End-2020 assessments noted that European banks remain well-capitalised, have solid liquidity ratios and have increased lending to the real economy.

As a result, there has been some relaxation around dividend restrictions, albeit within strict parameters. However, particularly in the Eurozone, the spectres of bad loans and Basel 4 requirements loom. And consolidation in the banking sector is likely to accelerate.

These issues were discussed in KPMG's “Financial resilience in banking: a balancing act”.

Cautious movement on dividends

In December 2020, the ECB revised its July 2020 recommendation and granted some leeway for banks to resume distributions. This echoed the UK Prudential Regulation Authority's (PRA's) update, with both regulators under pressure to give ground given their statements on the robustness of capital positions. However, conditions remain.

European banks are asked to consider refraining from or limiting dividends and share buy-backs until 30 September 2021. Where dividends are paid, they are expected to remain below 15% of cumulated 2019-20 profits and not higher than 20 basis points of CET1 ratio, whichever is lower. Banks should also refrain from distributing 2021 interim dividends. Extreme moderation is expected (PDF 57.3 KB) on variable remuneration. Banks' remuneration policies will be assessed closely, with a specific focus on their impact on banks' ability to maintain a sound capital base. National supervisors are expected to apply a similar approach to less significant banks under their direct supervision. From end-September 2021, the ECB intends to return to assessing banks' capital and distribution plans based on outcomes of the normal supervisory cycle.

In the UK, capital distributions may also restart, with bank boards allowed to determine the appropriate level of 2020 dividend distributions within temporary guardrails. 2021 dividends may be accrued but not paid out, pending the outcome of a full system-wide stress test in mid-2021. Distributions should not create excess vulnerabilities to stress for a bank or prevent it from supporting households and businesses. The PRA expects firms to exercise “a high degree of caution and prudence” in determining the size of any cash bonuses for senior staff, including material risk-takers, and proposed pay-outs will be scrutinised closely. The PRA intends to transition back to its standard approach to capital-setting and shareholder distributions through 2021.

The message is clear: banks that wish to make distributions need to be profitable and have robust capital trajectories. Both regulators have set clear limits, expect close cooperation with supervisors and are likely to set a high bar for any exceptions. Although banks may still feel somewhat constrained, these concessions strike a balance between permitting some distributions while enabling the regulators to maintain a suitably prudent approach given continuing economic uncertainty.

Action on non-performing loans

With that uncertainty in mind, and notwithstanding the positive headlines on capital and liquidity ratios, the EBA's Annual Risk Assessment of the European Banking System and the EU-wide transparency exercise, published in December, highlighted record low levels of profitability and early signs of deterioration in asset quality. Stage 2 and forborne loans are increasing, COVID-19 has aggravated the need for measures to reduce operating costs and banks have more to do to adapt their systems to a challenging technological environment.

The impact of the pandemic on banks' balance sheets has not yet been reflected in full. Banks are still benefiting from public support measures, and credit impairments may come with a significant time-lag, requiring further regulatory support.

The European Commission has announced an action plan to tackle non-performing loans (NPLs) following warnings that bad debts on banks' books could triple to almost EUR 1.4 trillion, worse than after the 2008 financial crisis. Banks with high levels of NPLs could struggle to continue to lend and thereby support economic recovery.

Under the plan, the Commission will support governments in setting up national asset management companies (essentially “bad banks”) that will allow banks to move NPLs off their balance sheets. It will also develop an EU network for these institutions to coordinate and share information among countries. This network will benefit from a central data hub, designed to collect information on the distressed assets and help facilitate a secondary market. Other initiatives include reforming corporate insolvency and debt recovery legislation, to reduce national variations and maintain high standards of consumer protection, and implementing precautionary public support measures where needed to ensure the continued funding of the real economy under the EU's Bank Recovery and Resolution Directive (BRRD) and State Aid frameworks.

Today we put forward a set of measures that, while ensuring borrower protection, can help prevent a rise in [bad loans] similar to the one after the last financial crisis

Mairead McGuinness
European Commission chief for financial services

Consolidation in the banking sector

In line with expectations that consolidation in the banking sector will accelerate in 2021, the ECB has published a final guide clarifying its supervisory approach. The key messages are that:

  • The ECB supports sustainable consolidation projects based on credible business and integration plans and which demonstrate high standards of governance and risk management. 
  • Credible plans will not be penalised with higher Pillar 2 capital requirements. The ECB will engage with banks during the application process to indicate the capital levels the combined bank will need to maintain. 
  • Profits arising from badwill are expected to be used as capital for the combined bank. Banks should therefore not seek to pay dividends from badwill profits until sustainability of the business model has been firmly established. 
  • Acquirers are expected to take advantage of a relatively low acquisition price to increase sustainability.
  • The ECB will accept the temporary use of existing internal models, subject to a strong roll-out plan.

Impact of Basel 4 reforms on EU banks

The EBA’s December 2020 report on the impact of implementing the final Basel reforms in the EU shows that full Basel 4 implementation, to 2028, would result in an average increase of 15.4% on the current Tier 1 minimum required capital for EU banks. For large and internationally active banks (Group 1), that figure would increase to 16.2%, and for systemically important banks (subset of Group 1) to 23%. These figures appear to reinforce concerns voiced by banks that they would not have the financial resources both to implement Basel 4 and to support economic recovery effectively.

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