The outbreak of the COVID-19 pandemic in the past year evoked a whole series of unprecedented emergency measures. The European Commission’s COVID-19 banking package, aimed at ensuring that banks were able to continue lending, and the decisive action of member states to alleviate liquidity difficulties, helped borrowers with temporary liquidity problems and prevented a surge in non-performing loans (NPLs), providing stable short-term relief for the European economy.
But, although pressures on asset quality are yet to be fully reflected with borrower relief measures still in place in many member states, it is important that policy makers and banks prepare for the challenges that increasing numbers of NPLs will bring, as the experience with the aftermath of the 2008 global financial crisis highlighted.
In this briefing we look at the regulatory response of the Commission’s plan to take on NPLs.
Recent Development in NPLs
Due to decisive action and far-reaching measures taken at national and EU level and by virtue of the overall better economic conditions compared to the years before the 2008 global financial crisis, the level of NPLs in Europe had declined substantially before the COVID-19 pandemic.
However, following the COVID-19 pandemic, NPLs are expected to increase. NPL levels and ratios continue to vary greatly across member states and banks. High ratios remain a serious challenge in some banks and weigh on their performance. Consequently, decreasing the number of NPLs is one of the EU’s priorities in order to reduce further risk in the banking sector.
Regulatory EU initiatives
In March 2017 the European Central Bank (ECB) published guidance on NPLs to banks across the Euro area. The objective of the guidance was to develop a consistent supervisory approach regarding the identification, measurement, management and write-off of NPLs. Later that year, member state finance ministers in the ECOFIN agreed on a first Action Plan to tackle NPLs (the 2017 Action Plan). An addendum to the ECB guidance was published a year later in 2018 which specified the ECB’s supervisory expectations for minimum levels of prudential provision for new NPLs. The latest Commission Action Plan builds on the 2017 Action Plan, in particular in relation to secondary markets and insolvency frameworks.
Building on the 2017 Action Plan, the Commission is pushing for further targeted measures to address a possible accumulation of NPLs as a result of the COVID-19 pandemic. In particular, the Commission t proposes a range of new procedures to stand against the economic pressure coming from a bigger flow of NPLs.
- The Action Plan focuses on a mix of complementary policy actions in order to:
further develop secondary markets for distressed assets, which allows NLPs to be moved off banks’ balance sheets while still ensuring enough protection for debtors; and to
- reform the insolvency and debt recovery frameworks to guarantee an appropriate balance of interests between creditors and debtors.
The Action Plan is designed to help the EU economy deal with a possible increase in COVID-19-related NPLs and as a consequence of that aid the economic recovery for the benefit of businesses and households across the EU.
The NPL strategy of the Commission consists of four main goals:
- further develop secondary markets for distressed assets, which will allow banks to move NPLs off their balance sheets, while ensuring further strengthened protection for debtors;
- reform the EU’s corporate insolvency and debt recovery legislation, which will help converge the various insolvency frameworks across the EU, while maintaining high standards of consumer protection;
- support the establishment and cooperation of national asset management companies (AMCs) at EU level; and
- implement precautionary public support measures, where needed, to ensure the continued funding of the real economy under the EU’s Bank Recovery and Resolution Directive and State Aid Frameworks.
Further description of the goals
1) Development of secondary markets for distressed assets
It is the Commission’s goal to create a deep and liquid secondary market for distressed assets so that banks may reduce their NPLs by selling them to third-party investors. By doing so, banks may focus on their core activities and be able to start lending again, enabling them to fund their economic recovery.
The Commission would like to build on its earlier proposal of a Directive on credit servicers, credit purchasers and the recovery of collateral (COM/2018/0135 final – 2018/063 (COD)) which seeks to open up markets whilst ensuring that debtor protection is not weakened. The Directive was adopted in March 2018 but has not reached inter-institutional negotiations in the European Parliament.
