Daria Sartori, PhD, Trainee Lawyer, Mercanti Dorio e Associati; Giulia Ferrari, PhD, Attorney-at-Law, Mercanti Dorio e Associati
In general terms, non-performing loans (NPLs) are bank loans which are considered as unlikely to be paid back because of the debtor’s delay in paying the agreed instalments or interest for a certain amount of time. When a loan is non-performing, banks must set aside capital on the assumption that the loan will not be paid back, thus reducing their capacity to provide new loans. When banks are overburdened by NPLs, the entire economy suffers, one of the consequences being that privates will face difficulties in having access to credit.
Within the EU, the issue of NPLs has been a substantial one since the outbreak of the financial crisis of 2007-2008. At a macroeconomic level, the significant upward trend of NPLs has reflected the consequences of heightened unemployment, depreciated currency and tight financial conditions. At bank level, the excessive amount of NPLs has been linked to poor loan underwriting, monitoring and control.
NPLs are now specifically addressed by the “Draft guidance to banks on non-performing loans” (the Guide), drafted by the European Central Bank (ECB) and open to public consultation from 12 September to 15 November 2016. The Guide collects a number of best practices identified by the ECB in the course of its supervisory functions and relating to the issue of NPLs, defined as all exposures of banks which are held to be at risk of non-repayment according to EU standards. While the Guide is not, technically speaking, a binding instrument, non-compliance with its standards may trigger the imposition of supervisory measures for credit institutions which, pursuant to Regulation n. 468/2014 of the European Central Bank of 16 April 2014, fall within the ECB’s scope of supervision (so-called “Significant Institutions”, or SIs).
The present contribution provides an overview of the Guide and highlights the main issues relating to the problem of NPLs at bank level.
Banking supervision within the EU
Following the financial crisis of 2007–2008, EU institutions have called for the creation of a “banking union”, ensuring the safety and soundness of the European banking system thorough increased financial integration and stability. The first step towards a banking union has been the creation of a Single Supervisory Mechanism (SSM), comprising the European Central Bank (ECB) and the national supervisory authorities of the participating countries. The SSM’s task is to ensure that EU policies and rules on the prudential supervision of credit institutions are implemented in a coherent and effective manner.
The ECB’s supervisory functions are exercised in accordance with the EU Capital Requirements framework, i.e. the Capital Requirements Regulation and Capital Requirements Directive. These instruments transpose into EU law the standards elaborated at international level by the Basel accords, and they confer on supervisory authorities the power of imposing measures.
With regard to the ECB, these measures range from less stringent (such as the power “to impose additional or more frequent reporting requirements”, pursuant to Article 16 of the Capital Requirements Regulation) to substantial ones (such as the power to impose pecuniary sanctions for non-compliance with ECB regulations or decisions, pursuant to Council Regulation (EC) No 2532/98 of 23 November 1998).
Whereas the Draft guidance to banks on non-performing loans is not an instrument allowing the ECB to impose sanctions, its standards represent the ECB’s supervisory expectation for the future and non-compliance may trigger supervisory measures, such as those articulated by Article 16 of the Capital Requirements Regulation. Thus, the standards of the Guide can be considered as de facto binding for SIs, who should plan ahead interventions on their internal organization and policies in order to be able to meet the requirements by the time the Guide’s final version will be publicly available.
The ECB “Draft guidance to banks on non-performing loans”
On 12 September 2016 the ECB has launched public consultation on the “Draft guidance to banks on non-performing loans”. The consultation has been closed on 15 November 2016 but the comments received by the ECB have not been published yet, and the Guide itself is still in its draft version.
As mentioned above, the Guide collects a number of best practices relating to the issue of non-performing loans. It includes seven Annexes, providing samples of criteria and practices relating to every phase of the NPL life cycle.
The term “non-performing loans”, as used by the Guide, refers to non-performing exposures (NPE), as defined by the European Banking Authority (i.e., exposures satisfying either or both the “90 days-past-due” and “unlikely-to-pay” criteria), as well as to foreclosed assets and performing exposures with an elevated risk of turning non-performing.
According to the Guide, SIs must develop a specific NPL strategy, on the basis of a comprehensive assessment of the operating environment, i.e. of internal capabilities (self-assessment) and external conditions. The strategy thus elaborated must include targets relating to the development of operational capabilities and projected NPL reductions over the short (indicative 1 year), medium (indicative 3 years) and long-term line horizons. An operational plan must be developed accordingly, approved by the management body and reviewed at least annually. Credit institutions with high levels of NPLs are expected to report their NPL strategy and operational plan to the banking authority in the first quarter of each calendar year.
