EBA advises European Commission on the use of prudential backstops to prevent the building up of new NPLs

14 March 2018

The European Banking Authority (EBA) published today its advice on the Commission's proposal for statutory prudential backstops on banks' provisioning practices for new loans that turn non-performing. The EBA notes that the backstop complements the existing prudential set of measures and the new accounting provisions under IFRS9 and the advice aims at providing some qualitative considerations as well as a conservative impact analysis of the proposed measures. 
The EBA conducted this analysis in response to the European Commission's request for advice to look into the expected impact the introduction of such statutory prudential backstops would have on banks, considering the different options proposed in its consultation, launched on 10 November 2017. In its impact analysis, the EBA provided some considerations about the design of the statutory prudential backstop as well as some quantitative evidence about the different specifications of the backstop.
As part of the process of repairing the EU banking sector, the EBA has pushed for speedy recognition, and resolution of asset quality issues in the EU. In this context, non-discretionary backstop requirements (i.e. compulsory deductions from regulatory capital) can help incentivise banks to address NPLs proactively and prevent their future accumulation on balance sheets. 
The quantitative analysis has been conducted under a static balance sheet assumption, where no changes are envisaged in the outstanding stock of exposures and other balance sheet items, such as CET1 and Tier 2 capital. The latter remain all fixed at their last available reporting date level, i.e. 2017Q2. Moreover, institution and exposure class specific parameters, such as default rate, cure rates, recovery rates and impairment loss ratios are also fixed at their values in the period 2014 – 2017, when asset quality issues at the EU level reached their peak. These conservative conditions are projected over a 20-year horizon.
The quantitative analysis is, therefore, based on a very conservative methodology, which extrapolates high NPL levels recently experienced within the EU onto a 20-year horizon and assumes no change in the banks origination standards nor in provisioning policies. The results show that, after 20 years, the statutory prudential backstop would lead to a decrease in the CET1 capital ratio of 205 basis points for the average European bank. Over a seven-year horizon, which is considered the maximum timeframe for banks and supervisors to adjust their policies, the cumulative impact would amount to 56 basis points, equal to 10% of retained earnings.
The analysis  should be seen as an exercise in estimating what the impact of the prudential backstop on capital would have been, if it had been introduced in 2014 and banks had taken no action in response to the regulatory change. In fact, with a well-functioning prudential backstop, the impact of the measure should help prevent the future building up of NPLs. 
The Report also includes a qualitative part, where the EBA considers the statutory prudential backstop from a supervisory perspective, focusing on the interaction of the backstop with the full set of available regulatory and supervisory measures, which are currently in place. In particular, it provides observations regarding the possible effects of prudential backstops in combination with existing CRR provisions, Pillar 2 measures as well as the newly introduced accounting provision under IFRS9.

Legal basis and next steps

This Report is the EBA's response to the European Commission's call for advice on the introduction of statutory prudential backstops proposed in its consultation document published on 10 November 2017 and complements the Commission's legislative proposal published on 14 March 2018.

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