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.

Please find the answer to this question jointly with question 2.

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?

Regarding DoD framework, operational issues are of utter importance for French banks such as the impact on ratings systems generating model changes, or the connection with other concepts such as NPE. This is why French banks favour alignment between NPE – default in the first place. Banks have made significant efforts throughout the years to align NPE and default definitions and consider that such alignment provides optimal framework. Any changes to the regulatory framework should be weighted with the possible operational implications for banks (e.g. material model changes).

We do not anticipate that the impact of the proposed EBA alternative measures (reduction of probation period, alternative definition of material payment) under their current form would be significant as the conditions would target few forborne measures. In current EBA proposals, the operational burden of the alternative measures would outweigh the potential benefit of them. Indeed, operational implementation implies the storage of detailed information regarding the forbearance measures and NPV test results which would be heavy to handle in comparison with the possible low number of facilities / obligors concerned by the measures:

• Applying an alternative probation period exclusively to certain types of forbearance could result in an IT complexification as it would require having a very detailed view of the forbearance stored in a database
• The results of the NPV test verification should be stored for each of the concerned forbearance measure, while the NPV test can be performed in less automated way

In addition, the alternative material payment definition proposed by the EBA will not solve possible issues encountered in corporate restructuring (see aspects mentioned further in our response).

Before EBA endorses any proposal which could imply potential NPE-default misalignment, such proposals should be reflected in prudential regulation from a holistic point of view, by amending conjointly the level 1 text (NPE definition in CRR) in order to avoid such potential misalignment. In any case, proposals should be built in a such a way that they provide reasonable benefits compared to the costs (e.g. enlarging conditions so that the targeted scope is material). In this current text, any modification in the Guidelines on the definition of default triggers a material model change in the implementation, thus we would like to highlight key important points in this regard:

• During the periods of transformation of banks’ business model and research for simplification and agility, the confrontation between long-term business gains/economic stability and the cost of adapting processes/systems/models certainly deserves further study.
• We encourage the EBA to finalise as soon as possible its updates on the RTS for assessing the materiality of extensions and changes of the IRB approach where the objective is to alleviate the materiality of certain changes including in relation to the definition of default. In addition, if EBA introduces greater flexibility to DoD framework, we support the EBA providing at the same time solutions to ease the implementation regarding impact on rating systems. Among various solutions, one pragmatic possibility is the intermediate trajectory in which default rules would be modified (thus reducing volumes to be processed) without a mandatory immediate review of the model calibrations requiring retropolation of definition of default in historical defaults for modelling data. Models could be reviewed at their normal pace, naturally integrating over time defaults according to the new rules, as long as calibration level of final risk parameters remain sufficient to cover the inherent risk of the covered exposures. This will ensure reasonable operational impacts as well as a relative stability of the risk parameter framework by avoiding unwelcome volatility of capital requirements.

As EBA asks in question 1 if current guidelines lead to some exposures under forbearance measures to be incorrectly classified as defaults, we would like to take the opportunity to provide below in a more general reflection an illustration of issues spotted in current regulation which may need greater flexibility. Whenever needed, such reflection for better identification of default will need a longer term discussion which involves other deciders such as legislators, in order to ensure consistency between different regulations / texts from a broader perspective. 

Conditions for returning to non-defaulted status:

Firstly, to clarify the context and provide a comparison, in the USA ALL aviation companies except one (Southern Airlines) have at one time or another been in Chapter 11 whose whole purpose was designed to enable viable companies to de-lever and emerge from insolvency in a position to create value for all stakeholders and therefore the economy generally.  

The European legislator, notably through the new Insolvency Directive, aims to remove the stigma associated with corporate failure in Europe and encourage a bounce-back of struggling but fundamentally still viable industrial businesses.  

