Credit risk supervision

ECB Office Blog on credit risk supervision: Q2 2023

We saw the ECB’s rigorous supervisory focus on credit risk continue in the first half of 2023, amid growing concerns about the potential impact of macroeconomic and geopolitical turmoil on banks’ asset quality. Forbearance and the adequacy of risk identification and loan loss provisioning under IFRS9 are among the topics receiving particular attention from the ECB.

While levels of European defaults and bankruptcies remain low, the latest ECB financial stability review states that the corporate sector is likely to feel a continuing squeeze from higher financing costs and the uncertain business outlook. Small and medium-sized enterprises (SME), which have benefited less from the economic recovery, also remain vulnerable to slower economic activity and higher borrowing costs. In addition, the ECB is concerned that debt instruments with high sensitivity to rate increases - such as leveraged loans - may be particularly exposed to any further tightening of financial conditions.

The ECB is also warning that the Euro area property market cycle may be turning, as higher interest rates weigh on affordability. The residential real estate market is likely entering a correction phase, posing risks to households - particularly if falling prices and higher interest rates make mortgages less affordable. The commercial real estate (CRE) market is also facing a downturn, with declining valuations and reduced demand in office and retail segments.

These credit risk vulnerabilities, together with the supervisory activities of recent months, echo the ECB supervisory priorities for 2023 to 2025 discussed in my previous blog of Q1 2023. 

The ECB continued its assessment of banks’ leveraged lending. That includes reviewing banks’ responses to its Dear CEO letter (PDF 407KB) of March 2022 and their progress towards meeting the expectations set out in the ECB’s Guidance (PDF 255KB) of 2017.

As a result, the ECB began sending Operational Act letters to selected banks during the first half of 2023. Each letter identifies the “bank specific” gaps that need to be remediated, which will feed into the Supervisory Review and Evaluation Process (SREP).

We also observe increased time pressure for compliance for many banks. The ECB has reiterated that it will continue to apply capital add-ons to P2R levels for banks with excessively high levels of perceived leveraged lending risks where risk appetite frameworks, risk controls and monitoring procedures remain unsatisfactory. This therefore remains a topic of great importance for banks with material exposures to leveraged loans. 

As discussed in our previous article on real estate, the ECB continued to perform on-site inspections (OSIs) and deep dive assessments of banks’ CRE portfolios across multiple jurisdictions.

While in recent years the ECB’s primary focus was on banks’ valuation frameworks and in confirming collateral values, the emphasis has now broadened to reviewing the accuracy of risk classifications, IFRS 9 stage transfers, and impairments. The ECB expects banks to adequately factor deteriorations in the risk environment into their provisioning practices and capital planning. As a result, we note that recent assessments of banks’ CRE portfolios have been integrated into broader IFRS 9 OSIs. 

Ensuring that IFRS 9 provisioning frameworks are robust remains a key priority for the ECB, with the current macroeconomic environment only accentuating its importance. The need for adequate and timely credit risk provisioning was recently reiterated (PDF 1.96MB) by the ECB, which aims to ensure that banks are resilient to shocks and that balance sheet risks are transparent to investors and supervisors.

To assess banks’ IFRS 9 compliance, the ECB has already begun an OSI campaign for 2023 focusing on large corporate, CRE, SME and retail portfolios. This follows the ECB’s targeted review of 51 supervised banks’ IFRS9 provisioning framework, initiated in November last year, to assess whether and how banks are provisioning adequately against novel risks. More specifically, the ECB reviewed banks’ ability to identify and quantify novel risks in areas like energy, supply chains, inflation, geopolitics and the environment, and to cover them with adequate loan loss provisions.

The results show that:

• As expected, overlays are the most common approach to capture novel risks.
• A significant minority of banks do not yet capture novel risks or quantify them robustly. For example, 80% of banks do not consider environmental risk factors at all.
• A proportion of banks are using legacy IFRS 9 macro-overlay models to capture novel risks. However, IFRS 9 models designed before 2018 fall short of adequately reflecting novel credit risk expectations in a rapidly changing environment.

The ECB confirmed that in-model adjustments and evidenced-based overlays are useful tools to address emerging and novel risks. However, overlays must be risk-sensitive and supported by strong governance. The ECB stipulates that instead of placing too much reliance on judgment or using umbrella overlays, banks should design evidence-base approaches to capture novel risks, quantify them at a sectoral level, and identify which client groups are affected by each risk. 

Last year, the ECB found too many banks falling short of expectations over forbearance and unlikely to pay (UTP). Earlier this year, the ECB therefore informed banks that it was planning deep dives to assess this topic. While this is not a totally new initiative, the theme is now one of greater urgency.

Building on its in-depth assessments of banks’ forbearance processes over the past year, the ECB communicated the remaining recurring areas where banks need to improve, including: 

• More consistent and proactive identification of clients in financial difficulty, based on sound criteria (both quantitative and qualitative) and supported by effective early warning systems.
• Ensuring that the most suitable and sustainable forbearance measures are granted, with assessment and approval in line with forbearance policies, supported by a complete forbearance toolkit and a clear decision process, and with affordability assessments performed using projections under different scenarios.
• Improving the monitoring of forbearance measures, both at individual and portfolio level, acting in a timely manner as further deterioration of clients’ financial situation emerges.

In the second half of the year the ECB is expected to continue monitoring banks’ preparedness for current economic conditions and a potential increase in distressed debt and refinancing risks. Some clients have already been informed of new ECB deep dives on forbearance, starting from September 2023, while others are being assessed as part of broader credit risk reviews.  

Finally, it is worth noting the ECB’s efforts to improve its supervisory assessments of banks in the current environment. For example, in May 2023 the ECB published its standardised SREP methodology (PDF 168 KB) for assessing credit risk. This represents a significant increase in transparency over exactly how this module will be assessed in future. What is interesting, is the evolution in the ECB’s overall approach - increasing its focus on using each bank’s material weaknesses to define areas for investigation, along with the frequency, scope, and depth of the associated assessments.

The General Board of the European Systemic Risk Board (ESRB) recently concluded that financial stability risks in the EU remain severe, which reiterates the ECB assessment. This is only expected to strengthen the supervisors’ response and scrutiny for credit risks. Banks must ensure they are keeping up with the supervisory expectations and credit risk impact of the fast-changing economic picture.

The provisional agreement reached on 27 June on the EU’s implementation of Basel IV is also expected to have a broad range of implications for banks’ credit risk management. While the final text is expected to be published from September 2023, the timeline for implementation remains broadly unchanged and is to become effective on 1 January 2025. This means that banks will need to rapidly familiarise themselves with the text to assess its implications on policies, processes, data needs, and systems, but also to quantify the broader impacts on portfolios, risk-weighted assets, capital, and funding. Stay tuned for more insights here.

This will all require adequate resource investments and a strong methodological and procedural effort from banks.