16 June 2021

SSM's McCaul: Strengthening credit risk management

More than one year has passed since the outbreak of the COVID-19 pandemic. What challenges do you see for the European banking sector going forward? What are the main risks and vulnerabilities it faces?

European banks have demonstrated considerable resilience during the pandemic thanks to both the extraordinary coordinated public policy measures and the efforts to strengthen their fundamentals since the great financial crisis through regulatory reforms, including the creation of ECB Banking Supervision. Nevertheless, looking ahead, a few challenges remain. The two major ones are asset quality and persistently low profitability in the banking sector.

Regarding asset quality challenges, the upcoming gradual withdrawal of government support measures has the potential to lead to an increase in non-performing loans (NPLs). Therefore, it is important that banks recognise and manage credit risk proactively and that any deficiencies in this area be addressed swiftly. This is especially true for banks in countries that depend on sectors which have proven to be particularly vulnerable to the economic effects of the pandemic, such as food and accommodation or commercial real estate.

With respect to the second major challenge, structurally low profitability was a characteristic of the European banking sector in general even before the pandemic, underscoring the need for banks to take advantage of digitalisation and consolidation opportunities. Banks need to implement initiatives to improve the sustainability of their business models and boost cost efficiency, hopefully taking on board some of the lessons learned from harnessing technology during the pandemic-induced lockdowns.

A lot has been said about a new wave of NPLs as a result of the pandemic. What are the signs so far? As banks have actually managed to reduce their NPL ratio during the pandemic, are the fears of a new NPL spike warranted?

Indeed, the NPL ratio in the euro area has declined during the pandemic. This is also true for Cyprus, where, according to Central Bank of Cyprus data, the NPL ratio decreased to 17.7% in the fourth quarter of 2020 from 27.9% in the same period in 2019. However, NPLs are expected to increase once public support measures are completely lifted. Typically, this impact will materialise with some delay and, due to the prevailing uncertainty, it is difficult to estimate the timing and size of an increase in NPLs. So it’s important to recognise early on any difficulties borrowers may have in making repayments, especially once pandemic-related support measures and payment moratoria expire. Responding to such situations with sound restructurings is an excellent credit risk management tool that has the advantage of both helping borrowers and avoiding cliff effects. This is why in ECB Banking Supervision we are focusing on the need to strengthen credit risk management and identify credit deterioration and asset quality as swiftly and accurately as possible.

As the pandemic unfolded, threatening lives and our economy, we responded by introducing extraordinary prudential flexibility. We continue to encourage banks to use their capital and liquidity buffers for lending purposes and to absorb losses. We will not require them to start replenishing buffers until at least the end of 2022. At the same time, we are encouraging banks to adhere to credit risk management requirements, such as having strong processes in place to distinguish between temporary and permanent credit deterioration induced by the pandemic. This will help to avoid the build-up of new NPLs on balance sheets, which would threaten the economic recovery as we emerge from the pandemic.

How would you describe the course of the Cypriot banking sector during the pandemic? Can Cypriot banks cope with a possible new wave of NPLs given the high levels of legacy NPLs?

Compared with the 2013 crisis, Cypriot banks are now better prepared to deal with an increase in distressed debt. Their capital positions today are stronger than they were in the immediate post-crisis period and there has been significant progress in making their balance sheets more resilient. According to Central Bank of Cyprus data, NPLs in Cyprus declined by €23.2 billion between December 2014 and December 2020. Even though the first moratorium expired at the end of 2020, we need to keep in mind that we are still in a period of great uncertainty about the overall impact of the pandemic on borrowers and thus on bank balance sheets. We haven’t yet seen the potential effects of the full withdrawal of fiscal support measures materialise on bank balance sheets. We don’t yet know whether certain sectors will struggle more than others once the support is no longer available. What we do know from experience is that credit impairments typically emerge only after some delay, and we know that we do not yet have data on potential future bankruptcies that may be latent on balance sheets now. Consequently, Cypriot banks need to be prepared for the impact of the pandemic on their balance sheets and plan proactively.

Supervisory Board Chair Andrea Enria recently said that 40% of supervised banks follow outdated credit risk practices. Does that also apply to Cypriot banks? How do you assess the provisioning practices of Cypriot banks, especially in the midst of the pandemic?

