Lessons for APRA from ECB lender scrutiny

Europe’s central bank has published proposals on provision requirements for loans which turn sour from January 2018. Accordingly, Australia’s banking regulator will be watching how this pans out very closely.

Broadly, the proposals require that banks set aside reserves of 100 per cent of unsecured non-performing loans within two years and on secured lending within seven years.

As UBS analyst Jason Napier sees it, the European Central Bank (ECB) sees arguments of collateral protection as ineffective if enforcement takes too long.

“The supervisor views it as 'immaterial whether the delays in realising the security were due to reasons beyond the banks control', a nod to national inefficiencies in some quarters," he said.

“We see these proposals as another piece of the regulator's drive to incentivise banks to cut non-performing exposures.

In March, the ECB published guidance on NPL resolution where firms with high NPL stocks were required to submit targets for reducing risky loan balances, closely monitored for compliance.
 

'Staying their hand'

Such banks might include Allied Irish Bank (AIB) - one of Ireland’s biggest lenders - which returned to the public markets in June seven years after its collapse. AIB almost brought down Ireland's banking system and forced the government to bail it out

“We think this principle applies elsewhere. Driving provision coverage on new NPLs higher, sooner, may make it more economic to sell rather than resolve new impaired balances," added Napier.

NPLs are not the same magnitude of problem in Australia so they are less of an APRA concern, according to KPMG partner Michael Cunningham

“The Euro banks and ECB have not handled the situation as determinedly as they should have resulting in a number of zombie banks (due to NPLs) still lurching around," he said.

“Having said that, given the Australian bank concentrations of residential housing debt, a China crash, or other severe economic scenario could place NPLs at the fore front of their attention.

“APRA should have the counter cyclical capital buffer higher than zero, but the cost to banks would be too much - so that is probably staying their hand.”
 

New proposals

These new proposals would apply only to new NPLs from Jan 2018.

Reserve coverage is composed of balance sheet loan loss reserves, advanced IRB expected loss deductions and other voluntary deductions from common equity tier one capital.

According to Napier, full provision coverage demands would take years to build and it appears that lenders may argue to include Pillar 1 credit risk CET1 capital as a component of coverage – perhaps worth between 5 -10 per cent of loans in unsecured lending.

“Earlier, higher reserve build needn't change losses incurred but the ECB's determination to reduce risks of sub-par assets in the next downturn is clear," he said.

The ECB confirmed that by end of the 2018 first quarter, it would "present its consideration of further policies to address the existing stock of NPLs, including appropriate transitional arrangements".

 

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