Response to consultation paper amending Guidelines on definition of default

1. Question 1: Do you believe the current guidelines result in some exposures under forbear-ance measures to be incorrectly classified as defaults, thus hindering proactive, preventive and meaningful restructurings given the detrimental effects that defaulted status has for the affected obligors? If so, please further specify the characteristics of the exposures, which you deem as being subject to an incorrect classification of default.

In this context, it should be clarified that the granting of multiple forbearance measures does not necessarily lead to a default. Particularly, in the context of complex restructurings, circumstances can change rapidly and could necessitate a further forbearance measure.

2. Question 2: Do you think that relaxing the criteria for the minimum period before returning to the non-defaulted status for defaulted forborne exposures could be an appropriate measure to alleviate a higher burden on your institution and clients? How material would the difference be in your case between the amounts of forborne exposures classified as NPE and as defaulted if the minimum one-year probation period in the definition of default were reduced to three-months for certain forborne exposures (with change in NPV below 5% and no loss on the nominal amount)? Would that proposal create additional operational burden or practical impediments? Do you see support such proposal, and if so, for which reasons?

We welcome a shortening of the one-year probationary period for defaulted forborne exposures. This would also be beneficial for the debtor, as it would make it easier for credit institutions to provide additional funds for debt restructuring if the client could return to performing status more quickly. However, this would also have to be accompanied by a revocation of the NPE status.

The change of reducing the period for returning to non-defaulted status for forborne defaulted exposures would be burdensome in the first stages of implementation, requiring changes in the IT systems and in the processes. Afterwards it may require changes of the IRB models as per the regulatory requests of considering the DoD changes effects on the models.  The change would also make a gap in the NPE and DoD definitions that so far were deemed to be aligned. Regardless of the magnitude of the potential RWA impact of the change, from a “process” perspective it will bring operational burdens and practical impediments and it may not be justified.

3. Question 3: Do you see any alternatives other than those referred to in this section that the EBA should consider under Article 178(7) CRR to update the Guidelines and encourage insti-tutions to engage in proactive, preventive and meaningful debt restructuring to support ob-ligors?

A simplification or relaxation of the criteria for classification as “no longer performing” set out in Article 47a CRR would be desirable.

4. Question 4: Do you use internal definitions of default and NPE that are different from each other? Which differences are these and how material are those differences? Do you have any reasons or observed practical impediment that warrants a different definition of NPE and default? If so, please provide examples where a different definition of NPE and default is appropriate.

There is no distinction in the definition of default and NPE.

5. Question 5: Would a potential lack of alignment between the default and NPE definition lead to issues in accounting in your case?

For accounting purposes, separate identification of default and NPE positions would be required, which would require additional technical effort.

More generally, any misalignment between the definition of default, the definition of NPE, and what is subsequently reported in financial statements constitutes a distortion and potentially misrepresents the actual risk profile. This does not only apply to the NPV threshold for debt restructuring. 

A truly clear example is represented by factoring arrangements where the purchased receivables are recognised on the balance sheet of the factor and the factor has exposures towards the debtors of the client (i.e. factoring without recourse). In fact:

1. the IFRS 9 accounting principle provides that if the client/assignor of the receivables transfers all the risks and rewards of ownership of the financial asset, it shall derecognise the financial asset and the factor has to recognise the exposure to the final debtor;
2. following the previous point, the factoring exposures are classified as without recourse for financial statement and supervisory reporting purposes only when accounting derecognition (by the assignor) and accounting recognition (by the factor) occur;
3. this is possible where the credit contract provides for the transfer of the substantiality of risks and benefits from the transferor to the factor;
4. the factor, therefore, in these transactions must deal with an upfront (so-called "discount") pricing mechanism while ensuring that the actual timing of payment cannot materially affect the transaction price for the transferor at a later date;
5. in order to do so, the factor is then obliged to formulate a price and agree with the assignor on the actual financial term of the transaction, reflecting the same in the factoring without recourse contract eligible for derecognition;
6. the factoring without recourse contract therefore provides – through the formulation of the price – for payment expectations agreed with the assignor/customer.
7. with respect to these agreed maturity dates, the factor sets its own risk management framework and accounts for the credit obligation at amortized cost.