Indeed, the preamble of the EBA’s consultation paper itself clearly recognizes the need NOT to discourage banks from extending debt restructuring measures where “deemed appropriate” and where concessions “might restore the likelihood of those obligors from paying the remainder of their debt obligations”

This wording could be interpreted as follows: when a borrower’s capital structure objectively can be considered to have been “right-sized” and suitable to the new circumstances it finds itself so that it can grow normally, then an exit from prudential default can be justified and indeed is a desirable outcome for both the bank and the borrower.  The objective of the banking sector in a restructuring (as opposed to a liquidation) is to recover a client that is in good health that we can continue to work with.

The key is therefore to distinguish between the type of restructurings:

• For sub-optimal restructurings where the borrower remains to a significant degree in financial stress or distress, a more rigid regulatory treatment may appear wholly relevant.  We recognize there do remain quite a few such cases and the propensity to adopt an “amend and pretend” solution is a legitimate concern for the EBA (and a reason for the introduction of backstop rules).

• For optimal restructurings, where the borrower’s financial standing has been restored however, a wholly prescriptive approach seems inappropriate since a “substance over form” and multi-criteria analysis applies just like the bank did for the initial lending decision.  

Generally, in the current regulatory approach, there is a lack of distinction between (i) chapter 11 style insolvency processes which aim to save an insolvent business and (ii) liquidation style processes which focus on applying distributable cash to creditors in a fire sale. 

There is also a lack of flexibility to distinguish between a clean deleveraging solution and a succession of piece-meal accompanying measures.  

Except for cyclical activities like property or shipping where LTV’s can be restored by the passing of time or cases where the initial stress/distress was caused by a liquidity issue rather than a solvency issue, most restructurings require a de-leveraging of some sort (eg haircut, conversion or equity raising), to provide the business with sufficient flexibility going forward.  Post restructuring, a company’s ability to raise fresh debt to address its liquidity needs is directly dependent on it carrying debt AT or BELOW its debt capacity.

It is also a fact that bullet lending has become a common feature of the large corporate lending market and rare are the cases where unsecured lenders achieve partial repayment during debt restructurings. In a bullet lending, the repayment of the principal is expected at the end of the loan. In this respect, the condition of a material cash repayment before exiting default is structurally difficult to meet rapidly for the vast majority of cases encountered as a practical matter, extending artificially the default duration. This is especially so following the imposition of court-imposed moratoria in certain jurisdictions having transposed the Insolvency Directive into local law (eg in France now, measures to seek repayment can be blocked upon opening of a conciliation procedure which did not use to be the case before the directive).

For a better framework regarding corporate lending, two areas could be reflected by the EBA:

1. Relaxing the criteria for the minimum probation period before returning to the non-defaulted status could be appropriate to support clients when financial difficulties are behind them and when their credit profile has returned to an acceptable level allowing a normalized course of business and access to debt markets. A reduction of probation period to 3 months could for instance applies if following a restructuring whether or not involving a formal insolvency procedure and whether or not cash repayments have been made since entering default, the borrower emerges with a credit standing compatible with normal course of business credit metrics considered as acceptable for in bonis borrowers of its sector (3 month probation period from the date the restructuring agreement became legally effective). To apply this derogation to the overall rule, it would be necessary for the bank to demonstrate its analysis that both the solvency and liquidity concerns which had led to the default criteria were no longer applicable (i.e. that the UTP criteria no longer applied as sole condition). To avoid NPE-default misalignment, there is a need to also work towards a modification of the minimum period for NPE exit mentioned in CRR article 47a 6(b).
2. Providing flexibility in current mandatory repayment conditions for exiting default under justifiable conditions (e.g. bullet or balloon loans) and removing any reference to amounts which have been written-off following for instance a partial conversion of the debt into securities or given the introduction of a better-fortune clause or any other mitigant, to focus on contractual payments under the restructuring agreement, if any. This would result in an adaptation of paragraph 73 (a) of EBA Guidelines on definition of default. To avoid NPE-default misalignment, it would create a need to amend the condition of “full and timely repayment likely to be made” as per article 47a 4(b) of CRR.

