BANKING REGULATIONDURING THE COVID-19 CRISIS

Mariken van Loopik and Maurits ter Haar | May 2020

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INTRODUCTION

The banking sector is expected to play a key role in managing and mitigating the economic shock caused by the Covid-19 crisis. Banks can, in particular, support economic activity in a countercyclical manner by continuing the flow of credit to the real economy, where many businesses (notably small and medium-sized companies) are faced with severe shortages of liquidity. Over the past weeks and months, lawmakers and supervisors in the Netherlands, Europe and the rest of the world have taken unprecedented measures to facilitate banks in playing this role and to mitigate the pro-cyclical effects that would result from a strict application of existing regulatory and accounting frameworks.

At the same time, regulators have been keen to stress that leniency and flexibility in applying prudential requirements does not translate into equivalent relaxation of rules on conduct or integrity risk management. On the contrary, banks are expected to continue implementing prudent product approval processes, maintain high standards in the fight against money laundering and exercise vigilance with respect to fraud and cyber-crime. Banks would be wise to pay regular attention to these topics at board level and remain informed of measures taken within their organisation to address increased risk.

Furthermore, although measures adopted to increase liquidity and stimulate lending may help banks to manage the immediate demands of the real economy, they must also be mindful of the medium and long-term implications of current supervisory measures. Banks will, for example, be required to restore their capital buffers. As a result, they may need to retain earnings and forgo dividends and variable remuneration for some time to come. Uncertainty surrounding future supervisory expectations relating to the rebuilding of buffers may adversely affect banks’ current willingness to make full use of available capital reserves. In this publication, we highlight the most important measures for the banking sector in the context of the Covid-19 crisis, taken or proposed by lawmakers and supervisors, including the Dutch Central Bank (DNB) and the Dutch Authority for the Financial Markets (AFM) at the national level, and the European Banking Authority (EBA), the European Central Bank (ECB), and the European Commission at the European level. We discuss capital and liquidity relief granted to banks; flexibility and adjustments in the area of credit risk and market risk; supervisory expectations for dividends and remuneration; management of conduct of business and integrity risks; and recovery planning. Finally, we look briefly at what might be next in terms of banking regulation as the Covid-19 crisis and its economic repercussions continue to unfold.

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1. CAPITAL RELIEF

2. LIQUIDITY RELIEF

3. CREDIT RISK FLEXIBILITY

4. MARKET RISK ADJUSTMENTS

5. DIVIDENDS AND REMUNERATION

6. CONDUCT AND INTEGRITY

7. RECOVERY PLANNING

8. OUTLOOK

DEFINITIONS AND ACRONYMS

CONTENTS

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1. CAPITAL RELIEF

As a result of increased capital requirements implemented in response to the financial crisis, banks have built up significant additional buffers. This has strengthened their resilience and will enable them to better withstand the impact of the Covid-19 crisis. By granting capital relief to banks, lawmakers and supervisors are encouraging banks to free up capital so that it can be used, in a countercyclical manner, to finance the additional liquidity needed by corporates and households.

CHANGES TO CAPITAL REQUIREMENTS

When seeking to mitigate pro-cyclicality in the financial cycle, the instrument supervisors would normally first resort to would be the countercyclical capital buffer (CCyB), a macro-prudential instrument explicitly designed for that purpose. The CCyB was introduced to be lowered in circumstances where the supply of credit needs to be maintained and the downswing of the financial cycle dampened, and conversely to be raised where necessary to protect banks against systemic risks arising from excessive credit growth. The level of the CCyB is set by the regulator of each member state and is reviewed quarterly. However, in most member states, including the Netherlands, the countercyclical capital buffer had so far never been set above 0%. Therefore, as the CCyB could not now be lowered, supervisors have taken other measures to achieve the countercyclical effect sought, as set out below.

USE OF THE CAPITAL CONSERVATION BUFFER

All banks are required to maintain a capital conservation buffer of 2.5% of risk-weighted assets. Its objective is to act as an additional buffer which, in case of a breach, can interact with the automatic safeguards that limit a bank in paying dividends and variable remuneration until such breach has been resolved. In March the ECB has announced that banks are allowed to operate temporarily below the level of capital defined by the capital conservation buffer (see again Visual 1: Capital requirements).

LOWERING OF SYSTEMIC RISK BUFFERS

The systemic risk buffer aims to address long-term, non-cyclical systemic risks that are not covered by the regular capital requirements in the Capital Requirements Regulation (CRR). The buffer level may vary across banks or sets of banks as determined by the national supervisor and, together with the other systemic importance buffers (the G-SIB and O-SIB buffers) is calibrated to increase with the systemic importance of a bank. Since 2015, DNB has required ING, Rabobank and ABN AMRO to hold a systemic risk buffer of 3% of risk-weighted assets in view of their systemic importance in the Netherlands.

In March 2020, DNB lowered the systemic risk buffers that these banks need to hold to 2.5% for ING, 2% for Rabobank and 1.5% for ABN AMRO (see Visual 1 : Capital requirements). These measures will remain in force as long as necessary. Once the situation is back to normal, DNB will compensate this reduction by gradually increasing the CCyB from its current level of 0% to 2%. This will bring back the capital requirements to its previous level, as DNB believes is prudent in the longer term. As the Dutch CCyB is only calculated over exposures located in the Netherlands, this compensatory arrangement is expected to work out more or less capital-neutral for the three large banks involved.

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capital conservation

buffer

Pillar 2 requirement

Pillar 1

Systemic risk buffer*

Pillar 2 guidance

capital conservation

buffer

Pillar 2 requirement

Pillar 1

Previous capital requirements Temporary capital requirements

8%

3%

2.5%

Discretionary, percentage set by supervisor

Discretionary, percentage set by supervisor

* Only applies to the three largest Dutch banks

8%

1.5%-2.5%

Banks allowed to operate below this level of capital

Discretionary, percentage set by supervisor

Banks allowed to operate below this level of capital

capital conservation

buffer

Pillar 2 requirement

Pillar 1

Systemic risk buffer*

Pillar 2 guidance

Countercyclical capital buffer

8%

1.5%-2.5%

2.5%

2%

Discretionary, percentage set by supervisor

Discretionary, percentage set by supervisor

Pillar 2 guidance

Systemic risk buffer*

Long term capital requirements

VISUAL 1: CAPITAL REQUIREMENTS

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FLEXIBILITY IN THE PILLAR 2 BUFFER

In addition to the regular “Pillar 1” capital and buffer requirements that a bank must meet, a “Pillar 2” buffer can be imposed to cover bank-specific risks not sufficiently covered by Pillar 1 capital requirements. The Pillar 2 buffer is composed of a Pillar 2 requirement (P2R) and Pillar 2 guidance (P2G). While the Pillar 2 requirement is treated as a mandatory part of capital requirements, the Pillar 2 guidance acts as a softer “expectation”, which means that it is not legally binding in itself.