In order to improve the functioning of secondary markets, better quality and comparability of NPL data through data standardisation across Europe is required. To achieve this, the Commission wants to rely on data templates that the European Banking Authority (EBA) developed in 2017 to build a common dataset for NPL transactions. However, due to their voluntary nature and complex structure, these templates are not widely used which is why the Commission proposes to review and improve them. Recently, the EBA issued a discussion paper intended to facilitate a review of the standardised NPL data templates.
Furthermore, to achieve market transparency and consolidate infrastructure, the Commission recommends establishing an EU central data hub that would act as a data repository underpinning the NPL market. The purpose of the hub would be to increase market transparency at a granular level whereby anonymised data on NPL transactions could be collected and stored. The hub would provide market participants with post-trade transaction details and sale prices. Using this data market participants could compare transactions and gain insights into the pricing of assets and market liquidity, thereby supporting price discovery and enhancing market efficiency on secondary markets.
Additionally, the Commission proposes to leverage already existing data sources, for example the ECB’s “Analytical Credit Dataset”, securitisation repositories and data reporting by banks. These could form the basis for regular reports on aggregate information that would be made available to secondary market participants.
The Commission is also aiming to develop guidance for sellers of NPLs, including recommendations on what entails a “best execution” sales process, while ensuring further strengthened protection for debtors.
Lastly, the Commission intends to develop, together with the EBA, a suitable approach to remove the remaining impediments for banks buying NPLs in the secondary market, in particular the regulatory treatment of purchased defaulted assets and the risk weights that banks need to apply to calculate capital requirements under the Standardised Approach for credit risk.
2) Insolvency, debt recovery and debt restructuring frameworks
Another key measure of the Action Plan is the convergence of insolvency frameworks across the EU, through legislative or non-legislative proposals, which would also improve the efficiency of these proceedings within the single market.
In the short term, the Commission would like to reach an agreement with the European Parliament and Council on the legislative proposal for minimum harmonisation rules on accelerated extrajudicial collateral enforcement (COM/2018/0135 final – 2018/063 (COD)) which would help the economic recovery by facilitating SME access to bank finance. Inter-institutional negotiations have not yet started.
Additionally, the EU now has access to the final report of the benchmarking exercise of loan enforcement regimes, which was part of the 2017 Action Plan and contains a wide range of useful data, including recovery rates, time to recovery and cost of recovery by member state and asset class. By analysing the data, the Commission wants to assess the efficiency of the legal framework in member states in terms of defaulting or insolvent debtors in relation to bank loans, thereby finding possible issues to improve. The Commission will further investigate whether it is appropriate to make insolvency benchmarking a more regular exercise.
Moreover, in the opinion of the Commission, the transposition of Directive (EU) 2019/1023 on preventive restructuring frameworks should also help prevent the build-up of NPLs. The aim of the Directive is to provide for a harmonised minimum restructuring standard across the EU enabling “honest entrepreneurs” to better manage financial difficulties with a view to giving viable businesses a “second chance” thereby helping to reduce the risk of loans becoming non-performing and mitigating the adverse impact on the financial sector. At the same time, non-viable businesses with no prospect of survival would be liquidated as quickly as possible. Member states should adopt the laws to comply with this Directive by 17 July 2021 at the latest.
Further, the Commission envisages a Recovery and Resilience Facility (RRF) that incentivises and supports reforms to reduce NPLs to improve the efficiency of member state insolvency frameworks and modernises administrative and judicial systems.
The benchmarking results should also be included in the preparatory work for a legislative or non-legislative action on targeted convergence of member state non-bank insolvency frameworks under the new Capital Markets Union Action Plan from September 2020. The Commission wants to work towards targeted harmonisation or convergence of core aspects of substantive insolvency law, such as triggers for opening insolvency proceedings, the ranking of claims, avoidance actions, the identification and tracing of assets belonging to the insolvency estate and asset valuation.
3) Asset management companies (AMCs)
To deal with an increase of NPLs, the Commission is going to support member states in the set-up of national AMCs and explore the merits of establishing a network of national AMCs at the EU level.
