This summer the European Banking Authority (EBA) published a consultation paper containing draft guidelines on loan origination and monitoring. The deadline for comments on the consultation paper was September 30, 2019. When finalised, the guidelines will apply from June 30, 2020 and Member State competent authorities will have to report on whether or not they intend to comply with them.
The EBA has published the consultation paper in response to the European Council Action Plan on tackling the high level of non-performing exposures. Specifically, the EBA was invited to “issue detailed guidelines on banks’ loan origination, monitoring and internal governance which could in particular address issues such as transparency and borrower affordability assessment.”
This banking reform updater will review the EBA draft guidelines and in particular, discuss the position concerning governance and risk as well as the loan affordability review aspects of the guidelines and the potential impact that the guidelines may have on the secondary debt trading market.
The EU statutory basis of the draft guidelines is Directive 2013/36/EU (CRD IV), Directive 2014/17/EU (Mortgage Credit Directive) and Directive 2008/48/EC (Consumer Credit Directive (CCD)). Specifically, it specifies the internal governance arrangements, processes and mechanisms as laid down in Article 74(1) of the CRD IV1, requirements on credit and counterparty risk in Article 79 of that Directive, and the requirements in relation to the creditworthiness assessment of the consumer as set out in chapter 6 of the Mortgage Credit Directive and Article 8 of the Consumer Credit Directive.
The draft guidelines apply to the internal governance and procedures in relation to credit granting processes and throughout the life cycle of credit facilities. They also apply to the risk management practices, policies, processes and procedures for loan origination and monitoring performing exposures, and their integration into the overall management and risk management framework. Debt securities are, however, excluded
from the scope of application of the draft guidelines.
The sections of the draft guidelines dealing with internal governance and monitoring2 apply in relation to all credit risk being taken by institutions. The requirements for loan origination and pricing3 cover the process of granting loans to consumers and professionals. However, these sections don’t apply to loans or advances to certain institutions4. The loans and advances that are within scope of the requirements are those that are originated after the application date of the draft guidelines (when finalised). However, they do operate to capture existing loan agreements where terms are renegotiated or that require specific actions triggered by the regular credit review of the borrower after the application date, even if they have been originated before the application date.
A further section5 applies to the valuation, monitoring and revaluation of immovable property collateral and moveable property collateral, excluding financial collateral. A final section6 covers the monitoring framework.
Supplementing the draft guidelines are three annexes that present a set of considerations for credit granting criteria (Annex 1), for the types of documents to be collected by the institutions for the purposes of the creditworthiness assessment (Annex 2), and metrics that can be used in credit granting and monitoring (Annex 3).
Linkage between prudential and consumer credit frameworks
The draft guidelines cover loan origination and creditworthiness assessment from both a prudential and consumer protection angle. This is unsurprising as it was indicated in the European Council Action Plan and the EBA’s own statutory objectives include both prudential and financial stability as well as consumer protection.
The EBA has previously issued guidelines specifying the creditworthiness assessment for credit agreements with consumers in respect of credit agreements that fall under Article 3 of the MCD. These have been incorporated into the draft guidelines and will be repealed on June 30, 2020 when the draft guidelines are finalised and apply to Member States. A useful table is set out on page ten of the final report illustrating how the draft guidelines incorporate the existing EBA guidelines on creditworthiness assessment. This will be particularly useful for institutions subject both to CRD, MCD and CCD (e.g. credit institutions offering loans secured by residential immovable property) in that in the future they will need to implement only one set of guidelines on creditworthiness assessment.
In terms of implementing the draft guidelines when finalised, a proportionality principle is applied in different ways in relation to various sections. For the implementation of the requirements relating to internal governance, risk management and control, institutions and competent authorities are to consider a proportionality principle that is based on the size, nature and complexity of the institutions concerned. When implementing the requirements for the creditworthiness assessment, loan pricing, collateral valuation and credit risk monitoring, competent authorities and institutions should consider the type, size, and complexity of the credit facilities being granted or monitored.
Governance and risk points
Robust processes for loan origination are key to ensure consumer protection and also fair outcomes in the lending sector. In its latest consultation the EBA includes some particular focus areas of clear merit
- Management body – having a clear governance body to define credit risk appetite, approve credit granting strategies and processes, and oversee both credit risk quality and provisioning
- Credit risk culture – both how this is disseminated throughout organisations and also how this is monitored and then deficiencies remediated
- Credit risk policies and procedures – containing clear information on credit approval and granting processes, information and verification required for creditworthiness assessments, conditions for automated decisioning, record keeping requirements and how exceptions and breaches are handled
- Credit decisioning – establishing a clear framework with properly articulated governance, decision-making powers, mandates and standards.
The consultation also usefully sets out guidelines for anti-money laundering and counter-terrorist financing, and environmental factors including green lending. The latter is becoming ever more important globally where regulators are beginning to require firms to build climate and environmental risks into their risk management and governance frameworks.
Importantly, these guidelines should result in more consistent frameworks across European banks and lenders. Aligning their credit risk processes to their wider Risk Appetite Framework (RAF) should also bring greater transparency and ability to challenge at senior management and board level committees.
As firms assess their processes against these guidelines they should also not lose sight of the “conduct risk” aspects of loan origination as well as the “credit risk” ones. Understanding good conduct management information (MI) around affordability, arrears levels and reasons for them, vulnerable customers and issues such as complaints are critical wider lenses that help both inform and refine the quality of responsible lending provided.
Firms would also be wise to develop metrics to help build predictive strategies – so they can help spot issues as and when they arise rather than deal with detriment that has already crystallised.
It is also critical to be able to evidence how, in practice, firms are carrying out their lending in accordance with these guidelines when they come into effect.
Potential impact on the secondary debt trading market
It is noteworthy that the guidelines identify three sectors in particular: commercial real estate, shipping finance, and project and infrastructure finance, for specific attention with regard to credit assessment expectations for lending banks. It is perhaps not surprising to find that these are sectors where the market has seen a large volume of secondary debt trading over recent years, particularly in the form of larger value portfolios, with an increasing proportion of wholly or partly distressed/non-performing portfolios becoming available.
So what impact might this have on the secondary debt trading market for these sectors in particular? One impact could be that potential buyers take a greater interest in understanding at due diligence stage the extent to which the guidelines have been complied with by the selling bank when originating or, potentially more relevant in the shorter term, re-negotiating pre-existing loans that are comprised in the book (whether or not originated by the selling bank). To the extent that the guidelines have been incorporated or otherwise reflected in local banking codes of conduct in the relevant country, this might further focus the minds of the buyer community if it could increase the likelihood of an obligor raising a complaint or seeking to challenge the sale. There is also a question as to how relevant banking regulators in the countries of selling banks will look at a sale where the guidelines have not been complied with.
Ultimately, it is a timely reminder of the increasing focus on loans in these sectors and suggests that the EBA sees a need to take an increasingly paternalistic approach to address some of the historical practices that have created such a large volume of secondary debt trading in these areas in recent years
As stated above, when finalised the guidelines will apply from June 30, 2020 and Member State competent authorities will have to report on whether or not they intend to comply with them. However, the Loan Market Association is lobbying the EBA for an extension to this deadline arguing that financial institutions need more time to implement the new procedures.