Do COVID 19 support programs result to shocks in non-performing loan exposure?

Managing the duplex cliff effects of the European COVID 19 payment moratoria

Thijs Peeters, Mount Consulting – November 2020

Relaxed regulations mitigating the COVID 19 impact on the banking sector

Since the outbreak of COVID-19 and its global spread since February, the European Banking Authority (‘EBA’), along with national competent authorities, and the European Central Bank have taken measures to ease the granting of moratoria (payment holidays) by the European banks to its customers. As part of a diverse set of relaxation measures, varying from a relief of operational aspects of supervisions to the allowance of using capital instruments that do not qualify as Common Equity Tier 1, the EBA and ECB introduced supervisory flexibility regarding the treatment of non-performing loans.

With the ‘Guidelines on legislative and non-legislative moratoria on loan repayments’ (“Guidelines”), EBA clarified that generalized payment delays due to legislative initiatives and addressed to all borrowers do not lead to any automatic classification in default, forborne or unlikeliness to pay. For this reason, exposures benefiting from moratoria will not be automatically classified as forborne or defaulted for regulatory and accounting rules (IFRS 9). Individual assessments of the likeliness to pay should be prioritized. When applying the IFRS 9 international accounting standard, institutions are expected to use a certain degree of judgement and distinguish between borrowers whose credit risk would not be significantly increased by the current situation in the long term, and those who would be unlikely to restore their creditworthiness.

Relaxations not being eternal     

At September 21, the EBA announced it will phase out its Guidelines on legislative and non-legislative repayments moratoria. The developments of the COVID 19-pandemic and the progress of the flexibility provided from April, gave, at that moment, reason not to extend their exceptional measures: the Guidelines had provided the necessary flexibility in light of significant number of actions taken by banks to support their customers. The payment moratoria have been an effective tool to address short-term liquidity challenges caused by the COVID 19-pandemic. Moreover payment moratoria will continue producing their effects for a while[1]. From September 30, 2020, the practice that any rescheduling of loans should follow a case-by-case approach, has returned. This means that the Guidelines will continue to apply to all payments holidays granted under eligible payment moratoria prior to September 30, 2020, and new or extended payment holidays from October 1, have to be classified on a case-by-case basis according to the usual prudential framework. Exemptions for default, forborne or UTP classification are over. At least for now.

The double whammy cliff effect

With the termination of exemptions, cliff effects risks pop up. Government measures will relieve borrowers’ financial burdens and cushion the impact of asset-quality deterioration on banks’ balance sheets. Vulnerable obligors, however, may not avoid default (or being classified as an obligor with a significantly increased credit risk) and will be unable to resume repayments once support is removed.

Regulators as well as rating agencies around the globe do expect a rise in non-performing exposures, particularly once the effects of the mandatory payment moratoria decreed by several euro area governments expire. Many banks seem reluctant to formally recognize any significant increases in credit risk on their exposures so far. Research shows that during the previous financial crisis, banks took a long time to fully recognize Non Performing Loans (‘NPL’) and NPL levels peaked at a much later stage. And those banks being ineffective in measuring and monitoring their actual NPL exposure will not only be hit by a shock increase of defaults but also by an ‘unexpected’ P/L hit and increase of required capital. In the previous financial crisis, IFRS 9-staging was not applicable. The use of lifetime probability of default will result into higher expected credit losses this time.

Managing the cliff effects

The banks that will get out this crisis best, have in place tight loan deterioration monitoring and management strategies which enable them to identify risks at an early stage and detect default during the grace period. They should proactively identify and engage with potentially distressed borrowers. By acting in a timely manner, banks can minimize potential cliff effects when the moratoria measures begin to expire and anticipate possible capital requirement effects.

Hard default triggers, identified automatically, like days past due, provide less comfort, due to the  payments holidays. So banks should rely/leverage on other indicators identifying unlikeness to pay of their vulnerable obligors. Front Offices, working closely together with Credit Risk Management, should pay extra attention to obligors from those sectors that are hit most by the country specific lockdown measures. Regular watchlist procedures should proof their effectiveness identifying those obligors with high inherent credit risk. UTP Assessments should take place shortly after the expiration of the respective payments holidays, prioritizing obligors with a multitude of moratoria extensions. Next to that, special attention should be given to obligors with multiple requests for payments holidays.

Proper recording of data by the front office, together with mutual understanding of the data across the reporting and modeling chain, are essential ingredients for accurate measuring and monitoring of increased default risk. Especially in multinational organizations covering different jurisdictions, each with their own menu of supporting measures, the use of consistent and unambiguous definitions is key for consolidated credit risk measurement. Hopefully banks can leverage from an effective embedding of definition of default legislation and IFRS 9 principles. The latter to have the definitions of expected credit loss and provisioning aligned with default and non-performing.

[1] The duration of the payment extensions in Europe has been on average between 6 and 12 months.