Credit risk landscape

ECB Office Blog on credit risk supervision: Q1 2023

The European Central Bank’s (ECB) supervisory expectations in the crucial area of credit risks have continued to evolve rapidly this year. In this blog, I share my thoughts on the likely pressure points for credit risk supervision that banks will face this year.

Credit risk continues to be a central priority for the ECB, which is now accentuated by the banking sector turmoil and concerns over possible credit tightening

In my article on credit risk in November 2022, I discussed the ECB’s growing concerns about the potential impact of macroeconomic and geopolitical turmoil on credit risk. Since then, the ECB has revised its priorities for 2023 to 2025 to account for these new and emerging risks. The turmoil in the banking sector in recent weeks has now accentuated the challenges ahead, reinforcing the relevance of these priorities.

Although the ECB remains confident that the risk of contagion from the events in the United States and Switzerland to European Union (EU) banks is minimal, this has brought great uncertainties to the market. This is likely to raise the level of concerns for risks already identified by the ECB as highly relevant and persistent. We therefore expect supervisors to continue closely monitoring not only interest rate risk in the banking book, as well as funding and liquidity risk but also credit risk. As Andrea Enria has recently mentioned, the response to the current developments confirm that strong, demanding supervision is needed more than ever.

With this in mind, credit risk remains a key area of focus for supervisors, along with funding risks, governance (including risk data aggregation and reporting), digitalisation and climate change. The strategic objectives also make it clear that the ECB expects banks to rapidly close any remaining shortfalls in the management of credit risk:

“Banks should effectively remedy structural deficiencies in their credit risk management cycle, from loan origination to risk mitigation and monitoring, and address in a timely manner any deviations from regulatory requirements and supervisory expectations.”
Source: ECB Banking Supervision, 2022

The ECB reiterated its concerns over credit risk deficiencies. with increasing requirements for banks to address persistent expectations gaps

To understand the ECB thinking on credit risk in greater detail, it is important to look back at the results of 2022’s supervisory activities and the areas identified as presenting the greatest expectation gaps.

On 8 February 2023, the ECB published aggregated results of its Supervisory Review and Evaluation Process (SREP) cycle for 2022 for directly supervised banks. This summarises the main deficiencies identified last year across all supervisory activities, and the remedial actions the ECB expects banks to undertake to address those weaknesses. Despite finding that banks have solid capital and liquidity positions, the ECB reiterated its concerns over some significant and persistent credit risk deficiencies. Identified areas of risk included:

• Inadequacies in risk management frameworks
• Failures to meet its expectations on leveraged transactions [detailed in the March 2022 Dear CEO letter (PDF 407 KB) and 2020’s Guidance (PDF 255 KB)]
• Non-performing exposures (NPE) management and provisioning (which I further discuss in my blog on NPLs)

To put this into numbers, nearly one in five of all deficiencies identified in 2022’s SREP related to credit risks. Of these, 44 percent represented shortcomings in banks’ credit risk management frameworks. An additional third related to non-performing exposures (NPEs), including lower than expected coverage and gaps in strategic and operational plans to tackle NPEs and reporting. Another 10 percent related to overall loan classification and provisioning. Leveraged transactions represented only 3 percent of findings, but while this topic is irrelevant for many banks it is viewed as a significant risk for a minority.

In addition to these deficiencies, it is worth noting that climate and environmental (C&E) credit risks received significant attention last year and are expected to become an increasing focus of supervisory activity.

In short, while the ECB’s objectives remain largely unchanged, the way the supervisor is rolling out its work programme has evolved significantly. After the pandemic years, which involved a lot of supervisory firefighting and required banks to implement a wide range of counter-cyclical measures, banks are now facing a more sustained set of geopolitical and macroeconomic uncertainties — with the potential for compounding effects on some borrowers’ risk profiles. For the ECB, the need for banks to address their remaining credit risk deficiencies is now a pressing issue.

A broad range of supervisory activities on credit risk are planned for 2023 and beyond

So, what can banks expect from the ECB this year? The supervisor’s action plan for credit risk covers a number of areas and could put banks under significant pressure.

First, the ECB is planning targeted reviews to assess banks’ implementation of the European Banking Authority (EBA) guidelines on loan origination and monitoring. While the principles of the guidelines have been assessed via numerous inspections in recent years, this has been largely fragmented. There is now willingness from the ECB to ensure the entire guidelines are implemented from end to end, in line with the set timeline. The ECB will also put a particular focus this year on residential real estate portfolios, partially echoing the approach to commercial real estate lending in recent years.

Another important area of focus is on forbearance and unlikely to pay (UTP) policies, where too many banks are still considered to be falling short of expectations. The ECB is therefore planning deep dives to assess this topic, and activity has already begun. This is also not a new initiative, but increasing urgency placed on the topic means that banks should remediate any findings as soon as possible.

A third key topic is IFRS 9, for which the ECB announced an on-site inspection (OSI) campaign. This is one of just two anticipated campaigns, with the other focusing on BCBS 239. The IFRS 9 campaign seems to be an extension of the inspections programme launched in 2021 for a selection of EU banks. OSIs will focus on large corporate, small- and medium-sized enterprise (SME) and retail portfolios, and on commercial real estate. In our experience these are intensive, time-consuming exercises that will require extensive planning and dedicated internal response teams from the banks.

The ECB has also intimated that it will conduct targeted reviews on specific banks to assess their compliance with the 2020 “Dear CEO letter" (PDF 256 KB) letter on credit risk, with particular focus on residual issues and modelling aspects. In my view, this is a follow-up to inspections already performed in recent years. Discussions with banks suggest some have already been approached to discuss their progress with remediation.

Finally, we’re seeing supervisory activities around internal model investigations (IMIs) and internal ratings-based (IRB) model changes related to new regulations, including follow-ups on previous findings. Based on the IMIs performed last year, we observe a step up in the complexity and risk-weighted asset (RWA) impacts of these inspections, with the ECB expecting more sophisticated and robust methodologies in line with the new regulatory framework. The ECB has also announced it will conduct targeted joint OSIs/IMIs for material portfolios in selected vulnerable sectors, assessing the adequacy of IRB models, accounting models and credit risk management frameworks.

We expect the ECB to be stricter when progress is considered inadequate

During the press conference on the results of the SREP 2022, Andrea Enria, Chair of the Supervisory Board of the ECB, had a strong message for banks: remediate any weaknesses identified in a timely manner, or face consequences for non-compliance. The current market turbulences can only accentuate this supervisor’s eagerness to keep credit risks under close control. The ECB will use all available tools to pressure banks if it deems progress is too slow, including targeted Pillar 2 capital requirements, enforcement measures or sanctions.

This message is reflected in the tone of credit risk inspections that have already started. Many banks across Europe are telling us of increased pressure to rapidly resolve remaining gaps, which may be challenging given the wide range of simultaneous remediation programmes already underway. In cases where systems need to be changed, long and complex implementations can conflict with the ECB’s short timelines, which can increase the risk of costs being duplicated by a mix of quick fixes and slower change programmes.

In our experience, a piecemeal approach to remediating ECB findings is rarely advisable, other than for critical issues. We usually advise banks to review all their expectation gaps, identifying common links between diverse findings. This can make it easier to develop a comprehensive remediation programme with defined milestones and a clear end-to-end timetable — helping to facilitate communication and a positive supervisory assessment.