The ECB’s NPL proposal highlights the need for a rethink on regulation

The addendum guidelines on the provisioning of non-performing loans (NPLs) recently put forward by the European Central Bank took the eurozone’s lending industry by surprise, coming at a turning point for the bloc’s recovering economy and following an unorthodox policy-making route.

For a long time, European banking trade bodies have highlighted the need for a break in the flow of new regulations affecting them. The progress made by European banks in increasing capital ratios (practically doubled from pre-banking crisis levels), common equity quality and liquidity ratios proves that there was a need for new rules following the crisis. Precisely these positive results, widely acknowledged by the European supervisory authorities, suggest a regulatory pause would be appropriate to allow the sector to focus on the challenges and opportunities posed by disruptive digital innovations.

Non-binding principles?

Yet the document containing addendum guidelines for the management of NPLs, made available for consultation by the designers of the Single Supervisory Mechanism (SSM), is of a part of the ongoing regulatory push. Furthermore, some methodological aspects make the document questionable well beyond its technical content.

The European regulatory framework includes two regulatory levels: legislative (directives and regulations) and administrative (the so-called regulatory standards issued by European authorities). The former defines the general regulatory principles, while the latter provides details on the technical measures. The new guidelines adopted by supervisors added a third layer.

According to supervisory bodies, this new instrument would not be binding provided industry participants are able to adequately justify any deviation based on the 'comply or explain' principle. However, because the adopters of these guidelines are the very same assessors of the banks’ compliance, demonstrating the validity of non-compliance becomes almost impossible. Therefore, this third level is in reality every bit as binding as the two others.

SSM power extension

What is more, the three levels should at least be coherent and co-ordinated. The second and third levels should be clarifications of the principles contained in the first, rather than an extension, a contradiction or even an amendment of their scope.

This is where the real problem posed by the SSM document emerges. In short, although there is no regulation empowering the SSM to define the level of the provisions for each portfolio of NPLs, the guidelines require that banks act as if the regulations actually existed and thus make additional provisions.

If this extra provision does not comply with the accounting standards, lenders must ‘voluntarily’ subtract this amount from the regulatory capital. Should they fail to do so, the SSM will intervene at the time of the supervisory review and evaluation process, requiring additional capital buffers. In other words, the SSM would assume the right to exercise this power without the European Commission and European Parliament’s prior legal authorisation to do so, and without the necessary assessment. No wonder the president of the European Parliament has expressed concerns about this method of exercising supervision.

Regulation loophole

Another serious consequence is that the primary and secondary layers must comply with the better regulation principles and thus be supported by an appropriate impact analysis, while guidelines do not have to. It is no coincidence that the document released for consultation does not mention the need for an analysis of the consequences of the new measures, nor offer a suitable justification for some of them (for example, the seven and two years granted, respectively, to complete the impairment depending on whether the receivables are backed or not).

Moreover, the guidelines also contradict the conclusions reached in June 2017 by Ecofin, which had launched an action plan comprising a series of measures aimed at preventing the risk of an excessive accumulation of NPLs in the future, based on a report by the task force of the Financial Services Committee. The measures under consultation must concern only new contracts, so they have no retroactive effect, not even if an old performing loan is transferred to the non-performing category. Furthermore, the committee report excluded collateralised loans from the automatic provision mechanisms.

These guidelines appear, therefore, to be forced when compared with the decision-making process taking place at appropriate institutional levels. As in the case of the US, where a process is under way based on the recommendations included in reports from the US Treasury, it is time for a sensible rebalancing of regulatory principles in Europe so the financial system serves consumers and businesses, supports their economic objectives and drives economic growth.

Giovanni Sabatini is general manager of the Italian Banking Association and chairman of the executive committee of the European Banking Federation.