As highlighted in our previous article on the ECB’s NPL guidance, the ECB is intensively working to solve the over 1 trillion NPL problem of the European banking sector. At the end of November, the ECB published an article in the Financial Stability Review (PDF 96 KB) that focuses on market failures in the resolution of NPLs. Two recommendations caught our attention:

• Reduce informational asymmetries through high-quality data. The article identifies informational asymmetries between sellers and buyers of NPLs as one of the major impediments to foster secondary NPL markets. In particular, the article focuses on the secondary market for complex and secured NPLs which is characterized as a “market for lemons”, referring to the famous model of Nobel laureate G. Akerlof. The authors mention the availability of high-quality data as being a key element to address informational asymmetries for higher quality, collateralized NPLs. Given this analysis, it appears reasonable to assume that the ECB’s NPL data requirements, in particular for high NPL banks, will be strongly aligned with data needs of potential investors that require a transparent and thorough due diligence process (to avoid ending up with “lemons”).
• Asset management companies to foster secondary NPL markets. The ECB authors outline the conditions under which an asset management company (AMC) may improve the secondary market for NPLs. Here the authors conclude that “many of the impediments to the creation of secondary NPL markets […] can be alleviated by the establishment of a well-designed AMC.“ The ECB focuses on the experiences from countries that have used such companies in the past (e.g. NAMA in Ireland, SAREB in Spain) to separate NPLs from the balance sheet of high NPL banks.

Aside from the article in the Financial Stability Review, the consultation period for the ECB’s NPL guidance has ended and a public hearing (for which a webcast is available) took place during the first half of November. Three points are worth mentioning to SSM banks from the consultation period and the public hearing:

• All significant banks are directly affected by the guidance, less significant banks are not affected “at this stage”. ECB representatives emphasized that the last three chapters apply for all significant institutions regardless of their NPL-ratio as these cover technical aspects of the NPL-management, which apply to all banks. As a result, the ECB expects every significant institution to closely examine at least the last three chapters of the guidance and to address any identified gaps. With regard to less significant institutions (LSIs), Sharon Donnery mentioned that there’s no requirement “at this stage” for the guidance to be implemented by LSIs – a description which could raise the attention of LSIs with high stock of NPLs.
• Workout units within the risk management function need a 2nd Line-of-Defense. During the hearing, it was highlighted that as soon as workout units de facto act as a profit center, the ECB expects an adequate 2nd Line-of-Defense (LoD) involvement. This means that banks where the workout unit is located effectively in the 2nd LoD have to consider where this 2nd LoD function should be allocated for the workout units.
• Results of the stocktake will influence supervisory discussions with banks. Simultaneous with the publication of the guidance, a stocktake of national supervisory practices and legal frameworks related to NPLs (PDF 96 KB) in eight countries was released by the ECB. The intention of this stocktake document (which will be extended to other countries) is to support and inform JSTs about major legal and extrajudicial impediments a bank faces (see figure 1). Banks may therefore find it useful to include the findings of the stocktake in their preparation for their discussion(s) with JST’s about the proportionate application of the guidance.

Although the ECB has not announced any implementation date so far for the NPL guidance, the limited materiality of issues raised during the public hearing could result in a swift entry into force and only minor changes the guidance compared to the consultation draft. For high NPL-banks, which already have close interactions with their JSTs about their NPL portfolios within the SREP 2017 decisions, the entry into force of the guidance will further formalize supervisory discussions on their NPL portfolio. A formalized, qualitative assessment of banks practices against the guidance will soon become part of their supervision, together with quantitative reduction targets for many banks.