European Mortgage Federation-European Covered Bond Council (EMF-ECBC)

[Please see the attached file for the EMF-ECBC general comments on the EBA's consultation paper]

The EMF-ECBC welcomes the objective of the EBA’s guidelines to harmonise the definition of default to ensure consistency of its application, transparency and comparability of risk parameters between banks across the Member States.

However, the EMF-ECBC considers the EBA’s proposed definition of technical default to be too narrow. The proposed conceptual scope of technical default as defined in subsection 3.2.2 “Technical defaults”, section 3 “Background and rationale” and paragraph 16-20, section 4 “Past due criterion in the identification of default” and letter C. of subsection 5.1.D “Definition of technical default”, section 5 “Accompanying documents” only considers credit obligations as technically past due when the delay results from data or system errors or lengthy payment allocation processes within the credit institution itself as opposed to including data or system errors caused by counterparties. By doing so the EBA determines that credit obligations with technical circumstances, which are not covered by the proposed definition, are by definition considered defaulted for the purpose of estimation of risk parameters.

This definition becomes problematic in instances where material payments are delayed due to lengthy allocation processes that are not carried out internally within the credit institution. For example, in cases of syndicated facilities to corporate borrowers, it is often observed that it takes time for the agent to forward the instalment payment to each participant in the syndication. This delay routinely exceeds the 90-days regulatory period, with no connection to any counterparty credit deterioration. In the modelling of larger bank customers, it is common that payment delays not caused by financial issues exceed the materiality threshold. If defaults that are a result of data or system errors of the counterpart are not regarded as technical defaults, modelling of PDs for large corporates will turn into a matter of modelling probability of errors in customer data and payment systems. With EBA’s narrow definition of technical default, the most relevant risk driver in large corporate portfolios could very well be the size of the company. As a consequence, delayed payments not related to deterioration of the credit quality of the counterparty should not be considered as an indication of default.

Another important example where a specific assessment will be needed is the merging of government entities. An example of this at a municipal level is the Établissement Public de Coopération Intercommunale in France. As a consequence of such mergers, existing loans need to be transferred to the merged entity and technical payment delays occur. Naturally this issue will dissolve with time once the mergers in question have been finalised, but during the implementation period the credit obligations involved should be viewed as merely technical defaulted given the administrative circumstances described. In addition, the low thresholds proposed also give raise to concern about the exposures of institutions to public administration and government institutions that are in some instances obliged to postpone their payments for administrative reasons. The default of a public administration therefore requires further consideration and evaluation.

Furthermore, paragraph 20 of section “Past due Criterion in the identification of default” of the CP states that the classification of the obligor to a defaulted status should not be subject to additional expert judgement. However, expert judgement has an important place within credit risk management and should continue to be used as situations may occur that will result in past due exposure of more than 90 days, however not due to a credit deterioration of the counterparty.

It is often the case that some commercial disputes can last for several months or even years meaning that borrowers, in accordance with the EBA guidelines, would stay in default during the whole period. It is therefore important to avoid capturing defaults related to exposures that are disputed or waived or that are not related to the decrease in the quality of the credit risk.
The EMF-ECBC agrees with the proposal and underlines the importance of having a harmonised application of the definition of default and clear rules for the treatment of SCRA.
The EMF-ECBC sees several possible concerns with the proposed treatment of the sale of credit obligations:

Firstly, whilst a sale of a credit obligation resulting in a loss due to decreased credit quality could be an indication of default, the EBA should consider increasing the proposed threshold of 5% to a minimum threshold of 10%. A 5% threshold is too low given that even a small deterioration in credit rating or changes in interest rate might lead to a 5% drop of the market value of an asset. The EMF-ECBC therefore recommends increasing the minimum threshold to the level of 10%.

In addition, an obligor might also want to sell for reasons such as concentration management, country limit management, liquidity management, regulatory capital savings or employment, balance sheet management, country envelope consumption or counterparty exposure management etc. Such reasons for selling, which are not meant to be exhaustive, are normal credit policies and they are not an indication that credit quality of the obligor per se is perceived as being problematic. Selling for the reasons mentioned above, even at a discount, should therefore not lead to the obligor being viewed as defaulted.

Thirdly, with regards to the materiality of economic loss used as an indicator of default, it is important to bear in mind that a discount incurred upon sale of a credit obligation may be justified by reasons that are not obligor specific. For example, recent history has proven that in volatile markets some bonds can be valued at 95% of their par value just because market anticipate future decrease of credit despite the issuer being in good health. In such circumstances, a bank may cease granting facilities to the obligor, thus potentially triggering an actual payment of default. Hence, it may well be inaccurate to attribute the discount incurred upon sale to the credit quality of the obligor and thereby trigger an actual payment default. In addition, disentangling the specific obligor contribution to the discount may itself prove difficult and disputable to apply in practice. It would therefore be worthwhile developing objective criteria to identify sales of credit obligations not related to credit risk.