I don’t want to enter into a discussion regarding individual countries or specific banks. Let me instead give you some perspective based on the overall picture of banks that we supervise. About 40% of the banks are falling short of what we expect regarding their provisioning practices, the classification of their loans, flagging forbearance measures, and the strength of their operational capability to prepare for the expected increase in NPLs. Rather surprisingly for a crisis situation, in some portfolios we discovered improvement in credit risk parameters (ratings), especially for probability of default. This may be the result of banks not fully including the impact of 2020 in their risk estimates yet, relying instead on 2019 borrower financials. And we need to consider whether some support measures such as public guarantees may be the reason behind better ratings and if so, whether such improved ratings will be sustainable over the longer term. But these concerns are being addressed, also thanks to the persistence of our supervisors.

In addition, banks with higher shares of loans under moratoria may face challenges in recognising risks on a borrower-by-borrower basis. This has to improve – credit risk practices need to be enhanced to overcome these challenges. Banks need to be forming a clear picture of potential underlying credit deterioration and providing the required transparency. In this regard, we are monitoring banks’ provisioning practices closely.

The Cypriot authorities are considering turning KEDIPES, the state-owned asset management company mandated with winding down the NPLs of the now defunct Cyprus Cooperative Bank, into a system-wide bad bank. What is the ECB’s response to such a project and what are the conditions set out by the supervisor?

Cypriot banks have made significant progress in reducing NPLs, as I mentioned. However, by all accounts, the NPL ratio in Cyprus remains high and the effects of the pandemic are still a source of uncertainty. Increased and sustained efforts, together with growth-oriented economic policies, will be required to substantially reduce NPLs. As banking supervisors, we welcome broader possibilities for banks to reduce NPLs: from securitisations to establishing well-designed asset management companies. If appropriately designed, state-supported solutions for promoting NPL disposal can complement banks’ own efforts by offering additional options to tackle NPLs more swiftly.

The success of asset management schemes as an effective solution to reduce NPLs depends on many factors: a well-functioning foreclosure framework is critical, as is the feasibility of the scheme’s time horizon and the type of assets transferred to the scheme (e.g. retail versus corporate exposures). In the case of KEDIPES, my understanding is that plans to extend the existing scheme to a national level still need to be finalised. Close attention is required to mitigate the risks of the scheme, as well as concerns regarding overall payment discipline.

Given that the banking sector in Cyprus is burdened with high NPLs, how would you describe efforts by lawmakers to amend the law on foreclosures? From the supervisor’s perspective, could such an amendment trigger increased requirements, either on capital or otherwise?

Policies protecting borrowers can benefit the economy and banks alike if they are properly designed and implemented. But such policies can also backfire and destabilise the banking sector if designed in a haphazard manner. So, the right mix has to be found. Let’s not forget that while banks have reduced NPLs on their balance sheets, it does not mean that debts have magically disappeared: they are still present elsewhere in the Cypriot economy. Adequate policies must therefore be in place.

In Cyprus, the amendments to the insolvency and foreclosure framework have indeed helped to remove some of the impediments to the insolvency framework and the foreclosure procedure. This initially reduced the delays caused by the various procedures. But there are several more impediments that need to be addressed, such as the low uptake of the insolvency and pre-insolvency tools, and existing backlogs in the judicial system. In addition, the amendments made to the foreclosure framework last year, enabling recourse to the Financial Ombudsman for breach of the Code of Conduct and extending the timelines of the various steps of the procedure, risk a negative impact on banks and may cause further delays.

Many believe that Cyprus is overbanked, despite significant consolidation since the 2013 crisis. Do you think that mergers and acquisitions are necessary given the current challenges such as low profitability and growing competition from fintechs?

As a supervisor, I can tell you that decisions on mergers and acquisitions must be made solely by market participants. Our role is neither to push for nor hinder consolidation. Yet, we are here to ensure that the resulting business combination complies with prudential requirements and ensures effective and prudent risk management. Those principles are clarified in the ECB Guide on the supervisory approach to consolidation in the banking sector that was published in January 2021. There is indeed a problem of overcapacity in some countries, which can be dealt with in different ways. Consolidation is of course one of the possible options: well-designed and properly executed consolidation projects can help address long-standing structural issues, such as low profitability and overcapacity.

However, consolidation is not the only option available to improve structural profitability and cost efficiency in the Cypriot banking sector. For example, for institutions with extensive branch networks, digitalisation could produce significant cost savings if supported by efficient internal governance and reorganisation. One of our supervisory priorities is the assessment of banks’ business models and profitability, also in the light of increasing digitalisation, which has received a boost from the pandemic situation and physical distancing rules. In this regard, our supervisory teams will continue to closely monitor the strategic plans of banks and the underlying measures they implement in order to deal with structural deficiencies.

SSM

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