The ECB and DNB have announced that banks will be allowed to temporarily operate below the level of capital as defined by their P2G. In addition, the P2R no longer needs to be composed entirely of CET1 capital, but can be a reflection of the minimal capital composition under Pillar 1 requirements. These are: at least 56.25% CET1, 18.75% Additional Tier 1 (AT1) and 25% Tier 2 capital (see Visual 2: Composition Pillar 2 requirement). This change in capital composition under P2R was initially scheduled to come into effect in January 2021, in line with the revised approach under CRD V, but is now brought forward. It should, however, be noted that DNB can still request banks to hold a different P2R composition, depending on bank-specific circumstances.

POSTPONEMENT OF THE G-SIB LEVERAGE RATIO BUFFER

CRR II introduced a 3% binding leverage ratio requirement, which banks must meet in parallel with their risk-weighted capital requirement. In addition, for global systemically important banks (G-SIBs) CRR II introduced a leverage ratio buffer requirement, calibrated at 50% of these banks’ risk-weighted G-SIB buffer. The date of application of this new leverage ratio buffer requirement was originally set for 1 January 2022. In the context of the Covid-19 crisis and in line with the revised implementation timeline agreed by the BCBS, it is now proposed that the date of application is deferred by one year, to 1 January 2023.

TRANSITIONAL PERIOD AND TARGET MREL REQUIREMENT

As part of the bank recovery and resolution framework, resolution authorities have the power to subject shareholders and creditors to a “bail-in” to absorb a bank’s losses and recapitalise the bank. To ensure that a bank has sufficient liabilities that can be subjected to this bail-in, banks must continuously meet a minimum requirement of own funds and eligible liabilities (MREL). Pursuant to the BRRD, resolution authorities can set transition periods for banks to build up their MREL buffer.

The Single Resolution Board (SRB) has addressed an open letter to banks under the SRB’s remit. In the letter, the SRB states that it has taken good note of the measures adopted by supervisors to provide capital relief to banks in support of the economy, and that it will carefully monitor the market conditions over the following months and analyse the potential impact on transition periods needed for the build-up of MREL. The SRB also announced that it is ready to use its discretion and the flexibility given by the regulatory framework to adapt transition periods and interim targets applied to banking groups, as well as to adjust MREL targets in line with capital requirements, with particular reference to capital buffers.

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18.75% AT1 capital

Previous Pillar 2 requirement New Pillar 2 requirement

100% CET1 capital

25% Tier 2 capital

56.25% CET1 capital

VISUAL 2: COMPOSITION PILLAR 2 REQUIREMENT

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EXEMPTION OF CERTAIN SOFTWARE ASSETS FROM CAPITAL DEDUCTIONS

As a general rule, intangible assets, including software, have to be deducted from banks’ regulatory capital. CRR II introduced an exception to this rule for prudently valued software assets if the value of these assets is not materially affected in a gone concern situation. Banks will no longer be required to deduct these particular software assets from their CET1 capital. The EBA was mandated to develop a draft regulatory technical standard (RTS) by June 2020 to specify how this exemption from deductions is to be applied. The application date of the revised treatment of software assets has been set to 12 months after the entry into force of this RTS. In a proposed regulation amending CRR (the “Quick Fix Regulation”), the Commission now proposes to bring forward the date of application of the exemption and allow banks to use it as soon as the RTS enters into force.

CHANGES TO THE CALCULATION OF RISK-WEIGHTED ASSETS

Updating risk-weights to reflect current market risks would lead to a de-facto increase of capital requirements which would make it (much) harder for banks to provide credit. Supervisors have therefore postponed new, more stringent, risk-weightings and have advanced the introduction of pending, more lenient, risk-weightings. These changes are in addition to flexibility and adjustments introduced by supervisors in relation to existing risk-weighting standards (see Chapter 3 – Credit risk flexibility and Chapter 4 – Market risk adjustments).

POSTPONEMENT OF DNB FLOOR FOR MORTGAGE LOAN RISK-WEIGHTING

DNB has decided to temporarily postpone the introduction of a floor for mortgage loan risk weighting, which was initially foreseen for Q3 2020. This forthcoming requirement would have obliged banks using internal models to apply a minimum floor to their risk weighting of domestic mortgage loan portfolios, ahead of a similar requirement that forms part of still outstanding capital standards, commonly referred to as the “Basel III reforms” or as “Basel IV” (see below). Introduction will be postponed for as long as necessary.

POSTPONEMENT OF NEW BASEL III RISK-WEIGHTING REQUIREMENTS

The Basel Committee on Banking Supervision (BCBS) announced on 27 March 2020 that it will delay the implementation of the still outstanding Basel III reforms, to allow banks to focus their resources on navigating the Covid-19 crisis. These reforms would overhaul existing risk-weighting requirements by revising the standardised and IRB approaches to credit risk, the operational risk framework, the credit valuation adjustment risk framework, the market risk framework, and by introducing an output floor: a floor in capital requirements calculated under internal models at 72.5% of those required under standardised approaches. The standards, originally set to be implemented on 1 January 2022, will now have a 1 January 2023 implementation date. The BCBS also extended the accompanying transitional arrangement for the output floor to 1 January 2028. These outstanding changes have yet to be implemented into EU law. A Commission proposal for their implementation, which was expected in the course of this year, will now likely be pushed back.

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SPECIFIC TREATMENT OF CERTAIN LOANS BACKED BY PENSIONS OR SALARIES

CRR II introduced a more favourable credit risk treatment of loans to pensioners or permanent employees that are backed by the borrower’s pension or salary. This revision was due to become applicable on 28 June 2021. The application of this treatment in the context of the Covid-19 crisis would incentivise banks to extend lending to employees and pensioners. To allow banks to start benefiting from the more favourable treatment during the Covid-19 crisis, the Commission has proposed bring the effective date forward. The favourable prudential treatment will apply as soon as the Quick Fix Regulation enters into force.

REVISED SME SUPPORTING FACTOR AND THE NEW INFRASTRUCTURE SUPPORTING FACTOR

The SME supporting factor refers to a capital reduction factor in the amount of capital that banks need to hold for credit risk in respect of loans they grant to SMEs. The SME supporting factor was introduced by the CRR to allow banks to ensure an adequate flow of credit to this particular group of companies. CRR II increased the supporting factor for exposures to SMEs. It also introduced a new supporting factor for exposures to entities which operate or finance physical structures or facilities, systems and networks that provide or support essential public services. This revision was due to become applicable on 28 June 2021. In light of the Covid-19 crisis, it is essential that banks continue lending to SMEs and supporting infrastructure investments. The Commission has therefore proposed to advance the date of application of the two supporting factors. The new supporting factors will apply as soon as the Quick Fix Regulation enters into force.

On 20 May 2020, the ECB issued an opinion in which it welcomed the targeted adjustments proposed by the Quick Fix Regulation.

