The European Central Bank (ECB) published a Dear CEO letter on Friday 4 December warning the region's biggest lenders that many of them are failing to do enough to prepare for the anticipated hike in bad loans as an outcome of the COVID-19 pandemic.

The President of the ECB said this potential failure to prepare is one factor to be considered in its decision whether or not to allow banks to restart dividend payments and share buybacks. The ECB has specifically observed a range of provisioning practices which might hinder the accurate assessment of underlying credit quality exposures and consequently banks' ability to support economic recovery post pandemic, these are:

  • “wait and see” approaches followed in situations in which delinquency-based triggers are not working
  • approaches involving the modification of triggers and thresholds (e.g. an increase in probability of default (PD) thresholds)
  • biased approaches used when macroeconomic forecasts are incorporated.

The ECB also took the time to remind significant institutions of six key guidelines which they expect to be incorporated into the current year's reporting and planning exercises. Significant institutions are expected to:

  1. Ensure that they have enhanced their procedures so that all contract modifications that qualify as concessions and are provided to distressed borrowers are correctly classified as “forborne” in their systems.
  2. Perform a regular assessment of borrowers’ unlikeliness to pay.
  3. Identify and record any significant increase in credit risk at an early stage. They should not rely solely on days past due as a trigger for a significant increase in credit risk.
  4. Correctly estimate their provisions using realistic parameters and assumptions which are appropriate for the current environment.
  5. Exercise adequate oversight over the critical elements of credit risk management.
  6. Forecast the most likely impact of the crisis in terms of stage allocations, provisioning and capital.

Finally the ECB expects that significant institutions in their response provide a sufficient level of detail to enable the Joint Supervisory Team to understand the bank's approach on how they plan to deal with the issues outlined in the letter, they also provide guidance as to how to structure the response.

In contrast to the UK

The PRA has issued various statements throughout 2020, most notably as early as 26 March with respect to the impact of COVID-19 on both IFRS9 and regulatory capital implications for banks (demonstrating a large degree of alignment with the ECB). Since then UK banks have taken significant impairments with the Bank of England Financial Stability Report of August 2020 expecting this to reach between £45-80bn by the end of 2021. While government support measures are slowly withdrawn as the pandemic eases the expectation is that regulators, banks and market participants will be keeping a watching eye on bad loan provisioning in both the UK and across Europe.

The ECB letter can be accessed here.