Credit risk remains at the top of supervisors’ agenda and is a key component of the 2021 Supervisory Review and Evaluation (SREP) dialogues which started in September 2021. Banks’ remediation of findings around governance, classification, staging and provisioning will continue to be the focus of attention during 2021 and into 2022.
Despite the ongoing effects of the COVID-19 pandemic, the asset quality of European banks continues to improve, thanks largely to the extensive coordinated efforts by EU authorities to support borrowers and the economies. The latest EBA risk dashboard shows that aggregate EU non-performing loan (NPL) ratios declined again in the second quarter of 2021, reaching 2.3% as of 30 June 2021. However, regulators remain alert – after all, the full impact of the crisis is not yet known. As a result, banks are still under pressure to ensure that their risk management frameworks will allow them to quickly identify and respond to signs of borrower distress.
This was evident from the initial SREP 2021 dialogues between banks and the ECB, which began in September 2021. It seems that credit risk remains one of the key SREP topics, and is likely to push up many banks’ Pillar 2 Requirements (P2R) this year. We also expect credit risk to remain one of the main SSM priorities for the year ahead, with follow-up on existing issues identified this year – as highlighted in a speech by Edouard Fernandez-Bollo of the ECB’s Supervisory Board in October 2021.
In 2022, banks will therefore be expected to continue improving their credit risk management frameworks. This includes adequate implementation of the EBA Guidelines on loan origination and monitoring, for which we anticipate more thorough assessments of compliance from the ECB. The emphasis on climate-related credit risk is also likely to gain momentum next year, given the upcoming ECB climate risk stress test and authorities’ growing focus on this area.
Dear CEO letters and SREP 2021
During the first half of 2021 the ECB has been assessing banks’ answers to its two Dear CEO letters of July 2020 and December 2020. Joint supervisory teams (JSTs) have provided feedback to banks’ responses, including key gaps identified with peers and findings to remediate. The number of findings varied between banks, with an average of around 10 to 15 per institution. Most findings related to governance, classification (i.e., early warning indicators, monitoring, forbearance, unlisted trading privileges), staging and provisioning, financial forecasts, and collateral valuation. Internal audit functions are often expected to improve review activities in these areas. Banks have also provided their responses to JSTs detailing how they will remediate the findings.
Following these answers, JSTs will assess banks’ proposed approaches and monitor the implementation of existing and additional remedial actions on an ongoing basis. Some banks have been told this will form part of SREP 2021, while others were informed that remediation can occur in 2022.
Increasing activities with Commercial Real Estate (CRE) off-site inspections
Earlier in the year, the supervisory focus on credit risks was concentrated on sectors considered particularly vulnerable to the crisis such as accommodation, food, high street retail and small and medium-sized enterprises (SMEs). In the second half of the year the ECB is also focusing on performing off-site inspections (OfSIs) for sectors potentially subject to more structural stresses, such as CRE.
Although CRE assessments were performed earlier in the year, they were mostly focused on banks with a large CRE book or identified as being most at risk. There is now a much broader range of European banks being informed they will be subject to such CRE OfSIs in the coming months. This includes banks with small CRE-specific loan books and those that rely heavily on real estate collateral for SME and corporate lending. In the latter case, this can lead to discussions on what falls within the scope of the CRE definition. Ultimately, the results of these OfSIs are expected to be used to confirm the adequacy of banks’ valuation frameworks and the accuracy of their risk classifications and impairments.
Looking ahead: focus on remediating the key areas of deficiencies by the ECB
Recent ECB assessments of banks' credit risk management practices highlighted several areas of deficiencies creating concern among some banks. These areas of concern, which will remain the subject of supervisory focus this year and in 2022, include:
- Incorrect flagging of forbearance, with banks’ policies ignoring relevant regulatory requirements and lacking clear and granular criteria to effectively identify financial difficulties.
- Early warning systems and indicators that are insufficiently granular, outdated and mainly backward-looking.
- No updated information or additional UTP triggers tailored to the specificities of the pandemic.
- Delayed recognition of stage 2 exposures, leading to inadequate provisioning and the deterioration of loans into NPLs due to delayed action.
- Use of biased approaches which artificially stabilise provisions.
- Inadequate governance and risk management frameworks needed to properly estimate overlays.
- Deficiencies with immovable collateral valuations, such as insufficient frequency of monitoring and updating, and the absence of clear linkage between market risk reviews and revaluations.
- Inadequate practices in the way banks include the potential impact of COVID-19 in their strategic and business planning – leaving them ill-prepared for a pick-up in distressed debtors.
- Incomplete coverage, scrutiny and review of these processes and controls by the internal audit function.
These weaknesses resonate with what we see as being the key areas of focus for JSTs, and the major findings they have identified. Banks will be expected in 2022 to continue dedicating adequate levels of resources and effort into resolving those findings during 2021, as well as increasing their focus on climate-related credit risk and modelling.