RELEVANT SOURCES

• ECB press release on temporary capital and operational relief in reaction to coronavirus, 12 March 2020

• DNB press release on the lowering bank buffer requirements to support lending, 17 March 2020 • DNB press release, CORONA – DNB measures in reaction to coronavirus, 20 March 2020• Communication from the SRB on the potential COVID-19 outbreak relief measures, 25 March

2020 • BCBS press release announcing deferral of Basel III implementation to increase operational

capacity of banks and supervisors to respond to Covid-19, 27 March 2020• BCBS press release on additional measures to alleviate the impact of Covid-19, 3 April 2020 • Proposal for a Regulation amending Regulations (EU) No 575/2013 and (EU) 2019/876 as

regards adjustments in response to the COVID-19 pandemic(the Quick fix regulation), 28 April 2020

• Opinion of the ECB on amendments to the Union prudential framework in response to the COVID-19 pandemic (CON/2020/16), 200 May 2020

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2. LIQUIDITY RELIEF

In addition to capital relief, banking supervisors have also moved to support the ability of banks to lend to the real economy by confirming that, where necessary for that purpose, banks can use their liquidity buffers. In addition, the ECB, in its capacity as central bank, has adopted a number of measures to further facilitate banks’ access to liquidity during the crisis.

PERMITTED USE OF LIQUIDITY BUFFERS

The Liquidity Coverage Ratio (LCR) is a liquidity requirement designed to promote banks’ short-term resilience. It ensures that banks hold an adequate stock of liquid assets which can be immediately converted into cash to meet their liquidity needs. Assets eligible for inclusion in the buffer are unencumbered, high-quality liquid assets (HQLA), including for example central bank reserves and government bonds. The LCR is calculated by dividing a bank’s stock of HQLA by its projected net cash outflows over a hypothetical 30-day stress scenario. The minimum level of the LCR is set at 100%.

Both the ECB and the EBA issued guidance in March 2020 confirming that banks are temporarily permitted to operate below the level of liquidity that would otherwise be required under prudential rules, that is, the buffers that have been built up in accordance with the LCR. This means that banks will be permitted, until further notice from their supervisors, to use their liquidity buffers in full to ensure that lending to the wider economy can continue to be supported during these times of market stress. Indeed, the ECB has stressed the importance of putting these reserves to work in order to ensure liquidity in the system and avoid contagion that might trigger liquidity problems in other banks.

However, a number of obligations will arise if a bank’s LCR drops below 100%. In particular, when a bank does not meet (or expects not to meet) the LCR requirement, including during times of stress, it must immediately notify its supervisor and submit a restoration plan without undue delay. Such plan must set out how the bank intends to restore the LCR and will be monitored by the relevant supervisor. The ECB has issued FAQs to reassure banks that no negative judgment will be attached to banks that make use of their liquidity buffers in the current financial climate and that they will be granted sufficient time to re-establish buffers.

ECB MONETARY POLICY LIQUIDITY MEASURES

PANDEMIC EMERGENCY PURCHASE PROGRAMME (PEPP)

The ECB announced further quantitative easing measures in March 2020 in the form of a temporary purchase programme of EUR 750 billion to buy government and company bonds. Under the Pandemic Emergency Purchase Programme (PEPP), the ECB may purchase both private and public sector securities until at least the end of 2020. All asset categories for purchase under the existing asset purchase programmes are eligible under the PEPP and a waiver of the eligibility requirements for securities issued by the Greek government has also been included. The ECB has further confirmed since the launch of the PEPP that it is prepared to increase the size of the PEPP and to adjust its composition, by as much as necessary and for as long as needed.

TEMPORARY COLLATERAL EASING MEASURES

The ECB is authorised to manage a number of liquidity providing operations which are available for Eurosystem banks to participate in, such as the targeted longer-term refinancing operations (TLTRO III). However, participation is dependent on banks having access to collateral of sufficient quality. Given that market conditions can impact the value of collateral and therefore its eligibility under such operations, the ECB adopted a package of temporary collateral easing measures. The measures include an enlargement of the scope of eligible credit claims and acceptance of (non-investment grade) Greek sovereign debt instruments.

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Furthermore, the ECB announced grandfathering measures for “fallen angels”. Corporate bonds that fulfilled minimum credit quality requirements on 7 April 2020 will remain eligible forms of collateral in the event of a deterioration in credit ratings, provided those ratings remain above a certain credit quality level. This measure is intended to mitigate the impact of possible rating downgrades on the availability of eligible collateral. In addition, including “fallen angels” in the collateral framework eases tensions on corporate bond and commercial paper markets, which in turn reduces reliance on credit lines from banks.

OTHER MONETARY POLICY DECISIONS

Amendments to a number of other liquidity providing operations have also been announced. In particular, (i) the conditions applicable to TLTRO III have been amended, and (ii) a new series of non-targeted pandemic emergency longer-term refinancing operations (PELTROs) will be conducted. The interest rate on TLTRO III operations has been reduced during the period from 24 June 2020 to 23 June 2021 to 50 basis points below the average interest rate on the Eurosystem’s main refinancing operations prevailing over the same period.

The PELTROs announced by the ECB consist of seven additional refinancing operations which are scheduled to commence in May 2020 and to mature in a staggered sequence between July and September 2021. The introduction of these PELTROs is intended to provide liquidity and support the smooth functioning of money markets by providing an effective backstop once the bridge longer-term refinancing operations (LTROs) expired.

RELEVANT SOURCES

• ECB press release on temporary capital and operational relief in reaction to coronavirus, 12 March 2020

• EBA statement on actions to mitigate the impact of COVID-19 on the EU banking sector, 12 March 2020

• FAQs on ECB supervisory measures in reaction to the coronavirus, (last updated as of 3 April 2020 at the time of publication)

• ECB press release announcing EUR 750 billion Pandemic Emergency Purchase Programme, 18 March 2020

• Decision (EU) 2020/440 of the ECB on a temporary pandemic emergency purchase programme (ECB/2020/17), 24 March 2020

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3. CREDIT RISK FLEXIBILITY

The significant worsening of the financial soundness of many companies in the real economy as a result of the Covid-19 crisis is expected to cause a major increase in the credit risk of banks’ loan books. In addition, banks have to take into account the effect of the public and private payment moratoria and government guarantee schemes that have been implemented to support these companies. Various supervisors have provided guidance on how banks should account for these developments in assessing their credit risk. In this section, we discuss the guidance on the definition of default, the prudential backstop for non-performing loans (NPLs), the application of the IFRS 9 accounting standards, and the treatment of securitised exposures.

IMPLICATIONS FOR THE DEFINITION OF DEFAULT

Article 178 CRR specifies the definition of default that banks must use for the calculation of credit risk both under the standardised and the internal ratings-based approaches. A default must be considered to have occurred in relation to a particular obligor when a bank considers that the obligor is unlikely to pay its credit obligation. One indication of such unlikeliness to pay is the bank’s consent for a distressed restructuring of the credit obligation resulting in a diminished financial obligation. A default must also be considered to have occurred where an obligor is more than 90 days past due on any material credit obligation.

