According to Moody’s, on 14 March, the European Parliament voted in favor of a regulation setting minimum loan loss provisioning requirements for nonperforming loans (NPLs). The European Union (EU) regulation aims to prevent the excessive accumulation of soured loans, a scenario that unfolded in several European countries during the global financial crisis. The new rules, which will become effective in the coming weeks, will be credit positive for EU banks.
All European banks will be subject to the same prudential standards. Until now, banks’ provisions were driven by two factors; accounting rules, which were recently amended to make them more prudent and forward-looking (IFRS 9), and supervisory expectations, which the euro-area banking supervisor, the Single Supervisory Mechanism’s (SSM), in March and July 2018 made more explicit by providing qualitative and quantitative guidance.
However, the SSM’s quantitative guidance on NPL coverage (the so-called
addendum) has been criticised because the SSM is not empowered to set rules; regulation is the joint responsibility of the European Council (of governments) and the European Parliament.
The new regulation will operate as a backstop to the accounting standard IFRS 9, which can be interpreted in different ways in different jurisdictions. The SSM will continue to have influence over banks’ provisioning decisions in rare instances that it considers the NPL regulation does not provide appropriate coverage.
The regulation directs minimum provisions (prudential provisions) on loans according to a prescribed timetable. The volume of provisions required may vary from the amount computed under IFRS 9 accounting standards.
The new rules categorize banks’ loans as unsecured and secured loans. For secured loans the regulation differentiates between immovable collateral such as property (the highest quality) and other eligible credit protection (the lowest quality). For unsecured loans that move into the NPL category, no provisions would be required for the first two years; a minimum provision of 35% of the outstanding amount would be required during the third year; and 100% coverage should be in place before the end of the
fourth year. This final timetable is slightly longer than that originally proposed (100% after two years of nonperformance).
For secured loans, provisioning follows a longer timetable. For loans with the highest quality immovable collateral, the timetable spans nine years, beyond which NPLs must be 100% covered by provisions. For loans with the lowest quality collateral, 100% coverage must be in place by the end of the seventh year after a sound loan is moved to the NPL category.
The new rules will not tackle the outstanding stock of NPLs, but we expect them to have an effect over time. NPLs still are a large proportion of banks’ loans portfolios in several EU countries, including Italy, where we estimate they comprise 10% of total loans. The scope of the NPL regulation, however, is restricted to new loans EU banks extend from the date of implementation. Consequently EU banks’ provisioning decisions on legacy NPLs will still be driven by IFRS 9 accounting rules and guidance from the SSM.
Nevertheless, we expect the SSM’s approach to legacy NPLs will mirror the new regulation, and at some point banks will find it untenable to maintain
two parallel provisioning policies.