The fact that the paragraph 28 of the EBA guidelines still provides that in case of factoring without recourse “the counting of days past due should commence when the payment for a single receivable become due” generates relevant distortions between regulatory prudential framework and accounting as:

• the recognition of default based on past due days linked to the due date of individual receivables - contrary to the use of payment terms defined in the credit contract used for amortized cost logics in line with accounting principles — often generates default/NPE classifications that do not represent a deterioration in effective credit risk;
• in most cases, the credit risk impairment associated with defaulted counterparties are very limited, as banks do not recognize an increase in their actual risk profile; this despite the penalizing treatment in terms of RWA;
• in addition to the past due objective classification mechanism, a second automatic mechanism is added —in the event of default persisting for a certain period — that does not allow banks to accurately assess risk (as required by accounting principles), consisting of deductions from CET 1 for calendar provisioning on credit exposures, even in case of limited credit risk.

In order to underline the above mentioned considerations, it is important to recall what is already and correctly stated by the 2024_7108 (rejected): with regard to non-recourse factoring (where the purchased receivables are recognized on the balance sheet of the factor in accordance with the applicable accounting principles, and the factor assumes exposures to the debtors of the client) it is crucial to note the following:

• the contract is exclusively between the financial institution and its client (i.e., the assignor of the receivables), and not with the debtor (i.e. the party generally making the actual repayment of the receivables to the factor), who remains a non-contractual party to the financial institution;
• the contract between the factor and the client must explicitly or implicitly reflect and determine specific payment timings in order to allow the transfer of substantially all risks and benefits of ownership, thus enabling the derecognition of the credit obligation from the client’s balance sheet (i.e., non-recourse condition according to IFRS 9, par. 3.2.6). These contractual timings are crucial to the factor to: (i) determine the pricing of the financial transaction, (ii) verify the compliance of the relevant financial transaction with the usury law thresholds from time to time applicable and (iii) record the financial instrument for accounting purposes;
• the contractual payment timings referred to in the previous point are therefore part of the factoring contract and its credit exposure. Their practical implementation, however, could reflect particular conditions deriving from commercial practices in place between clients and debtors.

In fact, applying the contractual payment timing deriving, even implicitly, from the contract with the client as the basis for calculating days past due ensures:

• full compliance with CRR3 (art. 5(b)(4)), defining credit obligation as "any obligation arising from a credit contract, including principal, accrued interest and fees, owed by an obligor", thus establishing a direct link between the credit contract (in place between the factor and the client/assignor) and the assigned credit obligation;
• enhanced identification of default and risk scenarios, preventing the misclassification of counterparties with high creditworthiness (for example, highly rated companies, public administration entities); in this regard, it is important to represent that adopting the due date of the single receivable very often leads to distortions in the representation of effective credit risk. This is the case for high-standing debtors with strong commercial power with their suppliers or public administrations, who are often classified as defaulted despite being fully solvent. Furthermore, the automatic default classification is supplemented by automatic calendar provisioning, which imposes deductions to CET 1 without further assessments of actual risk (i.e. low under IFRS 9 principle).
• consistency with the broader risk management framework and regulatory reporting, as the contractual payment timings reflect realistic repayment expectations and are used by the factor to calculate other regulatory indicators (e.g., Liquidity Coverage Ratio, Net Stable Funding Ratio, Interest Rate Risk in Banking Book limits);
• no conflicts with the formal payment terms deriving from the credit contract between the financial institution and the client, in contrast to the debtor who does not have a contractual relationship with the financial institution;
• a more harmonized definition of default across factoring and other financial instruments characterized by credit obligation due dates which are generally based on what is contractually agreed with the client. This could lead to regulatory and interpretative simplification without the need for further exemptions or specific provisions for factoring;
• prevention of arbitrage by financial institutions in defining contractual payment terms and in accurately identifying defaults, as extensive long payment terms could lead to: (ii) unattractive pricing for clients and (iii) delayed profit distribution through amortized cost accounting.