TREATMENT OF PAYMENT MORATORIA

The EBA clarified in its April 2020 guidelines on Covid-19 payment moratoria that public and private moratorium schemes introduced in response to the Covid-19 crisis must not automatically lead to a reclassification of an exposure as defaulted for the purposes of Article 178 CRR. Where a moratorium qualifies as a “general payment moratorium” it should not be considered a distressed restructuring and the 90 days past due criterion should be assessed, not on the basis of the original but on the basis of the modified schedule of payments. The BCBS set out a similar approach in its guidance of 3 April 2020.

Under the EBA’s guidelines, qualification of a moratorium as a general payment moratorium requires that all the conditions listed in the below box are met. Where an individual payment moratorium measure does not qualify as a general payment moratorium, the treatment for general payment moratoria could still be applicable, but this would be based on individual assessment.

GENERAL PAYMENT MORATORIA

Conditions for the qualification of a general payment moratorium pursuant to the EBA guidelines:(a) the moratorium is based on national law or is part of an industry- or sector-wide moratorium

scheme;(b) the moratorium applies to a large group of obligors predefined on the basis of broad criteria and

cannot be limited to obligors who experienced financial difficulties before the Covid-19 crisis;(c) the moratorium envisages only changes to the schedule of payments and not to any other terms

and conditions;(d) it offers the same conditions to all exposures subject to it; (e) it does not apply to new loan contracts granted after the date when it was announced; and (f) it was launched in response to the Covid-19 crisis and applied before 30 June 2020.

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The above does not remove the obligation for banks to apply their normal policies to assess the credit quality of these exposures and to identify any situation of unlikeliness to pay other than directly stemming from the application of a general payment moratorium.

TREATMENT OF GUARANTEES

Although Article 178 CRR specifies that default must be considered to have occurred where the obligor is unlikely to pay its credit obligation without recourse to actions such as realising security, the ECB has clarified that recourse to a guarantee in itself should not trigger the classification as defaulted. However, such recourse does not preclude such classification either. The bank will have to form an opinion as to whether the obligor is in a position to meet his obligation irrespective of the existence of the guarantee. After all, while the guarantee may limit the losses for the bank in the event of default, it does not affect the obligor’s payment capabilities and hence should not be taken into account in the assessment of unlikeliness to pay.

IMPLICATIONS FOR THE NPL PRUDENTIAL BACKSTOP

The NPL prudential backstop was introduced in 2019 for all EU banks as part of the EU’s comprehensive strategy to address the stock of NPLs that had built up on banks’ balance sheets after the global financial crisis. The NPL prudential backstop consists of a minimum loss coverage, achieved through a deduction from own funds, where NPLs are not sufficiently covered by provisions or other adjustments.

TREATMENT OF PAYMENT MORATORIA

On the basis of Article 47b CRR, a bank must, in determining whether an exposure must be classified as non-performing, take into account a number of factors including whether forbearance measures have been granted. The EBA has clarified in its April 2020 guidelines on Covid-19 payment moratoria that public and private moratoria schemes introduced in response to the Covid-19 crisis do not automatically lead to a reclassification of an exposure as forborne for the purposes of Article 47b CRR. Where a moratorium qualifies as a “general payment moratorium” (see Figure 1 above) an exposure should not be considered as subject to forbearance measures. This approach is also supported by the BCBS.

TREATMENT OF GUARANTEES

The ECB has indicated that NPLs under public guarantees will benefit from preferential prudential treatment in terms of supervisory expectations about loss provisioning. In addition, the Commission has proposed Article 500a CRR: for a period of seven years, an exposure’s classification as non-performing will not result in a deduction of own funds through the NPL prudential backstop to the extent that a guarantee has been provided by central or regional governments, central banks, multilateral development banks and certain international organisations and public sector entities as part of support measures to assist borrowers during the Covid-19 crisis. This extends the scope of Article 47c CRR, which currently contains such a provision for the first seven years of non-performing exposures guaranteed or insured by an official export credit agency.

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APPLICATION OF IFRS 9

IFRS 9 has been applicable to most banks since 1 January 2018 and aims to improve the financial reporting of financing instruments by addressing concerns that arose in this area during the global financial crisis. It does so in particular by moving to a more forward-looking model for the recognition of expected losses on financial assets, in order to mitigate the pro-cyclical effects resulting from recognizing impairments during a crisis. More specifically, IFRS 9 requires banks to recognise an impairment not only when it materialises but already when it is expected. Banks must take an impairment allowance measured as the present value of expected credit losses (ECLs) from default events projected over the next 12 months. Moreover, in case of a significant increase in credit risk (SICR), the impairment allowance must be measured as the present value of all credit losses projected over the asset’s full lifetime. There is a rebuttable presumption of SICR if contractual payments are more than 30 days past due

DETERMINATION BASED ON FORWARD-LOOKING SCENARIOS

The Commission indicated in its interpretative communication that it expects banks to make full use of the judgment and flexibility allowed within IFRS 9 to mitigate any unwarranted impact of the Covid-19 crisis on banks’ ECL provisions, without undermining investor confidence. This confirms earlier statements by the International Accounting Standards Board (IASB) and the BCBS that companies are not expected to mechanically apply their existing ECL approaches to determine the amount of provisions in an exceptional situation such as the Covid-19 crisis. Because of the unexpected nature of the Covid-19 crisis, banks had not made forward-looking provisions that accounted for the associated risks. To mechanistically apply ECL approaches now, with a view to the risks associated with Covid-19, could therefore result in a sudden and significant increase in expected credit loss provisions – which may create the pro-cyclical effect ECL was meant to avoid.

In particular, the Commission and the IASB have clarified that banks’ assessment of a SICR should be based on the remaining lifetime of the financial assets concerned. Sudden increases in the probability of default caused by the Covid-19 crisis should be treated as temporary and therefore should not lead to a significant increase in the lifetime probability of default. Therefore, they should not reasonably lead to a SICR compared to expected probability of default over the next 12 months.

In a letter to significant banks, the ECB recommends that, in assessing if a SICR has occurred, banks should give sufficient weight to scenarios based on long-term stable macro-economic outlooks, instead of simply extrapolating current uncertainty over the years to come. Given the unique character of the Covid-19 crisis, it is difficult for banks to obtain sufficiently reasonable and supportable information to prepare reliable forward-looking scenarios for determining a SICR. The ECB has therefore set out how banks should use ECB macro-economic projections for their IFRS 9 SICR assessment and ECL provisioning.

TREATMENT OF PAYMENT MORATORIA

Under IFRS 9, where there is “modification” of a loan, banks must recognise a modification gain or loss in their profit or loss. A “substantial modification” must result in a loan’s de-recognition and the subsequent recognition of the modified financial asset. In its interpretative communication, the Commission stated that it is unlikely that temporary relief measures related to the Covid-19 crisis, such as payment moratoria, constitute “substantial modifications” under IFRS 9. It is the view of both the Commission and ESMA that if the support measures are temporary and related to the Covid-19 outbreak, and if the net economic value of the loan is not significantly affected, it is unlikely that the modifications will be “substantial”. Ultimately, banks should use quantitative and qualitative judgment and take into account the specific characteristics of the moratoria to determine whether they would result in a “modification” under IFRS 9 or whether a modification is “substantial”. It appears safe to assume that a payment moratorium should not be treated as a modification if it qualifies as a “general payment moratorium” (see Figure 1 above).

