With asset quality on the brink, supervisors’ focus on credit risk is growing

May 2021

COVID-19 has fundamentally changed Europe’s credit outlook. In the short-term, supervisors are focused on minimising cliff-effects and maintaining balance sheet strength. The next few months will bring further scrutiny of asset quality, backed up by growing demands for data. Now is the time for banks to ensure they have the systems and resources in place to respond effectively.

KPMG’s recent publication on credit risk in the “SSM beyond COVID-19” series discussed how the Single Supervisory Mechanism (SSM) supervisory landscape has changed as a result of the pandemic, and asked what banks can expect post-COVID in the mid to long-term. In this article we take a closer look at how credit risk supervisory activities have evolved during the first quarter of 2021, and examine supervisors’ direction of travel over the coming months.

While the worst-case scenario feared in the first half of 2020 is now unlikely to materialise, the ultimate impact of the COVID-19 crisis on banks’ asset quality remains uncertain. The joint report on financial risk and vulnerabilities released on 31 March 2021 by the EBA, EIOPA and ESMA highlights a number of macroeconomic concerns and advises banks, supervisors and investors to prepare for an expected deterioration in asset quality.

The EBA’s latest Risk Dashboard Q1 2021 also stresses that banks remain vulnerable to adverse credit risk movements, and that the sectors hit hardest by the pandemic – such as accommodation, restaurants, arts, entertainment and recreation - are already showing signs of falling asset quality. The overall share of stage 2 loans increased from 8.0% to 9.1% of total loans in the last quarter of 2020, with stage 2 loans as a share of loans still under moratoria reaching nearly three times this level (26.4%).

In addition, the ECB expects forbearance and non-performing loans (NPLs) to inevitably increase as the benefits of measures such as payment moratoria and loan guarantees begin to erode¹. The ECB therefore remains focused on minimising cliff-effects and limiting the build-up of distressed exposures on bank balance sheets.

The banking sector’s actions over the next 12-18 months is expected to be crucial to limiting the impact of COVID-19 on asset quality, and to maintaining the supply of finance to the real economy. Lenders should identify any increases in credit risk early and address them promptly.

In these circumstances, it’s no surprise that credit risk remains at the top of the SSM Supervisory Priorities for 2021. In 2020 credit risk generated the largest number of supervisory findings, with key weaknesses including the underestimation of expected credit losses (ECLs), inappropriate classification of debtors and weak monitoring processes.^2,3 In 2021 the ECB will follow up on previously identified weaknesses, as well as continuing initiatives begun in 2020 aimed at ensuring that banks not only have adequate credit risk management mechanisms but also the capacity to manage expected growth in distressed borrowers.  One key aim will be to assess whether the short-term consequences of the crisis are evolving into longer-term issues.

During the first quarter of 2021, we have observed that:

• Numerous banks across Europe have been subject to deep-dives and ad-hoc data requests on vulnerable sectors of the economy, such as accommodation and food.
• More recently, banks have started to be contacted by the ECB with extensive data and information requests related to upcoming IFRS9 on-site inspections (OSIs). The data tapes to complete add up to over 300 data fields, including pre-COVID-19 to present financial data on loans (including for loans subject to moratoria), classifications, valuations and impairments as well as detailed information on past recovery cash flows and collateral inventories (for up to 15 years and on a monthly basis for some data). In addition, documentation on IFRS9 procedures, processes and models are being requested.  OSIs are likely to include the challenges of banks’ IFRS provisioning models and a deep-dive on a sample of files.
• In parallel with these focused activities, broader initiatives have been launched by the ECB to improve data quality, remediate issues and improve the overall data provision process. This includes standardised “ECB credit risk loan tapes”, composed of 317 data fields (covering most asset classes) with automated data validation routines and quality assurance measures. The risk loan tapes process should be industrialised in Q1-2022 and will be used by JSTs on a recurring basis as part of their credit risk OSIs process going forward.

Banks can expect supervisors to continue their credit risk-focused activities over the coming months, perhaps including the areas mentioned above. Moreover, banks will also receive a reply to their answers to the ECB’s Dear CEO Letter of December 2020, which is expected to spell out areas for improvement and additional ECB expectations for 2021.   

Throughout 2021’s supervisory activity on credit risk, banks should expect to continue being challenged on a broad range of topics, including:

• Their capacity to identify any deterioration in asset quality at an early stage, including the adequacy of banks’ unlikely to pay (UTP) triggers and assessment.
• Their provisioning models and policies, which should reflect the shocks from the pandemic. This includes ensuring timely and adequate provisioning for ECLs.
• The appropriateness of their classification of debtors, including suitable stages 2 and 3, identification of forbearance, and monitoring of risk metrics for loans subject to the EBA moratoria.
• The robustness of their governance, risk management and internal controls.
• The quality of their risk data aggregation and reporting, including testing the accuracy and completeness of data and assessing the banks’ processes and systems.
• Adequacy of collateral valuation and revaluation.
• Their capacity to appropriately manage loan arrears and NPLs.

The growing volumes of information that supervisors are requesting and the level of scrutiny that JSTs will likely exert mean that banks can face increasingly intense data demands during 2021. To meet these expectations, individual institutions should act now to ensure they are dedicating sufficient levels of resources and managerial oversight to this topic.