Conversely, the harmonization of the different frameworks (default, accounting, regulatory reporting) adopting the single receivables due date would lead to:

• underestimation of the liquidity risk;
• underestimation of the IRRBB;
• distortion and overestimation on the recognition of the profits in the financial statement;

In the light of this, therefore, without the possibility of adopting the contractual date from which to commence counting the days of past due or, alternatively, the due date of single receivables (which would, however, lead to significant distortions), the objectives of aligning the definition of default, the accounting framework and the regulatory reporting framework are unattainable.

Furthermore, initiating the counting of days past due based on contractual terms included in or implied by the contract agreed with the factor’s client would not incentivize late payments by the debtor, as those are bound by Directive 2011/7/EU, encouraging prompt payment practices by both enterprises and public authorities. In this regard, the role of financial institutions specialized in non-recourse factoring is also to ensure more effective collection processes compared to those of their clients.”

Moreover, the automatic default classification is supplemented by automatic calendar provisioning, which imposes deductions to CET 1 without further assessments of actual risk (i.e. low under IFRS 9 principle); this case is different from the exposures classified as UTP, where a specific assessment of risk deterioration is foreseen and done and where the automatic calendar provisioning mechanism correctly imposes a backstop for banks in terms of consistency of the provisions.

Therefore, the failure to provide for the possibility of using contractual payment terms to calculate the days of past due often results in a balance sheet representation that overestimates the effective risk, with a significant percentage of defaulted exposures and NPEs not corresponding to the risk increase. This could lead to even more significant distortions if these exposures are subject to prudential deductions from calendar provisioning, thus generating misalignments with what is required by accounting principles.

6. Question 6: Do you agree that no specific provisions should be introduced for moratoria on the grounds of the sufficient flexibility of the revised framework? In case you think the pro-posed alternative treatment for legislative moratoria should be included in these guidelines, do you have any evidence of the definition of default framework being too procyclical in the context of moratoria? Do you agree with the four conditions that need to be satisfied?

We believe that the proposed alternative treatment for moratoria should be included in the Guidelines, as the "flexibility of the legal framework" referred to by the EBA is, in our view, not sufficiently clearly and precisely reflected in the CRR or the Guidelines.

7. Question 7. Do you agree with the revised treatment of technical past due situations in rela-tion to non-recourse factoring arrangements? And if you do not agree, what are the rea-sons? Do you have any comments on the clarifications of paragraphs 31 and 32 in the current GL DoD?

We appreciate the revised treatment of technical past due arrangements in relation to non-recourse factoring arrangements, in case that the materiality threshold is breached but none of the receivables to the obligor is past due more than 90 days (instead of 30 days).

Having stated this, we would like to highlight the following:

Paragraph 32 of current EBA guidelines on the definition of default provides for: "In the specific case of undisclosed factoring arrangements, where the obligors are not informed about the assignment of the receivables but the purchased receivables are recognized on the balance sheet of the factor, the counting of days past due should commence from the moment agreed with the client when the payments made by the obligors should be transferred from the client to the factor".

Conversely, the guidelines under consultation provide for a cancellation of the aforementioned paragraph, while providing for the introduction of a further case of technical past due in paragraph 23: "in the specific case of undisclosed factoring arrangements, where the payment was made by the obligor to the client before the payment was 90 days past due and the transfer of this payment from the client to the factor occurred after the 90 days".

The proposed amendment, contrary to the current provision:

• does not take into account the factor's inability (given that the assignment of the receivable is not notified to the debtor) to act through collection strategies against the debtor and at the same time requires to count the days of past due on the debtor side;
• could be impractical from a technical standpoint; in fact, it would be difficult or impossible to implement it in a classification algorithm, as the factor may not have timely evidence (or within the timeframe necessary for classification as technical past due before classification as past due) of the debtor's precise payment timing to the assignor;
• it does not result in line with CRR3 (Article 5, paragraph 4), which defines a credit obligation as "any obligation arising from a credit contract, including principal, accrued interest, and fees, owed by an obligor," establishing a direct link between the credit contract (and its terms) and the assigned receivables.