NPV test threshold:

NPV ratio consists in an actuarial computation comparing net present value before and after restructuring. As per EBA requirements, net present value is discounted at the customer’s original effective interest rate and is therefore sensitive to the level of this interest rate. The outcomes of the NPV test would structurally fluctuate under different contractual interest rates and/or interest rate market conditions. In the simplified case of postponement of full amount, a threshold of 1% applies to the NPV ratio boils down to consider that the maximum period of postponement allowed is only 1 month under assumption of 10% interest rate. Indeed, as a simplified picture, a value of 100 discounted at 10% after one month leads to a value 99.21 (decrease of less than 1%), while if we discount 100 after 2 months, the value will be drop below 99 thus implying that the relative variation would be above 1%. If for instance this interest rate is now 4%, this maximum period of postponement could be of several months.

As expressed by the EBA during its public hearing (slide 11 of the displayed presentation), the 1% threshold is initially intended to capture rounding error and the 1% threshold is said to prevent arbitrage. In the example illustrated, according to EBA, in scenario 1 (no restructuring), the obligor is defaulted after 90 DPD, while in scenario 2 (restructured just before 90 DPD), the obligor would not be defaulted with NPV threshold at 2%. 

However, where NPV ratio is sensitive to higher interest rates, the computation of NPV test would not systematically lead to this conclusion in scenario 2. 

We would also like to point out that the NPV test does not constitute the only way to identify defaults, as other UTP triggers exist (refer also to our answer in question 3, where we explain that the perimeter of defaults identified through NPV test is narrowed).

This is why we think that the 1% threshold for NPV test is not an exact nor a supreme measure to identify defaults. An increase of the NPV test threshold may be justified in some instances, subject to our attention points stated previously (e.g. implementation issues and model change challenges). Any modification of the threshold made by the EBA should be done in such a way that the NPV threshold is set by the bank under a certain cap (e.g. 5%). Thus, banks remain compliant with their current framework with a 1% threshold and have room for manoeuvre in a longer term reflection for better default identification if they choose to increase the threshold under this certain cap.

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?

In the continuity of our answer to questions 1 & 2, we also share below other areas where the EBA could focus reflection.

Materiality thresholds for days-past-due amount for non-retail exposures:

Another possible improvement concerns the increase of the absolute materiality threshold for days-past-due amounts from 500 euros to 5000 euros for non-retail exposures. Indeed, the purpose of setting the materiality thresholds for days-past-due amounts is to ensure the application of a common level that reflects the level of risk considered as reasonable. In the case of non-retail exposures, based on our experience, the absolute threshold of 500 euros leads to consider exposures with relative “low materiality” in default. In the monitoring of defaulted exposures, banks favour a right balance between the need to focus on increased risk and the level of amount to which banks are exposed (in particular to possible loss levels). A threshold of 500 euros leads to monitor a high number of relatively low exposures where such exposures do not constitute significant issues for the banks. Increasing the absolute threshold would help banks in the risk monitoring of non-retail exposures to concentrate the effort more on significant cases. Also, if necessary, such absolute materiality threshold could also be differentiated according to the size of the Corporate (e.g. SME, Large Corp, Very Large Corp). In any case, such discussion regarding materiality threshold would need to involve supervisory competent authorities (e.g. ECB with regards to Regulation 2018/1845) which final decision determines the threshold for supervised banks.

We would like to emphasize that the issue is not only about simplification of processes and avoidance of unduly burdensome tasks given the expected reduction in volume of defaults and alerts to be handled, but also about the commercial challenge it creates with respect to major clients related to non-material or technical defaults while both institutions and clients should focus their time and energy to prevent actual financial difficulties.

Proportionate approach in NPV test computation:

We understand that CRR and EBA Guidelines provide a proportionate approach of the NPV test computation so we would like the EBA to provide better clarity in the Guidelines to ensure common reading between banks and supervisors.

First, we would propose to reword the paragraph 52 to align with CRR3 and the fact that the NPV test is only required in the objective of identifying defaults triggered by the diminished financial obligation which is induced by the forbearance measure (thus the NPV test needs not to be performed when the exposure defaults for other reasons).