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Similarly, the Commission and the BCBS have stated that loans should not automatically be considered to have suffered a SICR, simply due to becoming subject to payment moratoria. Moratoria reset the date compared to which the “days past due” of borrowers should be calculated and therefore impact the 30-days rebuttable assumption to consider a SICR. Furthermore, loans which performed well prior to the Covid-19 crisis and which are subject to a temporary payment moratorium would not automatically result in significantly higher, expected ECL provisions under IFRS 9. This is in line with similar statements by the EBA and ESMA.

TREATMENT OF GUARANTEES

As reiterated by the Commission in its interpretative communication, loan guarantees neither increase nor reduce the default risk of the obligor, but they reduce the amount of credit losses if a default of the borrower actually occurs. Accordingly, where a government or other entity provides guarantees for bank loans to obligors, banks need to take into account these guarantees when calculating the amount of ECL, which will consequently be lower. This is in line with statements by ESMA and the BCBS that public guarantees do not affect the SICR assessment, which focusses on the lifetime risk of default compared to this risk at initial recognition, regardless of whether a loss is expected to be recognised, but that they might impact the ECL measurement itself.

TRANSITIONAL ARRANGEMENT

Article 473a CRR, introduced in late 2017, contains a transitional arrangement for the implementation of IFRS 9. This progressive 5-year phase-in regime was introduced in 2018 to mitigate the impact of IFRS 9’s new impairment model and to prevent a sudden significant increase in expected credit loss provisions, and consequently a sudden decrease in banks’ CET1 capital.

As full application of IFRS 9 during the Covid-19 crisis may again lead to a sudden significant increase in expected credit loss provisions, the BCBS has accepted that increased provisions taken from 1 January 2020 may be subject to a new transitional arrangement. This new transitional arrangement basically resets the existing 5-year transitional arrangement for provisions taken as of the beginning of 2020, and with adjusted calibration. In addition, banks that opted not to use the IFRS 9 transitional arrangements in 2018 could reverse that decision subject to prior approval from their competent authority. This new transitional arrangement has been included by the Commission in a proposed amendment of Article 473a CRR. The ECB recommends that all banks that have not done this so far opt for application of these transitional rules.

TREATMENT OF SECURITISED EXPOSURES

In a statement of 22 April 2020, the EBA detailed how its guidelines on payment moratoria should be applied to securitised exposures. For those purposes, an exposure of a bank should be understood as any underlying exposures which remain on the originator bank’s balance sheet in accordance with the applicable accounting standards or which the originator bank has not excluded from its calculation of risk-weighted exposure amounts and, where relevant, expected loss amounts, in accordance with the rules on the recognition of significant risk transfer under Article 244 CRR. In the case of synthetic securitisations, relevant exposures are any underlying exposures in respect of which the transfer of risk to third parties is achieved through credit derivatives or guarantees, where the exposures being securitised remain on the originator bank’s balance sheet, regardless of the treatment for risk-weighted exposure amount calculation purposes in accordance with Article 245 CRR.

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TREATMENT OF PAYMENT MORATORIA

Pools of securitised assets may comprise assets falling under the scope of a “general payment moratorium” (see Figure 1 above). In such case, the servicer may or could be obliged to defer the collection of payments for those assets until the end of the moratorium period without triggering an event of default under the assets.

When calculating the regulatory capital requirements on their securitisation positions, banks should classify the underlying securitised exposures in accordance with the EBA guidelines on Covid-19 payment moratoria, where those exposures are subject to a general payment moratorium. Accordingly, the entry into force of a general payment moratorium should not automatically lead to reclassifying securitised exposures as in default or in forbearance, where those securitised exposures were not classified as exposures in default or in forbearance prior to the date of entry into force of the general payment moratorium. Banks should continue to assess the potential unlikeliness to pay of obligors subject to the moratorium (including, in particular, as regards the impact on the pool’s expected and unexpected losses).

In addition, the EBA has noted that where an originator bank suspends, postpones or reduces payments due under a securitised asset or grants the obligor a new loan as per a general payment moratorium, this should not be automatically regarded as prohibited implicit support within the meaning of Article 250 CRR. This is also the case for a number of other actions listed by the EBA, including the replacement of securitised assets in the pool that are subject to such moratorium, by assets of a similar risk profile that are not subject to it, if the contractual documentation governing the replacement of assets allows this.

RELEVANT SOURCES

• ECB press release entitled ECB Banking Supervision provides further flexibility to banks in reaction to coronavirus, 20 March 2020

• ESMA statement on accounting implications of the COVID-19 outbreak on the calculation of expected credit losses in accordance with IFRS 9, 25 March 2020

• EBA statement on the application of the prudential framework regarding default, forbearance and IFRS9 in light of COVID-19 measures, 25 March 2020

• IASB statement entitled IFRS 9 and Covid-19, 27 March 2020• ECB letter to significant institutions regarding IFRS 9 in the context of the coronavirus (COVID-19)

pandemic, 1 April 2020 • EBA guidelines on legislative and non-legislative moratoria on loan repayments applied in the light

of the COVID-19 crisis, 2 April 2020• BCBS guidance on measures to reflect the impact of Covid-19, 3 April 2020• BCBS press release on additional measures to alleviate the impact of Covid-19, 3 April 2020• EBA statement on additional supervisory measures in the COVID-19 pandemic, 22 April 2020• Proposal for a Regulation amending Regulations (EU) No 575/2013 and (EU) 2019/876 as regards

adjustments in response to the COVID-19 pandemic (the Quick fix regulation), 28 April 2020• Commission interpretative communication on the application of the accounting and prudential

framework to facilitate EU bank lending, 28 April 2020• FAQs on ECB supervisory measures in reaction to the coronavirus, continually updated (last update

3 April 2020)

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4. MARKET RISK ADJUSTMENTS

Volatile markets leave banks, particularly those with large trading books, exposed to the consequences of adverse movements in market prices. In particular, increased price volatility affects mark-to-market valuations, the results of calculations required under capital rules, the level of margin calls and the cost of closing-out positions. Regulatory responses have sought to mitigate these pressures on banks and especially their consequences for banks’ capital positions. In this section, we discuss the flexible approach in relation to the Internal Models Approach (IMA) under CRR, the amendment to the prudent valuation calculations, the postponement of FRTB market risk reporting under CRR II; the postponement of the start dates for margin requirements for non-centrally cleared derivatives; the postponement of the SFTR reporting obligation; and, finally, the measures adopted to allow short-selling to be more closely monitored or even prohibited.