The strategy and plan must be embedded in processes at all levels of organization, and human resources must be organized accordingly. Thus, for instance, the NPL Guide requires the creation of separate NPL workouts units (WUs), dealing with NPLs along their life cycle and composed by staff members with dedicated NPL expertise and experience. Technical resources must be also implemented, including automated monitoring processes of the loan status, with early warning signals and reporting.
Credit institutions must implement effective and efficient control processes for the NPL workout framework, involving three lines of defence. The first line of defence comprises control mechanisms within the NPL workout units, ensuring that the NPL policy is adequately embedded in daily processes. The second line must ensure that the first line of defence operates effectively: it comprises risk management and compliance functions and requires continuous monitoring and reviewing of NPL operating model’s performance. The third line comprises the internal audit function, which must conduct regular (i.e., at least annual) assessments to verify adherence of the NPL framework to the NPL policy. Annex 5 to the Guide provides key elements of NPL framework-related policies (such as arrears management policy, forbearance policy, debt recovery/enforcement policy) that should be implemented by high NPL banks.
An entire chapter of the Guide is dedicated to NPLs secured by immovable property held as collateral. In the past, delays in assessing the decline of real estate value have proved to affect substantially credit institutions’ balance sheets. In fact, a high number of NPLs is secured by immovable property, and the value of the latter may significantly change over time. The Guide requires regular monitoring and reviewing of the valuations for collaterals, carried out by independent and qualified appraisers in accordance with the requirements set forth by Article 208(3) of the Capital Regulation Directive. It emphasizes the importance of maintaining the valuations for collaterals in line with market changes: thus, while establishing a minimum regular interval for updates (one year for commercial immovable property, three years for residential), it also requires credit institutions to carry out more frequent valuations where the market is subject to substantial negative changes and/or where there are signs of significant decline in the value of the individual collateral. In this last regard, banks are also required to establish their own criteria for determining whether a “significant decline” has taken place.
With regard to NPL impairment measures and write-offs, the Guide encourages credit institutions to align consistently with the standards set out by the Capital Requirements Regulation and Capital Requirements Directive, even when the institution is part of a group and some units of the group are not located in the EU.
Internal organization and timely intervention on NPLs
The Guide stresses the importance of adequate internal organization and coherent NPL policies, allowing timely intervention on NPLs. These aspects are particularly significant when it comes to dealing with high value NPLs, whereby the sums involved are significant (usually, because the loan is granted to enterprises/corporations). In this case, a good management of NPLs can affect both the bank’s capacity to conduct businesses profitably and the good functioning of the overall economy.
With regard to high value NPLs, measures aiming to restructuring are more appropriate than enforcement measures. However, in order to be effective, restructuring must be timely and conducted by staff with adequate expertise and experience. Restructuring is a process to which banks frequently turn too late (when the exposure has significantly worsened, making it more difficult for the borrower to repay the entire debt). For this reason, the Guide’s focus on the organization of human resources and on the timely recognition of NPLs should be appreciated: an increased attention by credit institutions to these aspects can positively affect the economic growth.
In the light of the best practices collected by the ECB in the Draft guidance to banks on non-performing loans, credit institutions subject to the Single Supervisory Mechanism must tackle NPLs by assessing the operating environment, developing and implementing a specific NPL strategy and an operational plan.
The Guide’s focus on internal organization and timely intervention on NPLs is particularly appreciated, as it favours solutions to the main issues contributing relating to the problem of NPLs at the bank level.
Whereas the Guide is not a binding instrument, compliance with its standards may trigger the imposition of supervisory measures by the ECB on Significant Institutions. For this reason, SIs should plan ahead interventions on their internal organization and policies in such a way as to be compliant with the Guide’s standards by the time its final version will be publicly available.
 For a technical definition of NPLs, infra sub n. 7 and 8
 For a general overview of the topic, see the ECB’s explanation at: https://www.ecb.europa.eu/explainers/tell-me/html/npl.en.html
 IMF Working Paper of the European Department Non-Performing Loans in CESEE: Determinants and Macroeconomic Performance, by Nir Klein, March 2013, p. 3 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2247224)
 ibid., p. 5
 Draft guidance to banks on non-performing loans, sub par 1.3
 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, OJL 176, 27.6.2013, p. 1–33
 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC, OJL 176, 27.6.2013, p. 338–436
 Draft guidance to banks on non-performing loans, sub par 1.2
 See paragraph 145 of Annex V to the “Implementing Technical Standards on Supervisory Reporting” (ITS)
 Draft guidance to banks on non-performing loans, sub par. 1.3
 Draft guidance to banks on non-performing loans, sub par 7, “Collateral valuation for immovable property”