Paragraph 52 of EBA Guidelines details “For the purposes of unlikeliness to pay as referred to in point (d) of Article 178(3) of Regulation (EU) No 575/2013, for each distressed restructuring, institutions should calculate the diminished financial obligation and compare it with the threshold referred to in paragraph 51. Where the diminished financial obligation is higher than this threshold, the exposures should be considered defaulted.

We suggest replacing in paragraph 52 “for each distressed restructuring” by “for an exposure subject to a forbearance measure potentially in default because of that measure likely to result in a diminished financial obligation due to the material forgiveness, or postponement, of principal, interest or, where relevant, fees”. In addition, we propose to add at the end of the paragraph “For the avoidance of doubt, the NPV test should only be performed for exposures subject to forbearance measures where no other rationale for classifying or maintaining a default exist”.

Indeed, such nuance is crucial as we understand that CRR targets the identification of default by performing NPV test only when the trigger is the forbearance measure likely to result in a diminished financial obligation due to the material forgiveness, or postponement, of principal, interest or, where relevant, fees. This is concurred by the following references:

• In the level 1 text, article 178.3(d) of CRR was modified in CRR3 and now indicates:  “For the purpose of point (a) of paragraph 1, elements to be taken as indications of unlikeliness to pay shall include the following […] (d) the institution consents to a forbearance measure as referred to in Article 47b of the credit obligation where that measure is likely to result in a diminished financial obligation due to the material forgiveness, or postponement, of principal, interest or, where relevant, fees;”
• Paragraph 50 of the EBA Guidelines specifies “given that, as referred to in point (d) of Article 178(3) of Regulation (EU) No 575/2013, the obligor should be considered defaulted where the distressed restructuring is likely to result in a diminished financial obligation, where considering forborne exposures, the obligor should be classified as defaulted only where the relevant forbearance measures are likely to result in a diminished financial obligation.”
• EBA feedback on the consultation of the first version of the Guidelines on definition of default mentions page 99 that “As the calculation of NPV should be applied for the purpose of the identification of default, it only applies to those exposures that are subject to distressed restructuring and have not been recognised as defaulted yet […]”

As paragraph 52 of EBA Guidelines only mentions “for each distressed restructuring”, there could be diverse supervisory understanding which deems for instance that the NPV test should be performed systematically for every exposure subject to forbearance measure, even if such exposure is subject to other default triggers (such as UTP or DPD) and is put into default in any case. From a pragmatic point of view, we would like to highlight that when the NPV test is performed for a forborne exposure only when the exposure has not defaulted yet for other triggers, this leads to the same outcomes that performing the NPV test systematically for every forborne exposure (in terms of status of default for obligors, same duration of probation period - 12 months - as the forbearance is identified before possible need to perform NPV test). This is why a more proportionate approach regarding performing the NPV test should be clearly mentioned in the EBA Guidelines.

Reset of probation period for forborne exposures:

We also deem that this point deserves to be clearly mentioned in the EBA Guidelines to ensure common reading between banks and supervisors.

EBA provides clarification in Q&A 2022_6527 on the reset of probation period regarding forborne exposures. In particular, the following part of the EBA response to the Q&A should be reflected in the EBA Guidelines regarding forborne exposures in order to provide common understanding (across supervisors):

“Since Article 47a(3)(c) of the CRR requires an exposure that has been under distressed restructuring to be considered as non-performing in the case it becomes more than 30 days past due, there is a rebuttable presumption that the probation period referred to in paragraph 72 of the guidelines on the definition of default should be reset as soon as the exposure becomes more than 30 days past due, unless this delayed payment is not related to financial difficulties of the obligor.”

Such clarification provides further alignment between NPE and default and implies that the probation period for defaulted exposures is not reset to zero when the obligor is not more than 30 days past due.”

We suggest modifying the condition in paragraph 73(c) of the guidelines by adding materiality thresholds for reclassifying a forborne exposure to a non-defaulted status at the end of the probation period. These thresholds could be identical to those applied at the entry in default status. 