AMENDMENTS TO MARKET RISK CALCULATIONS

A FLEXIBLE APPROACH TO THE IMA

The CRR requires banks to hold own funds in order to cover market risk. Banks can calculate this own funds amount by using the standardised approach or, with the permission of the competent authorities, using internal risk models. Under an IMA, a bank’s capital requirements are calculated by applying multiplication factors to the VaR and stressed Value-at-Risk (VaR) calculations. One such multiplier is the quantitative multiplier, which is calculated on the basis of capital requirement rules set out in the CRR. Another is the qualitative multiplier, which may be imposed by prudential supervisors and is intended to compensate for a possible underestimation by banks of their capital requirements for market risk.

Recent market volatility has seen VaR figures increase while the quantitative market risk multipliers, reflecting the number of back-testing overshootings, have also increased.

In response to this, the ECB, on 16 April 2020, announced a temporary reduction in capital requirements for market risk, implemented through a reduction in the qualitative multiplier. This reduction is intended to smooth the pro-cyclicality that would otherwise be caused by the combined effect of the quantitative and qualitative multiplication factors. The measure is further aimed at ensuring that banks can continue to provide market liquidity and market-making activities - both crucial functions in times of market upheaval.

Similarly, in a statement issued on 22 April 2020, the EBA recognised the impact of market volatility on the VaR risk metrics. It echoed the ECB by pointing to the flexibility inherent in CRR and acknowledged that competent authorities are permitted to reduce certain multipliers used in the calculation of own funds under an IMA – specifically, in cases where additional add-ons are not justified by deficiencies caused by a banks’ internal model.

The EBA also indicated that while CRR requires banks to perform an annual review of the period selected as the stressed VaR “observation period”, this review could be postponed to the end of 2020 and should not constitute a supervisory priority at the present time.

Finally, the ECB has noted that BCBS standard on market risk internal models contains greater flexibility for competent authorities with regard to the treatment of back-testing overshootings and has suggested that the CRR be revised to allow competent authorities similar flexibility in extraordinary circumstances.

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AMENDMENTS TO PRUDENT VALUATION CALCULATIONS

The EBA has also proposed amendments to the applicable aggregation factor used in the calculation of additional valuation adjustments (AVAs). AVAs are used to determine the prudent valuation of fair-valued financial instruments under the CRR. In recognition of the extreme impact of current volatility on the calculation of AVAs, the EBA has proposed increasing the applicable aggregation factor from 50% to 66%. The proposal would amend the regulatory technical standards on prudent valuation.

The amendment would be relevant only for those banks calculating AVAs based on the “core approach” (rather than the simplified approach) and would apply until 31 December 2020. The proposal will need to be adopted by the Commission before this change can be implemented. The EBA has suggested that the amendment could be implemented by 30 June 2020 if the Commission acts swiftly.

POSTPONEMENT OF THE FRTB REPORTING REQUIREMENT UNDER THE CRR II

The implementation of a number of measures that were set to be implemented as part of the Fundamental Review of the Trading Book (FRTB) will be postponed. The package of rules was developed by the BCBS as part of the Basel III reforms (sometimes referred to as ‘Basel 3.5’ or ‘Basel IV’). Since the FRTB was only finalised in January 2019, CRR II only contains a reporting requirement based on FRTB calculations. The reporting requirement will also only be applicable to banks with business that is subject to market risk of at least 10% of assets and valuing EUR 500 million.

The FRTB reporting requirements were scheduled to apply as of the first quarter of 2021. In recognition of the increased operational challenges in the area of reporting in general, the EBA has acknowledged that introducing an entirely new market risk reporting framework would be challenging at the present time. It has therefore announced that it will submit implementing technical standards (ITS) to the European Commission, which would introduce FRTB-SA reporting in the third quarter of 2021. The first reference date would be 30 September 2021.

Before these proposed postponements can take effect, a number of steps must be taken. First, the ITS are subject to adoption by the Commission. Second, formal postponement of the reporting obligation will require the Commission to make a corresponding delay in the date of application of its own delegated act on market risk, which was adopted in accordance with Article 461a of the CRR.

OTHER TRADING RELATED MEASURES

POSTPONEMENT OF MARGIN REQUIREMENTS FOR NON-CENTRALLY CLEARED DERIVATIVES

The EBA has announced its intention to postpone by one year certain initial margin requirements on derivatives that are not centrally cleared with a central counterparty (CCP). These proposals followed a joint BCBS/IOSCO statement on 3 April 2020 announcing their intention to allow a deferral of the final two implementation phases of the initial margin requirements. This would allow banks to free up their operational capacity to respond to the Covid-19 crisis.

Counterparties with an average aggregate notional amount of trades above EUR 50 billion will, under currently applicable timelines, be subject to an initial margin requirement starting in September 2020. For counterparties with an average aggregate notional amount of trades above EUR 8 billion, the requirement is due to begin in September 2021.

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In recognition of current market circumstances, however, the EBA (in cooperation with ESMA and EIOPA), will prepare an amendment to the rules which set down the current timelines. These dates are now moved to September 2021 and 2022 respectively.

POSTPONEMENT OF THE SFTR REPORTING OBLIGATION

ESMA has responded to the additional pressure on bank resources caused by the impact of Covid-19 by issuing a statement urging supervisors not to prioritise their supervisory actions in respect of reporting obligations under the Securities Financing Transactions Regulation (SFTR), until 13 July 2020. Similarly, the introduction of the new tick-size regime for systematic internalisers under MiFID II has been postponed from 26 March 2020 to 26 June 2020.

SHORT SELLING MEASURES

The threshold for notifying net short positions to competent authorities under the Short Selling Regulation has been lowered from 0.2% of issued share capital to 0.1%, for a period of three months. The decision was taken by ESMA on 16 March 2020, in order to allow supervisors to more closely monitor market developments. The measure means that holders of net short positions in shares traded on an EU trading venue are required to notify the relevant competent authority if the position reaches or exceeds 0.1% of the issued share capital (and about each further increase of 0.1% or more).

A number of competent authorities took additional measures pursuant to the Short Selling Regulation, issuing temporary bans on certain net short positions. Such bans were adopted, for example, in France, Belgium and Greece. The AFM declined to introduce comparable prohibitions, with the Dutch Ministry of Finance noting that such measures had not resulted in increased market stability in the countries that had introduced such bans. In May 2020 ESMA announced that the bans that had been put in place were being terminated.

RELEVANT SOURCES

• ESMA decision lowering short selling thresholds, 16 March 2020• ESMA public statement setting out approach to SFTR implementation, 19 March 2020• ESMA public statement setting out actions to mitigate the impact of COVID-19 on the EU financial

markets regarding the new tick size regime for systematic internalisers, 20 March 2020• Responses of the Dutch Minister of Finance to parliamentary questions regarding potential

liquidity issues in the financial sector as a consequence of COVID-19, 27 March 2020 • BCBS press release announcing deferral of Basel III implementation to increase operational

capacity of banks and supervisors to respond to Covid-19, 27 March 2020 • BCBS and IOSCO joint press release on deferral of final implementation phases of the margin

requirements for non-centrally cleared derivatives, 3 April 2020• ECB press release on temporary relief for capital requirements for market risk, 16 April 2020• EBA statement on the application of the prudential framework on targeted aspects in the area of

market risk in the COVID-19 outbreak, 22 April 2020• Draft RTS amending the RTS on prudent valuation under Article 105(14) of Regulation (EU) No

575/2013 (CRR), 22 April 2020• Opinion of the ECB on amendments to the Union prudential framework in response to the

COVID-19 pandemic (CON/2020/16), 20 May 2020

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5. DIVIDENDS AND REMUNERATION

In addition to taking measures releasing banks temporarily from certain capital, liquidity and operational requirements, supervisors have been keen to emphasise that managing the current financial turmoil also requires concessions from banks. In particular, supervisors have stated that banks are expected to act prudently to make sure their capital base, and therefore their ability to lend, is preserved or reinforced. In this section, we discuss supervisors’ expectations in relation to banks’ dividends and remuneration policy during the Covid-19 crisis.