Lastly, sales of credit obligations ‘en bloc’ should also be taken into account, as a discount is usually applied compared to a one to one evaluation (in order to conclude the deal earlier) with no link to the real risk of the block.

The EMF-ECBC therefore proposes that the sale of credit obligations is considered as an indication for unlikeliness to pay but should be associated with other indicators and not as a stand-alone criterion. In addition, a clarification from the EBA on whether securitised credits have to be considered within the “sale of credit obligation” category would be welcome.
The EMF-ECBC would advocate the discounting with the “original effective interest rate”, in line with the IFRS 9 (5.4.3).

In section 3.3.3 “Distressed restructuring” of the CP the EBA states: “In order to keep consistency with the supervisory reporting framework it has been specified that distressed restructuring should be considered to have occurred when forbearance measures have been extended towards a debtor as specified in the ITS on forbearance and non-performing exposures. Therefore those forborne exposures, where the forbearance measures are likely to result in a diminished financial obligation should be classified as defaulted.”

This wording does not differentiate between performing forborne exposures and non performing forborne exposures as otherwise defined in the EBA’s Technical Standards on reporting on forbearance and non-performing exposures (see EBA/ITS/2013/03). Performing forborne exposures should not be classified as defaulted. In the case of a renegotiated performing exposure, it is by definition the lender’s best guess at the time of renegotiation that the loan is likely to be paid in full according to the post renegotiation schedule. It would therefore be inconsistent to classify the forborne exposure as defaulted.

Considering the 1% threshold for diminished financial obligation in the EBA guidelines, the EMF-ECBC recommends that the relevant measure for recognition of default should be re-examined and set at a level where the new cash flow would no longer be adequate to cover the book value of the obligation, regardless of the decline in Net Present Value (NPV). Moreover, classifying performing forborne exposures as defaulted could also create perverse incentives for banks, as arguably it would make more sense for lenders not to negotiate payment plans with borrowers at all ahead of the default stage.

In addition, article 178 (3)(d) of the CRR considers “material forgiveness…., of principal, interest or, where relevant fees” an element to be taken as an indication of unlikeliness to pay. In this respect, the proposed threshold is arguably not consistent with the above mentioned materiality criterion, and should therefore be re-examined in order to be consistent with a (common) higher level or restructuring arrangements. Likewise, it seems unnecessary to specify additional indicators regarding the identification of default, if the net present value of expected cash flows on the distressed restructuring arrangement is higher that the net present value of expected cash flows modifications.

Concerning the formula for calculation of the diminished financial obligation (DO) in paragraph 40 “Distressed restructuring”, section 5 “Indications of unlikeliness to pay” of the CP, it is not clear whether the cash flows include the expectation of recovery. If account recovery expectation is not taken into account, the threshold would not make much sense as the new restructured loan could include a reinforcement of the collateral value which might mitigate (partially or totally) the diminished financial obligation measured with the proposed formula. The formula arguably also provides the possibility of hiding a distressed situation by sufficiently extending maturity and maintaining an equivalent NPV of cash flows. Likewise, it is not clear if the two NPV parameters only include the future contractual cash flows or also PD and LGD associated with those cash flows in each moment. In the case of latter, the approach would suffer from a circularity problem. Moreover, some restructuring would not be considered as defaulted under the proposed formula. For instance, when a credit obligation is turned into a payment in kind loan (PIK loan) with capitalized interest during the period the proposed formula’s output is an economic loss of zero.

Lastly, it is worth underlining that the concept of distressed restructuring does not apply in case a revision of the conditions is allowed by the contract (e.g. embedded clauses) or by specific laws (e.g. moratoria issued by banking association/government) or to commercial renegotiations (e.g. change of interest rate for commercial purposes or alignment with current market practices).
The EMF-ECBC agrees if the consultation paper wording (paragraph 46 and paragraph 47, letter g) is in accordance with the IFRS 9, Appendix A “Defined terms” that states “Evidence that a financial asset is credit-impaired include observable data about the following events: (…) f) the purchase or origination of a financial asset at a deep discount that reflects the incurred credit losses”.

If not we disagree. A material discount can be the result of other criteria than financial distress, e.g. general changes to market conditions, or the result of negotiations for example when settling other transactions etc. It therefore seems unreasonable that the discount as such should be an indicator of unlikeliness to pay. Such an assessment is normally part of the due diligence of the asset to be bought in order to be able to establish a relevant value/price of the asset.