AMCs provide a very effective measure when impaired assets affect large parts of a domestic banking system and mainly cover loans secured by commercial real estate and large corporate exposures. AMCs can be private or partly publicly funded, alternatively they can be established at the national level. National AMCs may procure and centralise expertise, benefit from economies of scale and creditor coordination at a higher level, and provide relief to affected banks.
In order to make a meaningful contribution to tackling COVID-19 related NPLs, AMCs would need to have sufficient financial firepower in terms of loss-absorbing capacity. AMCs at the national level would therefore need substantial financial backing when starting up. In proposition of national AMCs, the Commission highlights the possible set-up according to the needs of the domestic banking sector where the asset perimeter could be defined in a way as to maximise potential and upside, building on the Commission’s AMC Blueprint guidance.
Furthermore, the Commission is thinking about a cross-border network at the EU-level for cooperation among member state national AMCs and for creating valuable synergies. Such cooperation could take advantage of economies of scale in dealing with information in which the aforementioned data hub could provide a platform for coordination and cooperation between the AMCs. Data gaps could be filled and transparency could be added to the secondary market because AMCs possess a wealth of data that could be valuable to market participants. Benefits of such a network depend on the degree of homogeneity and on the number of national AMCs.
4) Precautionary public support measures
In the Commission’s proposal market-based solutions should remain the first and primary tool for addressing NPLs and the strategy that the Action Plan lays down aims to facilitate them and exploit their full potential. However, if there are signs that the effects of COVID-19 could cause distress to banks and pose financial stability concerns that exceed the capacity of available market-based solutions, the Commission is of the view that the EU’s bank crisis management and State aid rules would allow for the provision of precautionary public support.
As banks play a central role in dealing with the effects of COVID-19 by maintaining the flow of credit to the economy, support to the banking sector is meant to incentivise the continued funding of economic activity in the EU. Precautionary measures by member states can take different forms as alternative or complementary solutions. In particular, the Commission confirmed the possible use of precautionary measures to finance the transfer of NPLs to an AMC in its AMC Blueprint, as long as such transactions pursue the same objectives of capital injections. This is also the case with asset protection schemes (APSs), which is why it is possible to implement APSs as precautionary measures under the Bank Recovery and Resolution Directive (BRRD).
The EU’s crisis management framework provides a set of tools for institutions that are failing or likely to fail. The BRRD recognises the existence of exceptional situations where the need for public financial support does not trigger a declaration that an institution is failing or likely to fail. The Commission considers that the exception in Article 32 (4) (d) (iii) BRRD may be applied during the COVID-19 pandemic on the basis that it identifies the pandemic as a serious disturbance to the economy which can fall within the scope of the 2013 Banking Communication. Measures taken to remedy such disturbance can belong to the exception provided for by the BRRD. For the avoidance of doubt, measures may be granted only to solvent banks. The condition of solvency is to be assessed by the competent authority, and should be met at the time when the measure is granted.
NPL transfers to a publicly backed AMC are considered impaired asset measures (IAMs), which are governed by the Commission’s guidelines on State aid to banks.
The EBA has welcomed the Commission’s Action Plan to tackle rising NPLs, which, as stated, also requests the support of the EBA to improve data quality and comparability, enhance transparency and address regulatory impediments to NPL purchases. The EBA states that it will act accordingly to support the initiatives.
Building on the measures presented by in the 2017 Action Plan, further structural measures are needed to address a possible accumulation of NPLs over the medium term. The regulatory response of the Action Plan to the possible increase in NPLs during and after the COVID-19 pandemic is pieced together by different measures and presents an EU-wide strategy to anticipate a future build-up of NPLs on bank balance sheets, while ensuring a high degree of consumer protection. The strategy combines measures at member state level with a pan-European effort. The success of both member state and European measures will ultimately depend on a range of legal acts harmonising insolvency and enforcement frameworks across member states.