RECOMMENDATIONS ON DIVIDEND PAYMENTS

The ECB published a recommendation on 27 March 2020 calling on banks not to pay dividends for the 2019 and 2020 financial years, until at least 1 October 2020, and recommending banks also to refrain from share buy-backs which aim to remunerate shareholders. The ECB explained that, although the recommendation does not retroactively cancel the dividends already paid out by some banks for the 2019 financial year, banks that have asked their shareholders to vote on a dividend distribution proposal in their upcoming general shareholders meeting, are expected to amend such proposals in line with the recommendation. The ECB intends to evaluate the economic situation and to consider whether further suspension of dividends is advisable after 1 October 2020.

The ECB’s recommendation is addressed to significant banks (those under the direct supervision of the ECB) directly and also to national supervisors, with the expectation that the national competent authorities would apply the recommendation to those less significant supervised entities under their direct supervision. DNB responded to this request, issuing a statement on 27 March 2020 calling on those banks under its direct supervision to refrain from paying out dividends and from effecting share buy-backs aimed at remunerating shareholders. DNB reiterated that the intention of the recommendation is to ensure that capital is conserved and remains available for lending purposes.

The recommendation has also been supported by the EBA, which issued a statement urging all banks to refrain from dividend distribution or share buybacks and stressed the importance for banks to maintain ‘robust capitalisation’. The EBA further encouraged any banks concerned that they were under a legal obligation to make distributions to revert to their supervisors.

The policy is also closely related to the easing of the capital measures in another way: even if banks are not currently required to maintain their buffers, they may choose to do so in order to retain the option to pay out dividends. That, in turn, might tighten their ability to lend, and therefore be pro-cyclical. By having a blanket dividend restriction, that consideration does not apply (at least temporarily, see Chapter 8 – Outlook).

RECOMMENDATIONS ON VARIABLE COMPENSATION

The EBA has also stressed the need for a prudent approach with respect to variable remuneration, recommending competent authorities to ask banks to review their remuneration policies, practices and awards. In particular, the EBA has advised that variable compensation be set at a conservative level and that remuneration be consistent with sound and effective risk management and appropriate in the current economic climate. Deferral of bonuses over a longer period, paid out in equity instruments, was suggested as a method of better aligning remuneration with those risks stemming from the Covid-19 crisis.

The EBA’s call for restraint on bonus payments has also been echoed by Andrea Enria, Chair of the Supervisory Board of the ECB, who has called on banks to exercise “extreme moderation” with respect to the variable component of remuneration. He also, however, noted the importance of the changes that had already been made to the remuneration framework after the previous financial crisis, such as payments in equity instruments, deferrals and clawback possibilities.

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RELEVANT SOURCES

• EBA statement on actions to mitigate the impact of COVID-19 on the EU banking sector, 12 March 2020

• DNB press release - CORONA - DNB measures in reaction to coronavirus, 20 March 2020• DNB press release - CORONA – DNB calls on banks to temporarily refrain from dividend distributions

and share buy backs, 27 March 2020• ECB Recommendation on dividend distributions during the COVID-19 pandemic and repealing

Recommendation ECB/2020/1 (ECB/2020/19), 27 March 2020• EBA Statement on dividends distribution, share buybacks and variable remuneration, 31 March 2020• Financial Times interview with Andrea Enria, Chair of the Supervisory Board of the ECB, published on

the ECB website, 31 March 2020• Commission interpretative communication on the application of the accounting and prudential

framework to facilitate EU bank lending, 28 April 2020• ESRB press release entitled The General Board of the European Systemic Risk Board takes first set

of actions to address the coronavirus emergency at its extraordinary meeting on 6 May 2020, 14 May 2020

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6. CONDUCT AND INTEGRITY

While regulators are being lenient on the prudential requirements, they are not on the conduct and integrity requirements. Supervisors have stressed that banks should continue to comply fully with conduct obligations towards customers and with requirements to limit integrity risks. As also set out by several supervisors, the Covid-19 crisis and many of the measures taken, have in fact created new risks and concerns in these areas that banks should be aware of and act upon. This section highlights the main points of attention for banks in this context.

CONSUMER PROTECTION

TERMS AND CONSEQUENCES OF FORBEARANCE MEASURES

Many retail customers may be unable to fulfil contractual obligations or might be obligated to change their normal financial behaviour. Banks have taken several measures to reduce the financial impact of the Covid-19 crisis on retail customers, such as by granting payment holidays. The EBA stresses that banks must continue at all times to act in the consumer’s interest when engaging with retail customers on such matters. The debt moratoria and payment holidays granted should be compliant with all regulation and the rules on full information disclosure and on transparency and clarity of terms and conditions cannot be neglected when implementing Covid-19 measures.

Banks must also be aware of cross selling while giving forbearance measures towards customers. Furthermore, the acceptance from such temporary measures by the customer must not automatically lead to negative implications for the consumer’s credit rating as banks are being granted leniency on loan reclassification by the regulators. Banks should continue to follow prudent product approval processes while designing and implementing Covid- 19 measures.

COMMUNICATION ON MORTGAGES IN THE COVID-19 CRISIS

The AFM has published guidance on how banks should behave towards their customers with respect to mortgage payment difficulties. The AFM highlights that the information on Covid-19 solutions must be online easily retrievable. Again, information on these measures must be clearly communicated and customers must receive a written confirmation on the agreements made.

The AFM emphasises that it is important for banks to gather information on the personal financial situation of the customer before they offer payment solutions and to stay in contact with their customers during the deficit period. The additional costs that arise from these measures must be charged to the customer at a minimal level.

SUITABILITY AND APPROPRIATENESS

Since the start of the Covid-19 crisis, there has been an increase in the number of retail investors, attracted by the lower valuations of many companies. Risks for this growing group of new customers might be greater under these highly uncertain market circumstances. ESMA has emphasised that firms have greater duties towards such clients, who decide to invest during times of intensified market volatility, particularly when they are new. With regards to the MiFID II suitability and appropriateness tests, banks must pay attention to the potential impact of the Covid-19 pandemic on the client’s personal situation.

