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EBA Report on Statutory Prudential Backstops Summary

Core Content

The EBA report provides an analysis of the European Commission's proposal for introducing statutory prudential backstops, aimed at addressing insufficient provisioning for newly originated loans that turn non-performing. The report includes both qualitative and quantitative assessments of the potential impact of the backstop mechanisms on EU banks, focusing on capital ratios and profitability.

Main Viewpoints

• Purpose of the Backstop: The statutory prudential backstop is intended to prevent underprovisioning of non-performing exposures (NPEs) and reduce the accumulation of new NPEs on bank balance sheets, thereby supporting the stability and health of the EU banking sector.
• Design Options: The Commission proposes two main approaches: the deduction approach and the haircut approach. The deduction approach involves compulsory deductions from regulatory capital, while the haircut approach applies a reduction to the value of collateral.
• Impact on Capital: The report estimates that the statutory prudential backstop could lead to a decrease in the CET1 capital ratio of 205 basis points over a 20-year horizon under the baseline specification. However, the impact is significantly lower when considering a 7-year horizon and the ability of banks to use retained earnings for coverage.
• Profitability Considerations: The impact on profitability is considered, with the median bank able to cover the backstop requirements with 10% of retained earnings after dividends. Banks with conservative provisioning practices are not expected to experience any impact.
• Methodology and Assumptions: The quantitative analysis is based on a static balance sheet assumption, using data from 2014 to 2017. The analysis does not account for future improvements in loan origination or provisioning practices, leading to a conservative estimate of the impact.
• Caveats: The report acknowledges that the results are based on historical data and are subject to significant uncertainty. The findings should be considered as an upper bound rather than a prediction of future outcomes.

Key Information

3.1 Design of the Statutory Prudential Backstop

• Deduction Approach (Options 1 and 2):
  • Option 1 (Baseline): Full deduction of defaulted secured loans after 7 years.
  • Option 2a (Linear Path): Linear deduction path for secured exposures, leading to full coverage after 7 years.
  • Option 2b (Progressive Path): Progressive deduction path, which results in a higher impact than the linear path.
• Haircut Approach (Option 3):
  • Applies haircuts to collateral for secured exposures, with varying levels over time.
  • The impact is estimated to be slightly higher than the deduction approach, ranging from 15 to 45 basis points.

3.2 Level of Application

• The backstop applies to newly originated loans that turn non-performing.
• The analysis considers different horizons for when the NPLs are fully provisioned, such as 6, 7, or 8 years.

3.3 Interactions with Regulatory and Accounting Frameworks

• The backstop interacts with the existing prudential and accounting frameworks, including:
  • CRR Provisions: The backstop is considered alongside existing capital requirements.
  • Pillar 2 Measures: Supervisory discretion is involved in the application of the backstop.
  • IFRS 9: The new accounting framework introduces expected credit loss (ECL) provisions, which may affect the backstop's implementation.
• The EBA emphasizes the importance of considering these interactions to ensure the effectiveness of the backstop.

3.4 Impact on Banks' Profitability

• The report highlights that the backstop could affect bank profitability by requiring additional provisions.
• However, the impact is less severe when considering the ability of banks to use retained earnings for coverage.
• Banks that already apply conservative provisioning practices are not expected to experience a significant impact.

Quantitative Analysis

• The analysis is based on data from 2014 to 2017, assuming no changes in loan origination or provisioning practices.
• The results are presented in terms of CET1 capital ratio and profitability.
• Baseline Deduction Approach: Results show a decrease in CET1 capital ratio of 56 basis points over a 7-year horizon.
• Haircut Approach: Results are similar to the deduction approach, with slightly higher impacts.
• Distribution of Impact: The impact is distributed across institutions and exposure classes, with higher impacts for those with a greater stock of NPEs.

Methodology and Constraints

• The analysis uses static balance sheet assumptions, with no changes in exposures or capital.
• Data Sources: Relies on existing data rather than ad hoc collections, introducing simplifying assumptions.
• Uncertainty: The results are subject to significant uncertainty due to the reliance on historical data and the assumption of no future changes in bank behavior.
• Scaling Factor: Used to re-scale projected defaulted exposure amounts to historically observed values, ensuring reliability in the overall estimates.

Conclusion

• The EBA's report serves as a response to the Commission's call for advice on statutory prudential backstops.
• The findings indicate that the backstop could have a significant impact on CET1 capital ratios, but this impact is likely to be lower in practice due to banks' potential adjustments in provisioning and loan origination practices.
• The report is intended to provide a conservative estimate of the impact and should not be read as a forecast. It highlights the importance of a comprehensive approach to tackling NPLs, including supervision, structural reforms, and secondary market development.