No justification for proposed capital requirements relating to non-performing real estate loans

Jens Tolckmitt, Chief Executive Officer of the Association of German Pfandbrief Banks (vdp)

Published in the Börsen-Zeitung on October 20, 2018.

The Brussels negotiations taking place in the European Council and Parliament on the Commission's proposal to tighten up requirements for the treatment of non-performing loans (NPLs) by banks and savings banks are well underway. The intention behind the provisions, as part of the proposals to revise the European Capital Requirements Regulation (CRR) that were put forward on 14 March 2018, is worthy of support in principle. The proposal does, after all, aim at avoiding large holdings of non-performing loans, which are currently very widespread on the balance sheets of some banks in certain European states, especially Greece, Cyprus, Portugal and Italy. As things stand at present, however, there is a risk that European regulations are created that will damage the business model of the German banking industry and consequently also Pfandbrief banks.

The rules currently under discussion stipulate that unsecured loans must be written down in full after two years, and secured loans after eight years. The regulator thus assumes that, after this period, no further capital flows can be expected from the non-performing loans. If the loan loss provision or write-down recognised in net income is not applied to the required extent, for example if accounting rules do not permit this, the difference is deducted from the bank's "hard" Common Equity Tier 1 capital (CET 1).

The new requirements are also expected to apply to the low-risk real estate financing business. The minimum levels of loan loss provisions for these secured NPLs as given in the Commission's proposal do not come close to reflecting the actual recovery rates observed for realised real estate collateral that are used in models approved by the supervisory authorities. As a rule, institutions stand by their clients even in economically difficult times to work together to find the best possible solution for both sides. This support may, however, last longer than assumed by the aforementioned write-down periods that are simplistic in the case of NPLs. These time-based restrictions would plainly compel institutions to instigate measures prematurely for repayment of claims – or to sell these claims in the non-banking sector, which is not subject to the appropriate regulation. This would do a disservice to client protection and financial stability. It would block any individualised treatment of non-performing loans in the interests of the client and with the optimum economic outcome. It would also, completely unnecessarily, provoke unpredictable earnings volatility.

A property value of zero euros, as assumed by the regulator after eight years, is out of touch with reality for the minimum level formulated as the normal case. It can also be shown that, not only in Germany but also in other European countries, significant recovery rates can be obtained for NPLs secured through real estate. A survey conducted by the Association of German Pfandbrief Banks (vdp) among its members for the period from 2000 to 2017 shows that the recovery rate for realisation of collateral in Germany actually averages 53.6% after the eighth year, and not zero, as the regulatory proposal assumes.

An explicit objective of the Commission's proposal is to stimulate the secondary market for portfolios of non-performing loans. It is thought that by targeting the sale of NPLs to investors outside the banking sector, institutions can avoid further deductions from their capital and apply the remaining capital "more usefully" to new business rather than primarily dealing with bad loans. This intention seems reasonable at first glance. In these circumstances, however, institutions can then no longer benefit from the frequent cases of successful restructuring, or from collateral realisation that does not need to be carried out under high pressure of time. The pressure to sell NPLs could also have a long-term adverse effect on the long-standing client relationships maintained by institutions.

The net effect is that this results in higher losses from NPLs and a further weakening of the earnings position for banks and savings banks. Lastly, specifically selling NPLs to the shadow banking sector, which is only regulated to a small extent or not at all, does not appear to be desirable from an overall viewpoint, either in terms of consumer protection (the German "locust debate" of a few years ago comes to mind, as it dealt precisely with this issue), or in terms of the stability of the financial system.

According to the current proposal, the requirements shall only apply to loans that were granted from mid-March 2018 onwards and are subsequently classified as non-performing loans. Yet there is the direct danger that the time-based NPL minimum cover will also have an influence on the assessment of capital requirements for credit risks relating to loans that are not non-performing. This affects institutions which are permitted by the competent authority to use their own estimates for loss given default (LGD) in the advanced internal ratings-based approach (IRBA). The reason for this is that regulatory specification of minimum cover could affect supervisory expectations when assessing the adequacy of the IRBA that is used. This would have the effect that the economically observable loss rates could no longer be used when estimating the LGD; instead, these estimates would be restricted by the specifications of the NPL minimum cover. As a consequence, the capital requirements for all loans would increase.

Against this background, the regulations in the form currently under discussion are unsuitable and without any objective justification. Instead, it would be better to tackle the avoidable causes of high NPL holdings. In this connection it is particularly important to ensure that, in all EU member states, the accounting regulations relating to loan loss provisions are implemented appropriately. An improvement in compulsory execution practices in some national judicial systems would also lead to accelerated realisation of collateral. In addition, the risk management of non-performing loans should be developed. Starting points already exist that are going in the right direction, for example the NPL guidelines issued by the European Central Bank, or the NPL guidelines that are currently being developed by the European Banking Authority (EBA). Further development should be promoted on this basis. Ultimately, any treatment of non-performing loans that is appropriate for each particular case can only be properly assessed within the framework of the Supervisory Review and Evaluation Process (SREP) and, in the event of deficiencies, penalised appropriately. These issues should definitely be taken into consideration during the negotiations in order to ensure that no regulations are created that will damage the business model of the German banking industry and result in inappropriate requirements being imposed on institutions.