By introducing rules that links indications of default to the price of purchased (or sold) assets the EBA could in effect disincentives banks from purchasing/selling assets at discount to avoid putting their client in default (if a bank already has an exposure to the issuer). This would arguably have a negative effect on banks in their role as intermediaries on the financial markets. For example, purchased receivables management is an integral part of the banking sector’s activities and could be perceived as less attractive with the proposed EBA guidelines.

In the view of the EMF-ECBC, default should only be triggered for reasons that are directly linked to the credit risk of the counterparty.
The EMF-ECBC considers that institutions are best placed to recognise when a customer is no longer in default and sees the proposed set of common probation periods as unnecessary. The proposed probation period from default to non-default status is inconsistent with Article 178(5) of the CRR which states that: “If the institution considers that a previously defaulted exposure is such that no trigger of default continues to apply, the institution shall rate the obligor or facility as they would for a non-defaulted exposure.”

In addition, IFRS 9 states that favourable changes in credit risk should be recognised alongside unfavourable changes in credit risk (IFRS 9 BC 5.210). By applying a probation period, financial instruments would arguably move into default status quicker than back to non-defaulted status. This might result in exposures being classified as defaulted but not credit impaired under IFRS 9 (bucket 2 exposures) or the exposure being potentially classified as defaulted and credit impaired (in bucket 3) but with no loan loss allowance, which is counterintuitive.

In any case, the suggested 3 months’ probation period is too long in relation to both large corporate exposures and retail consumers in particular when applied together with the strict definition of the technical default as proposed in the EBA Consultation Paper (CP). In cases of retail and SME customers, payments are not always fully automatized by systematic debit of the customer’s account. In such circumstances, a delay does not necessarily indicate a deterioration of the credit quality of the borrower especially if the cure period is short (less than 30 days). As also discussed previously in question 1, delays in payments of large corporates may be caused by systems or data errors, without necessarily indicating a deterioration of the credit quality of the borrower. This is especially true if the cure period is short (less than 30 days). In such cases, customers should be returned to non-default status as soon as the obligation is paid. The three months’ probation period should therefore be eliminated as a mandatory provision or at least take other default triggers into account such as past due.

With regards to distressed restructuring, the criteria upon which an exposure can return to a non-defaulted status should be selected on the basis of the expert’s assessment and judgement of whether the obligor will remain unlikely to pay. Not using a minimum probation period. Following this line of thought, should a defaulted bank client be bought by another client of the same bank that is not in default, the exposures of the client B should not be considered defaulted if there is no decrease in the credit quality of purchasing client (due to the acquisition). The remaining unlikeliness to pay should be the decisive criteria. Depending on the portfolio specific characteristics, there might also be different or no probation periods.
To summarise our understanding of the proposed guidance:

The guideline confirms that for retail exposure, the financial institution in accordance with second sub-paragraph of Article 178 of the CRR may apply the definition of default at the individual credit facility level rather than at the obligor level. Furthermore the choice should reflect the financial institution’s internal risk management practice. This may imply that a financial institution in general applies the definition of default at obligor level, but for some specific types of exposure applies it at facility level.

Under IRB the financial institution is required to ensure that the risk estimates correctly reflect the definition of default applied to each type of exposures.

The EMF-ECBC agrees that credit institutions should be allowed to choose between the definition of default between obligor and facility, and how to apply the definition at the level of an obligor for some types of retail exposures and at the level of a credit facility for others.
In the view of the EMF-ECBC, a default pulling effect could be considered useful with regards to an obligor if part of the obligor’s exposures have already defaulted due to related credit risks.
The EMF-ECBC disagrees with the joint credit obligation proposals and suggests that credit institution conducts assessments on a case by case basis.

If a joint obligation defaults, the individuals taking part in the joint obligations (and their individual obligations respectively) should not be automatically considered as defaulted. Such an approach is even more difficult to justify economically when applied to joint obligations consisting of a large number of individuals, as all the individuals involved in a defaulted joint obligation would automatically be considered defaulted without investigating their financial state any further.

Moreover, the EBA should also consider that the identification of joint fully liability of retail obligors (e.g. married couple) would expose institutions to an unmanageable workload especially when this implies ongoing updates of dynamic information (the marital status) which are difficult to obtain. The EMF-ECBC therefore recommends the deletion of paragraph 85 “Application of the definition of default for retail exposures at the obligor level”, section 9 “Application of the definition of default for retail exposures”.
The EMF-ECBC agrees with the requirements on internal governance for the use of the IRB approach. The requirements appear to be in line with CRD IV requirements. However, it should be ensured that there is also an alignment with the final Basel Committee Guidelines on credit risk management processes to be applied in accounting for expected credit losses.
European Mortgage Federation-European Covered Bond Council (EMF-ECBC)