ECB paper on NPL Coverage
Macroeconomic impact of 2 ECB policies
ECB Published an occasional paper on the economic impact of the NPL coverage expectations in the euro area. The paper looks at the macroeconomic impact of the two policies proposed by ECB Banking Supervision to tackle the high share of non-performing loans (NPLs) on the balance sheets of euro area banks.
The first is the coverage expectations for new NPLs set out in the Addendum to the ECB’s NPL Guidance, which aim to prevent the build-up of new NPLs, and the second is the coverage expectations for legacy NPLs, which target the reduction of already existing stocks of NPLs.
The high stock of non-performing loans (NPLs) remains one of the key risks facing euro area banks.1 In recent years, regulators and supervisors have therefore put forward several policies to speed up the resolution of banks’ NPLs. These policies involve hard requirements embedded in the Capital Requirements Regulation (CRR), the European Banking Authority (EBA) guidelines on management of non-performing exposures, and the ECB’s Guidance to banks on non-performing loans (NPL Guidance). The NPL Guidance includes an array of solutions such as development of NPL strategies, instructions on NPL governance, or forbearance. The Addendum to the NPL Guidance of March 20182 and the later communication of August 20193, reinforce the solutions presented in the NPL Guidance by introducing coverage expectations for new and legacy NPLs.
In the short run, the NPL coverage expectations can weigh down bank profitability. Following the original calendar of the coverage expectations, higher provisioning rates would reduce bank profitability most during the years 2020-26, with an impact of 0.2 percentage points on return on assets (ROA). This profitability is likely to be exaggerated because of very conservative model assumptions, excluding the recovery of collateral and the supporting impact of sell-offs, which allow banks to minimise their credit losses on their way to reducing NPLs.
The positive effect of reduced NPLs on funding costs supports the medium-term growth of bank lending and reduces system procyclicality. The clearance of the NPL burden from banks’ balance sheets supports loan supply and fosters a decline in funding costs. As a result, the impact of the package on lending to the non-financial private sector and economic activity turns positive around 2025. The NPL coverage expectations appear to shift the full distribution of output growth, with the upward shift of lower tails of the euro area GDP distribution signifying lower costs of recessions, and the downward shift of its upper tails substantiating that the euro area economy will be less prone to episodes of overheating.
The impact of the coverage expectations on new and legacy NPLs is only weakly correlated across banks. From the perspective of the overall banking system, the two parts of the policy package are complementary. Nevertheless, the overall impact of the package is also correlated with the initial stock of banks’ NPLs, which emphasises the important role of coverage expectations in clearing legacy NPLs by 2026.
The results also reveal that the overall impact on bank capitalisation differs across banks using different regulatory approaches. Lending by banks that rely on the internal ratings-based (IRB) approach to credit risk is likely to be less affected by the phase-in of the NPL coverage policies than lending by banks following predominantly standardised approaches. The IRB shortfall would constitute a buffer with which to absorb the initial increase in provisioning rates. The IRB shortfall decreases when required provisioning rates increase and thus serves as a buffer for credit risk losses.
Link to the paper
https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op297~e4d8b4ce0f.en.pdf