Therefore, current wording of paragraph 32 is better able to represent both the effective credit risk and the counterparty through which the risk is based: the factor, once it has proof of payment from the debtor to the client/assignor, has a credit exposure against the latter and would calculate the days of past due and classify the credit towards its client following the agreement between the parties, also because from both an accounting and prudential standpoint (e.g. calculation of RWA) the credit exposure is shifted by the factor from the debtor to the client side.

Article 31 (besides the case in which the debtor has not been adequately informed about the cession, proposed to be moved under par. 23) according to which "where the obligor has been adequately informed about the assignment of the receivable but has nevertheless made the payment to the client, the institution should continue counting the days past due according to the conditions of the receivable" requires further clarification.

In fact, in some specific cases, the debtor, although adequately informed of the assignment, proceeds with direct payment to the client because:

1. the debtor has lawfully refused the assignment according to the provisions of the legal framework of its relevant country and, therefore, is no longer called upon any payment requests by the factor and the assignment between the factor and the debtor is no longer effective (legally effective only between the factor and the client);
2. the debtor denies the assignment of the receivables and refuses to pay the factor, which is however the legitimate creditor, since the assignment is effective between the parties (both between the factor and the client both between the factor and the debtor).

In the first case, it is unclear why institutions should continue to count the days of past due towards the debtor who has properly repaid its debts according to its legal framework. As said, in this case, the assignment of the credit is ineffective against the debtor, and the same rules as the current wording of paragraph 32 would apply, i.e., that the credit is considered past due to the client (and no longer the debtor) only if the latter fails to repay the payments received from the debtor to the factor according to the contractual terms established with the same factor.

In the second case, the factor could essentially have only two options for collecting the receivables (and calculating the past due days):

• requesting the client to repay the factor. In this case, it would fall under the same rules as the current wording of paragraph 32, i.e., that the credit is considered past due to the client (and no longer to the debtor) only if the latter fails to repay the payments received from the debtor to the factor according to the contractual terms established with the same factor.

if allowed and provided by the legal framework, the factor has to require the debtor to proceed with a further new payment to for the amounts due by virtue of the effectiveness of the assignment between factor and debtor; in this specific case, it appears clear that the calculation of the days of past due could commence only from the moment the factor requests the debtor to repeat the payment.

8. Question 8. Do you agree with the other changes to the guidelines to reflect updates from Regulation (EU) 2024/1623?

As regards this question, we would refer back to our responses to question 5 and question 7. 

Specifically, with regard to non-recourse factoring, the definition of credit obligation introduced for the first time by CRR 3 (art. 5(b)(4)) was not taken into account in defining when the counting of days past due should commence (par. 28). A credit obligation is in fact defined as "any obligation arising from a credit contract, including principal, accrued interest, and fees, owed by an obligor" thus establishing a direct link between the credit contract and the financial institution. The contract is exclusively between the financial institution and its client (i.e., the assignor of the receivables), and not with the debtor (i.e., the party generally making the actual repayment of the receivables to the factor), who remains a non-contractual party to the financial institution.

The proposed changes to paragraph 32 also go in the opposite direction to the definition of credit obligation. In this case, even in the case of undisclosed factoring arrangements, comparable to cases of refusal of assignment by the customer's debtor, where the assignment of the credit is not even enforceable against the debtor (and not only, there is no contract between the factor and the debtor), the proposed changes introduced to paragraph 23, letter (f), would require that the days past due would continue to be counted on the debtor side according to certain criteria. This treatment appears unjustified, especially since the factor, in the event that the factor has information of payment by the debtor to its client (e.g. escrow account, information flows - if present - from the clients to the factor) would have to consider a direct exposure to the same client counting the past due days on client side according to the contractually agreed upon criteria.

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