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Regulation: EU NPL initiatives spell confusion for banks

European Commission vice-president Valdis Dombrovskis hopes to complete banking union by June

In mid March, the European Commission (EC) announced a proposal aimed at preventing Europe’s banks from becoming embroiled in another non-performing loans (NPLs) crisis. A day later the European Central Bank (ECB) announced its own measures to achieve the same goal, although by different means.

The moves are part of an effort to appease some jurisdictions, most notably Germany, hesitating to agree to a pan-European depository insurance scheme (EDIS). The reluctance stems from the higher perceived risks in banking markets such as Greece, Cyprus and Italy, where the NPL problem has been most acute and progress has been relatively slow. EC vice-president Valdis Dombrovskis says the EC’s proposal provides hope that full banking union could be completed by June this year. EDIS is the final piece of that plan.

The EC proposal seeks to introduce a minimum coverage ratio for NPLs through an amendment to the Capital Requirements Regulation, meaning that it will be binding for all banks in the Union. Loans originated after March 1 this year will be subject to a timeline of increasing provisions. Secured loans would need a coverage ratio of 5% in year one, increasing to 100% by year eight. Unsecured loans would need 35% coverage in year one; 100% by year two. Banks would do this either by deducting from their capital or writing them off via profit and loss provisions.

The ECB’s guidance, on the other hand, is non-binding and will be set on a case-by-case basis. It only applies to loans that become delinquent after April 1, regardless of origination date and it differs in its timeline for secured loans, which would need to be fully provisioned by year seven. Its incremental step ups are also different to the EC’s, with secured loans needing 40% provisioning after three years of being classified as non-performing.

The ECB noted that if it deems Pillar 1 requirements as insufficient for any given bank, it may implement Pillar 2 requirements.

How the two proposals (if the Commission’s is adopted) would interact is unclear. “That’s the crux, and will be a focus of much analysis,” says Pablo Portugal, director at the Association for Financial Markets in Europe (Afme) in Brussels. But the ECB’s proposal will be the one that bites first, Portugal says.

Taken issue

Afme and other market participants have taken issue with the Commission’s proposal, arguing that many banks have NPL measures in place already and that a Pillar 1 requirement could make the playing field uneven. “We are unconvinced that statutory prudential backstops are an appropriate tool as they are blunt and not designed to cater for the diversity of NPL situations in institutions and member states,” says Portugal.

The European Banking Authority estimates that the impact to the average European bank would, after 20 years and under the assumption that there is no improvement in origination standards or changes in provisioning policy, be a decrease of 205 basis points in its common equity tier-1 ratio.

Analysts at CreditSights say that estimate is “fairly limited.” If actions are taken, it could be as little as 56 basis points by year seven, although the actual impact will vary from bank to bank. “Banks which already apply conservative provisioning practices would not experience any impact as a result of the proposed measures,” says CreditSights.

Changes in provisioning practices stemming from the implementation of IFRS 9 this year – under which banks have to account for expected losses over the lifetime of assets – will be taken into account, the EC says. Nonetheless, questions remain about how the two proposals will interact in practice.

Some of the EC’s proposals do target existing NPL stock. It issued guidance on how banks and public authorities can set up asset management companies, like those in Ireland (Nama) and Spain (Sareb), through directives that would have to be transposed onto each country’s statutes. It also proposes removing barriers in some national laws to servicing and loan transfers to third parties, by providing licenses to asset managers to buy and trade the loans across the EU; a measure broadly applauded by the industry.

And for NPLs originated to small businesses, the EC proposes creating a process to accelerate out of court collateral enforcement that would help cut through national insolvency laws that often make it difficult for banks to seize collateral without going to court.

Italy’s insolvency laws are notorious in this regard – it often takes banks more than a year to access assets underlying loans. The acceleration process would only be available on loans: “Where the business explicitly agrees to it when concluding the loan contract,” notes CreditSights.

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