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Limited impacts from ECB’s latest bad-loan initiative

Expectation-setting with individual banks – the latest initiative in the ECB’s ongoing mission to deal with legacy NPL stocks in the euro area – is unlikely to have a major impact on in-process improvements in the overall landscape.

Using a benchmark of comparables and on the basis of NPL ratios and financial orientation, the ECB plans to set individual supervisory expectations around NPL management in order to achieve the same coverage of the stock and flow of bad loans over the medium term.

Supervisory dialogue already captures banks’ divergences from the prudential provisioning expectations laid out in the ECB’s March 2018 Addendum (and incorporated into the Supervisory Review and Evaluation Process from 2021). The latest initiative will likely have little impact on the majority of banks in most jurisdictions. Particularly as the NPL problem is in any case restricted to a small group of banks in a limited number of jurisdictions which experienced chronic economic and banking problems through the global financial crisis, euro sovereign crisis and since.

“I don’t see much novelty here: asset quality is already a part of the bank-supervisory dialogue – and a big part of it for banks with high NPLs. The ECB is merely formalising an approach it has likely held for some time,” said Marco Troiano, executive director in the banks team at Scope Ratings.

This new element of supervisory expectation-setting represents just the latest in a series of steps by the ECB and EBA to slay what they still see as the bête noire of legacy bad loans. They believe the aggregate level is still too high compared to international standards.

Potential future NPLs have been addressed through new provisioning rules – 100% coverage in two years for unsecured facilities; seven years for secured – as well as accounting rules that force banks to provision on an ongoing expected-loss basis.

On this latter point, the ECB acknowledged in its May Financial Stability Review that NPL coverage had continued to edge up in high-NPL countries, partly as a result of IFRS 9. “Based on public disclosures for a sub-set of high-NPL banks applying transitional arrangements under IFRS 9, the median estimated increase in NPL coverage due to IFRS 9 first-time adoption from the beginning of 2018 was four percentage points relative to stated end-2017 coverage levels,” the ECB noted. That is not trivial.

The continued focus on NPLs from policy makers, regulators and supervisors flies in the face of multi-year improvements. The significant institutions supervised by the ECB have reduced their NPL ratios from 8% in 2014 (the point at which the Bank started treating credit risk as a supervisory priority) to 4.9% by the end of 2017. In Q4 2017, the average NPL ratio for EU banks reached its lowest level since Q4 2014. Steady NPL sales activity over 2018 will have further reduced the ratios.

By way of comparison, however, the NPL ratio in the US was just 1.127% at the end of 2017, using World Bank data.

“Supervisors like to claim merit for the reduction in NPLs in Europe in recent years, but this is mostly driven by the improvement in economic conditions. NPLs are a lagged function of economic growth,” said Troiano.

The ECB noted in the Financial Stability Review that lower impairments costs were the main driver of higher bank profitability as new NPL formation slowed. The number of significant institutions with double-digit NPL ratios nearly halved over the last three years, the Bank noted, adding that for a sample of 17 high-NPL banks publicly disclosing their quantitative targets, the median reduction in NPL ratios would be around seven percentage points by the end of their target horizon (varying from 2019 to 2022).

Countries at the high end of pretty widespread cross-EU dispersion still lie at the heart of the issue. If overall NPL ratios by country range wildly (from 0.7% to 44.9%), non-performing exposures to real estate starkly highlight the issue. Greece had an NPL ratio in this category of 56.2%, while eight countries had ratios in excess of 20% – Cyprus (43.3%), Bulgaria (42.3%), Italy (34%), Portugal (33.4%), Ireland (30.2%), Slovenia (30%), Croatia (29.9%) and Romania (21.8%). Data for construction shows a similar trend.

“The continued focus on NPLs supports risk-reduction efforts as part of the Banking Union but should not be overplayed. This is yesterday’s battle. Tomorrow’s battles involve sovereign risk, cyber risk and banks’ readiness to upwards interest-rate shocks” said Troiano. “The ECB has done a good job helping banks improve the quality of their balance sheets. But if I had to weigh what has mattered most between the SSM’s several announcements and initiatives in this area and Mario Draghi’s monetary policy, I’d say the latter.”