Analysis: “Measures adopted by the European Commission to mitigate the impact of COVID-19 in the banking sector” by Pablo Biscari García
The severe economic shock caused by the COVID-19 pandemic as well as the severe containment measures adopted by countries around the world to control the spread of the outbreak have significantly affected the world economy, and the banking sector is no stranger to the negative effects of the pandemic. To enable the banking sector to respond effectively to this challenge and mitigate its impact, the European Commission has adopted a series of measures to clarify and recalibrate the banking prudential framework with a view to helping mitigate the economic impact caused by the outbreak.
As an introduction, it is important to understand that the European Union’s prudential framework aims to ensure, amongst other objectives, that credit institutions operating in the EU are adequately prepared in order to successfully withstand stressful economic conditions. Strict capital rules provide that credit institutions must hold sufficient capital to absorb potential losses in such scenarios, without becoming unviable.
Contrary to the global financial crisis, banks today are in a much more comfortable position than they were in 2008. The banking sector plays a key role in managing the economic shock derived from the pandemic by helping channel credit towards those who have been most affected; particularly small and medium-size enterprises. Banks themselves are vulnerable to the economic consequences of COVID-19 and may also experience difficulties due to challenging prospects and heightened volatility in financial markets. It is therefore appropriate to offer clarity as to how lending activities can continue in such an adverse scenario whilst complying with prudential rules responsibly.
European Commission’s banking package
With this in mind, the European Commission has adopted a banking package which aims to facilitate lending by banks to households and businesses throughout the European Union. The package is composed of two key instruments: (i) an interpretative communication on the EU’s prudential and accounting frameworks (the ‘Communication’); and (ii) a set of targeted amendments which fine-tune the existing EU prudential rules.
Communication on EU’s prudential and accounting frameworks
With the Communication, the European Commission issues a call for flexibility in the application of EU rules and underlines that the existing legal framework already allows for flexibility. However, the European Commission also warns that, in any event, flexibility must be applied in a responsible manner. This means that, whilst supervisors may tolerate a more flexible interpretation of the rules so that banks have more capital available to lend, banks must still adequately monitor the effects of the pandemic on their balance sheets. Accordingly, the areas of flexibility in the EU’s regulatory framework include:
(a) the rules on how banks assess the risk that a borrower will not repay a loan in a sudden economic crisis, such as the coronavirus pandemic, and the effect on the amount of money a bank needs to set aside for potential losses. A strict application of the International Financial Reporting Standards (IFRS) 9 rules, which introduced a more forward-looking approach to loan-loss provisions, could lead to banks having to increase their expected credit loss (ECL) provisions due to households or businesses not being able to pay back their loans as a result of the pandemic. The Communication confirms that the ECL approach under IFRS 9 enables banks to use their own judgment to determine if ECL provisions must be recognised. In this regard, international bodies (including IASB, BCBS, ESMA, the EBA and the ECB) have indicated that banks are not expected to apply existing rules mechanically in a situation as exceptional as the COVID-19 pandemic.
(b) the prudential rules on the classification of non-performing loans (NPL) when relief measures (such as guarantee schemes or moratoria) have been adopted either by Member States or by banks. The Communication recalls that prudential rules do not require banks to automatically consider an obligor in default if it calls on a guarantee. As the COVID-19 crisis may put many borrowers under financial stress, banks should take into account the long-term prospects of the borrower when assessing his capabilities to meet his obligations.
(c) the accounting treatment of delays in the repayment of loans. Member States have introduced temporary measures which enable borrowers to defer repayment of their loans for some time. This moratoria, which is intended to address short-term liquidity difficulties, could have significant prudential impact if a flexible approach to credit risk is not adopted. The Communication clarifies that individual or corporate loans that benefit from the moratoria should not automatically be considered to have suffered a ‘significant increase in credit risk’ (SICR) just because they have been subject to the moratoria, as such financial difficulties are expected to be temporary. The Communication further indicates that, in order to identify whether a SICR has occurred, banks should give sufficient weight to scenarios based on long-term stable macro-economic outlooks.
The overall objective of the European Commission’s Communication is to ensure that the flexibility available in existing prudential rules is applied and that, therefore, effective economic support and relief measures adopted by public authorities are not hindered by a strict application of prudential rules. In fact, prudential rules are there to help banks be better prepared to withstand and respond in adverse economic scenarios; it would be somewhat contradictory if, due to prudential rules, banks were not able to effectively serve as a transmission channel for the financial aid to support businesses and households in times of need.
Targeted amendments to Regulations 575/2013 and 2019/876
On the other hands, the objective behind the proposed legislative amendments to existing EU rules is maximising the loss-absorbing capabilities of banks to manage the impact of the COVID-19 pandemic. In order to achieve this, the European Commission has proposed a series of targeted amendments to the Capital Requirements Regulations, Regulation (EU) 575/2013 (the ‘CRR’) and Regulation (EU) 2019/876; namely:
(a) The transitional arrangements for the application of IFRS 9 have been extended by two years. Stakeholders have identified that the application of IFRS 9 during the COVID-19 pandemic could lead to a sudden increase in ECL provisions of banks, therefore resulting in an erosion of their capital and, ultimately, a restriction of a bank’s ability to provide lending in the current situation. Extending the transitional arrangements allows banks to add back to their regulatory capital any increase in new ECL provisions that are recognised in 2020 and 2021 for their financial assets.
(b) The applicability of the new leverage ratio buffer requirement has been pushed back to 1 January 2023. The leverage ratio helps monitor an excessive build-up of banks’ balance sheets in relation to their capital. Pushing back its date of applicability further frees additional capital and helps free up banks’ operational capacity and allows them to focus on the current challenges. Moreover, part of the leverage ratio is modified to avoid the materialisation of negative incentives that have been identified in respect of a discretion given to competent authorities to exclude central bank reserves from the calculation of the leverage ratio. This modification aims to ensure that liquidity measures provided by central banks in a crisis context are effectively channelled by banks to the economy.
(c) Preferential treatment is given to NPLs guaranteed by the public sector in the context of measures aimed at mitigating the impact of the COVID-19 pandemic, putting their treatment on par with the one given to NPLs guaranteed by official export credit agencies (‘ECA’, who issue guarantees on behalf of national governments to provide credit protection for loans used for financing exports). The objective is to recognise that the guarantees provided in the context of the COVID-19 pandemic are recognised with the same level risk-mitigation effects as the guarantees provided by official ECAs.
(d) The applicability of certain measures has been brought forward to incentivise banks to finance employees, SMEs and infrastructure projects, as well as to invest in software. Accordingly, the European Commission has proposed to bring forward the application of:
(i) the exemption which would allow banks to no longer deduct particular software assets from CET1 capital;
(ii) a beneficial treatment of loans given to pensioners or employees with a permanent contract that is backed by the borrower’s pension or salary, to loans;
(iii) the SME and new infrastructure supporting factors. The SME supporting factor refers to a capital reduction factor in the amount of capital that banks need to hold for prudential reasons in respect of loans granted to SMEs. Similarly, the new infrastructure supporting factors introduces a similar discount on the capital requirements linked to exposures to entities that operate or finance physical structures or facilities, systems and networks that provide or support essential public services.
The application of the Communication will be closely monitored by the European Commission, national competent authorities and the ECB. As for the legislative proposals, they are still to be discussed by the European Parliament and the Council. However, given the urgency of the situation, the objective is to have the package adopted in June 2020.
Pablo Biscari García is a lawyer specialised in EU and banking law at an international law firm in Madrid, Spain.