The soft law of the ECB for the management of Non Performing Loans

The ECB has recently brought to the attention of operators of the banking system a Guidance for the management of Non Performing Loans (NPLs) by means of a public consultation started on 12 September and closing on 15 November, with an intermediate public hearing fixed on 7 November.

The issue is receiving increasing attention from the European banking authorities and the ECB relates the current initiative to the results of Asset Quality reviews and Stress tests carried out in recent years.

The scope of the Guidance is set out in the introduction: the high level of non- performing loans shown in the balance sheets of many European banks frustrates bank lending to economy, reduces profitability and has a negative impact on bank capital requirements established by the legislation in force.

So the topic of proper management of NPLs and their reduction within a reasonable time has raised an interest both at general and at system level.

The ECB immediately pointed out in the document that the rules defined within the scope of the Guidance are not intended to supersede primary or secondary laws in force, including national ones, or to replace the provisions applicable to banks pursuant to the existing regulatory framework. Therefore, such rules remain non-binding in nature. Nonetheless, to a certain extent, they mandatorily apply in the relationship between banks and the supervisory authority, which expects compliance with such provisions and in case of non-compliance may adopt specific supervisory measures.

The constraint seems to be weakened by effect of the “comply or explain” rule. Banks not wishing to comply, in whole or in part, with the practices of the Guidance may explain such choice justifying their reasons. Such possibility introduces the necessary degree of flexibility to adjust the rules to the specific characteristics of the actual case and is likely to be defined with the constant dialogue between banks and supervisory authorities that will evaluate deviations from the rules and justifications produced in light of the “sound and prudent management” criteria. However, apparently, the margins of autonomy granted to banks concern especially certain organisational methods in the strategy for the management of NPLs and the timing for the achievement of objectives that the ECB clearly defines in the Guidance as unavoidable. Moreover, the document specifies that the Guidance also aims to clarify to the operators what the supervisory authority expects with regard to internal organisation measures and procedures to be adopted to deal with a problem whose solution can no longer be postponed.

In light thereof, the document establishes first of all the scope of its application by setting forth the definition of NPLs to be adopted by operators in compliance with the new rules. It is a prudential definition of Non Performing Exposures adopted by the EBA that outlines a broader field of impaired receivables, and includes also non- performing, doubtful and restructured loans (forborne).

The main commitment imposed on banks by the Guidance is the development of a specific “strategy” for the management of impaired receivables aimed at their sustainable reduction, with more stringent provisions fixed for banks with high NPL levels. For such purpose the Guidance provides precise process indications, requesting that the strategy contemplates the assessment of the operating environment, of the internal capability to manage NPLs based on the analysis of the characteristics of the current portfolio and of actions taken in the past, as well as an assessment of the impact of the aforesaid strategy on financial requirements.

Each of these three key points is developed in details by the Guidance, which requests to take into account the characteristics of the markets in the specific sectors where high levels of NPLs are present, markets and financial analysts expectations, the characteristics of the NPLs market and of connected services as well as applicable legislation (by way of example, on collateral enforcement or insolvency proceedings) and to align the strategy model chosen with the Risk Appetite Framework adopted (RAF) and with the evaluation of capital adequacy requirements (ICAAP).

The strategy must set specific targets determining sustainable NPLs levels over the long period and specific NPLs reduction targets over the short (1 year) ad medium (3 years) period.

An interesting aspect of the Guidance requirements concerns the organisational method to implement an NPL strategy. Indeed, the operational plan, approved annually by the management body and subject to the periodical review of the Joint Supervisory Team (JST), must provide for the creation of a dedicated governance structure entrusted with the implementation of the strategy.

On this point the Guidance gives precise indications, requesting first of all the setting up of special workout units that are separate from units responsible for loan origination, in order to avoid potential conflicts of interests that may jeopardise the effectiveness of the initiatives to be adopted. Therefore, all activities carried out within the management of impaired receivables, including the negotiation of concession or restructuring arrangements, should ideally be reserved for the dedicated workout unit. Where the setting up of an ad hoc workout unit is impossible or too burdensome,  banks need to find alternative solutions suitable to mitigate potential conflicts of interest.

Besides, investments are required to promote the development of NPL-related specific expertise, as well as the creation of those infrastructures necessary for the implementation of the strategy (by way of example, updating of the IT system, which is of the essence for the early detection of non-performance signals and for the management of information flows).

Further rules are established for forbearance measures whereby banks are requested to grant them only after a careful assessment of their sustainability and of their real effectiveness in light of the preconditions set forth also by the Guidance. More in general, banks are requested to create uniform rules within a specific forbearance policy whereby such concessions are granted with the most standardized criteria possible.

The document ends with a set of rules on monitoring of NPLs, allocation policies, evaluation of real estate collaterals.

Said set of indications relating to both managerial and organisational aspects of banking activity aimed at ensuring the prompt activation of the monitoring of NPLs and of consequent initiatives and, in such framework, at reducing the discretionary power of directors, not only on timing but also on the ways to manage impaired loans, has undoubtedly a normative content.

Indeed, these are general and abstract rules, with the characteristics of the so-called soft law: a set of rules and principles, per se not binding and with no direct sanction, destined however to become established for the authority of the source that issued them and for their connection with the exercise of supervisory and compliance powers entrusted to said source.