their data and IT systems. Even though data management itself does not constitute a countercyclical measure per se, it should ensure, for example, that banks' portfolio analyses and market intelligence will be meaningful and reliable.

Indications of how the crisis will impact portfolios comes not only from credit monitoring, but also from banks’ internal risk models. Here too the situation is evolving rapidly, with many banks actively adjusting their approach.

Prudential regulations require risk parameters to be estimated over the full economic cycle, but banks can exercise some flexibility in calibrating their models. This could be important if models are to balance degraded conditions with the exceptional features of the current situation. Many banks are actively reconsidering their long-run PD calculations and readjusting their cyclical correlations.

Banks with internal ratings-based approaches will be faced with challenges to ensure the discriminatory power of rating models given the current exceptional economic conditions, not reflected in past historical time series. Model calibration and model validation will have to cope with the new significant change in rating inputs, especially with regards to rating overrides (also impacting banks' internal policies and procedures).

When it comes to the capital treatment of loans under government guarantee, the Basel Committee has already specified that the relevant sovereign risk weights should be applied. However, the possibility that some national guarantees may not be recognised as credit risk mitigation under Article 215 of the CRR makes the impact of these schemes unsuitable with the initial objectives. That could mean that sovereign weightings will not be enough to prevent an increase in RWAs. Even though we have seen some national decrees recently adjusted by some governments to allow a CRR recognition, this topic calls for careful assessment by banks, especially for international banks performing group-level consolidations.

European institutions are well aware of the damage that procyclicality could cause to the supply of credit and the whole economy. Supported by the financial industry, governments and supervisors are already taking action to mitigate these risks. Even so, banks still face a challenge to implement these changes, and to make assumption on mid to long-term implications. These assumptions are key to take the right credit decisions today and to appropriately develop ratings systems in the coming months.