According to Commission Delegated Regulation EU 2018/171 of 19 October 2017, these thresholds amount to 100 EUR for retail exposures and 500 EUR for non-retail exposures.

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.

No specific comment.

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

Answered in the other questions

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 welcome the alternative treatment which clarifies that legislative moratoria under specific conditions are not forborne measures.

Regarding the conditions for legislative moratoria to benefit from the treatment underlined by EBA, we think that such conditions should align with the ones specified in legal texts detailing the moratoria (in particular regarding the fact that the moratorium does not apply to new loans granted after the date when the moratorium was announced).

In addition, we would favour extending such treatment (derogation from reclassification to forbearance) to a non-legislative payment relief initiative of a bank as part of an industry- or sector-wide moratorium scheme agreed or coordinated within the banking industry. Indeed, some initiatives may take the form of industry-wide measures, agreed and documented by banks through industry associations in a given jurisdiction. In some Member States, such initiatives are openly encouraged by the government, sometimes supplemented by government guarantees, which provides incentives for banks to adopt these measures. In the context of an economic event (e.g. COVID), these industry measures would supplement the legislative moratoria. Thus, we consider that possible derogation given by the EBA should also target measures agreed or coordinated with the banking industry (even if moratorium is non-legislative). 

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?

Yes, we do agree with the revised treatment of technical past due situations in relation to non-recourse factoring arrangements.

In addition, we would like to reconsider the inclusion of leasing into the same specific treatment as factoring.

As expressed in the Guidelines, EBA also considered to extend the exception for factoring to leasing arrangements, but the EBA deemed in the first place that the dunning process is under full control of the leasing institution such that late payments should be addressed (pre-emptively) by the leasing institution in order to prevent default classifications. 

Actually, leasing activity (both operational and financial) is impacted by the definition of default because of its specific characteristics that differentiate them from traditional bank lending. This significant impact leads to artificial Non-Performing Exposures (NPE) rates that are not triggered by financial problems but due to the way the counting of the days are defined in the final guidelines as well as the way the obligors make their monthly payments. 

Payments in the leasing industry

All lease obligations have to be invoiced and only become due when invoiced. Subsequently, the invoices are processed by the debtor’s finance department. 

Leasing is a tri-partite contractual agreement involving a debtor, a creditor and a supplier. The lessee selects an asset from a supplier and this asset is then purchased by the lessor and made available to the lessee to be used in its day-to-day operations in return for rentals. 

As a result, lease transaction obligations are often treated by the obligor as supplier obligations rather than financial obligations. 

Vendor leasing 

The vendor lease channel is of specific importance for European SMEs to obtain access to financing of their production assets. Vendors use leasing to facilitate access to assets needed by their customers in their day-to-day operations and to establish a long-term customer relationship that goes beyond the maintenance and servicing of the assets. Financial leasing companies fund these structures by purchasing “leases chains” written by vendors or by accepting direct referrals from vendors. It is quite common that the vendor writes the lease, sells the lease contract to the financial leasing company, whilst the lessee (customer of the vendor) remains unaware of such sale. The customer’s relationship with the vendor (asset supplier) is a commercial one and not primarily of a financial nature.

Proposal for leasing 

Delayed payments within leasing are not uncommon and have a technical and an operational background. Based on our experience, we estimate that 90 days should be sufficient to absorb the administrative delays in payment of lease obligations.

Therefore, we request the EBA to treat leasing in the same manner as factoring for the days past due. 

The Original EBA Guidelines 2017 is to be amended:

23 (d) in the specific case of leasing or factoring arrangements where the purchased receivables are recorded on the balance sheet of the institution and the materiality threshold set by the competent authority in accordance with point (d) of Article 178(2) of Regulation (EU) No 575/2013 is breached but none of the receivables to the obligor is past due more than 90 days.

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

No specific comment, the amendment of the Guidelines to reflect CRR3 updates seems to be logical

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