Asset Quality Review: How will the ECB treat forbeared but performing loans?

In October 2013, the European Banking Authority (EBA) published binding clarification for what constitutes forbearance and non-performing loans. Apparently, the ECB is keen to use these long awaited definitions in its Asset Quality Review, as the identification of stressed but not impaired exposures is at the core of the Comprehensive Assessment.

According to the EBA an accounting impairment is required if the loan is classified as non performing. The current challenge lies in the fact that it is not obvious how to treat forbeared but performing loans as the EBA’s understanding differs from the understanding from eg. the ESMA or the FSA. The treatment of forbeared loans was also not clear before. In the BoE’s December 2011 Financial Stability Report focussing on UK-Banks, the bank reports that forbearance actions do not appear to be fully reflected in lenders’ provisioning processes. With regard to this report, Deloitte states „there is potential for under-provisioning in relation to forbearance caused by:

  • Inaccurate data regarding loans subject to forbearance.
  • Overly optimistic assumptions used in determining the timing and size of cash flows from forborne loans in specific impairment assessments.
  • Inappropriate inputs for collective assessments, which do not reflect the particular characteristics of loans subject to forbearance. For example, should the PD be higher for commercial real estate loans subject to forbearance?“

Where does this uncertainty come from?

To determine a comparable playing field, it is clear that harmonised definitions are key for the success of a unified European Bank Supervisory. So far so good. The challenge: In clarifying this, is it not visible to what extent the IASB was consulted. IAS 39.59 defines triggers indicating an impairment exposure, whereby such events include significant financial difficulties of the obligor. As mentioned above, the question is in how far forbearance defined by the EBA triggers an accounting impairment in case the loan is performing. In other words: Are there forbeared but performing loans that should actually be classified as non performing according to the concept of the EBA? The definitions and interpretations pronounced by different regulators do not yet fit together. According to the ESMA, lender granted concessions that the lender would not otherwise consider due to the borrower’s financial difficulty indicate an accounting impairment. The UK-based FSA has a similar understanding. As Deloitte states in its UK-based review „Loan forbearance. No such thing as free lunch“: „The granting of forbearance is likely to constitute an impairment trigger, meaning that the loan should be assessed 
for impairment, either individually or as part of a collective assessment. Lenders should also assess whether borrower requests for forbearance amount to impairment triggers – even where forbearance is not granted – as the request may imply the borrower is in financial difficulty.“

Why is this uncertainty crucial with respect to the Asset Quality Review?

We touched upon the experience made in Spain in an earlier article. This showed that Asset Quality Reviews focus on assessing the default probability as well as the loss given default estimates. In using the EBA-definitions, the ECB enjoys a range of interpretation on what constitutes adequate PDs for forebeared but performing loans and on if relevant loans should be classified as non performing loans. It is probable that some banks may have to adjust their PD assessments contingent on the final understanding of the ECB. This in turn may have an impact on accounted impairments. In addition, changing PDs as well as LGDs will impact the minimum capital requirements of banks using the Internal Ratings Based (IRB) approach. The impact will be defined in the course of the Capital Stress Test expected to start in mid 2014.

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