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INTEGRITY RISK

ANTI-MONEY LAUNDERING

Although the EBA acknowledges that due to the Covid-19 crisis, the immediate operational burden on banks should be alleviated by making use of the flexibility embedded in regulatory frameworks, safeguarding the integrity of financial markets should remain a priority for banks. It is therefore essential that banks maintain effective AML/CFT systems and controls during the Covid-19 crisis. Banks should keep up their high standards combating financial crime. There will be no lenience towards banks that discover later that they have been used for AML/CTF-purposes in the Covid-19 crisis. Banks should therefore continue to pay regular attention to this topic and the measures taken to address these increased risks in board meetings.

With respect to transaction monitoring, banks should pay attention to suspicious patterns in payment behaviour and cash flows. Specifically, banks must take risk-sensitive measures to determine the source of unexpected cash flows. Unexpected cash flows are, for example, similar volumes or even spikes in financial flows that originate from customers in sectors known to have been significantly affected by the Covid-19 crisis (such as the hospitality sector and companies involved in international trade). Banks should continue to report suspicious transactions to the Financial Intelligence Unit (FIU).

FRAUD AND CYBERCRIME

Evidence from the global financial crisis showed that fraud and illicit financial practices arise and continue during financial downturns. In the current crisis, evidence of increased levels of cybercrime, Covid-19- related fraud and scams targeting vulnerable people and companies has already been found. In addition, there are indications of fake fundraising campaigns and criminal networks selling rationed goods in the Netherlands at a higher price (face masks etc.). The number of phishing attacks on companies and instances of CEO fraud have also increased since March 2020. Banks should therefore remain alert to specific Covid-19 fraud techniques and update their monitoring measures accordingly.

RELEVANT SOURCES

• EBA statement on consumer and payment issues in light of COVID, 25 March 2020• EBA statement on actions to mitigate financial crime risks in the COVID pandemic, 31 March

2020• EIOPA call to action for insurers and intermediaries to mitigate the impact of Coronavirus/

COVID-19 on consumers, 1 April 2020• AFM Uitgangspunten betalingsproblemen bij hypotheken door de coronacrisis, 24 April 2020• ESMA public statement entitled COVID-19: Reminder of firms’ MiFID II conduct of business

obligations in the context of increasing retail activity, 6 May 2020

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7. RECOVERY PLANNING

OBLIGATION TO ENSURE THAT RECOVERY PLANS REMAIN UP TO DATE

In recognition of the importance of recovery plans in restoring banks’ financial and economic viability under stress scenarios, the EBA has underlined that those plans should be kept reviewed and updated. In particular, the EBA has called on banks to ensure they continue to focus on understanding which recovery options are necessary and available under the current stressed conditions and to adjust their analysis as the situation develops. Close monitoring of the current crisis will enable recovery plans to swiftly be implemented in the event that this becomes necessary.

The EBA also reminded banks of a number of on-going obligations under the BRRD including the requirement that banks monitor their recovery plan indicators and report any breach to their supervisor in a timely manner as well as the obligation to ensure that the list of credible and feasible recovery options included in recovery plans takes into account current stressed conditions. Banks should, in particular, be mindful of their obligations (i) to review and update the list of credible and feasible recovery options included in their recovery plans and (ii) to take preparatory measures to increase their ability to quickly implement those recovery options should the need arise.

Moreover, banks have been called on by the EBA to keep their supervisors informed of their monitoring efforts. In particular, supervisors should be kept informed in respect of a bank’s recovery indicators (where necessary on a weekly basis) as well as in respect of a banks’ updated assessment of the available recovery options.

OPERATIONAL RELIEF

While underlining the important function of recovery plans, the EBA has also acknowledged that banks should be granted operational relief where appropriate. It recommended that national competent authorities communicate to those banks under their supervision the specific form of such operational relief.

The EBA has made two broad suggestions in this respect. First, it has suggested that banks may be allowed to submit only key elements of their recovery plans to their supervisors and to postpone other parts until the following assessment cycle. This option could be available to those banks with a recovery plan in place and where no significant changes have occurred. Second, the EBA has noted that it may be appropriate to narrow the amount of information to be submitted by banks. In particular, it has suggested that relief could be granted in relation to elements of the recovery plan that remain relatively stable or where the relevant information is available in other sources of regulatory information and/or is less relevant in the context of the current situation. Finally, the EBA has noted that “dry-run” exercises planned in 2020 to test recovery plans, could be postponed.

RELEVANT SOURCES

• EBA statement on additional supervisory measures in the COVID-19 pandemic, 22 April 2020

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8. OUTLOOK

The measures taken by lawmakers and supervisors described in this booklet provide banks with a welcome degree of flexibility in capital and liquidity requirements, while at same time underlining that banks should remain attentive of their obligations in the areas of conduct and integrity risk and recovery planning. In the short term, these measures may contribute significantly to the ability of banks to sustain lending to the real economy. Some measures still require formal adoption, either by the Commission, as is the case for the RTS regarding the bilateral margin requirement and prudential valuation, or by the Council and European Parliament, as is the case for the Quick Fix Regulation. It might therefore take a few months before all measures are fully applicable.

In the medium and long term, however, the Covid-19 crisis is likely to leave banks substantially weakened. They will be less well-capitalised, will have a far larger stock of non-performing loans on their books and will face increased pressure on the profitability of their business models. Current regulatory and supervisory measures designed to encourage credit provision, for example a loosening of the capital regime, may also contribute to reduced resilience of the banking system over time. Once we progress into this stage, new measures will likely be required to help banks restore capital buffers. Depending on the shape of the economic recovery, and the extent to which banks will ultimately make use of the current measures to deplete their capital buffers, banks might need to retain earnings and forgo dividends and variable remuneration for some time to come.

Whether banks choose to make use of their buffers could, in part, be informed by their understanding of supervisory expectations to rebuild them. Under normal circumstances, banks operating below their buffer levels are subjected to dividend restrictions in order to encourage the rebuilding of buffers. Currently, the ECB’s recommendation that banks do not pay dividends temporarily removes that consideration. Over the longer term, however, the blanket dividend restrictions may be lifted and buffer requirements may be enforced again, in which case only banks operating below their buffer would face dividend restrictions (or calls to raise capital). Anticipating that, banks may be hesitant to draw on their buffers now. Supervisory clarity concerning the timeline and future process of rebuilding buffers, providing confidence that deadlines for rebuilding will be sufficiently flexible and consistent with a normalization of economic activity and capital market functioning, will therefore likely strengthen the ability and willingness of banks to draw on their buffers and provide credit today.

Equally and perhaps more importantly, banks will need to clean up their balance sheets. The need to get rid of stocks of non-performing loans quickly and decisively is one of the lessons the global financial crisis of 2007/2008 has taught us. This is particularly important to prevent the creation of “zombie banks”: those with high levels of non-performing assets that are barely solvent and profitable but are kept alive thanks to low funding costs. One way of offloading such non-performing loans is through state supported schemes, which can help create a secondary market for these loans. National schemes to offload non-performing loans, such as the Italian guarantee on securitisation of bank non-performing bank loans (GACS) in Italy, have in recent years proven to be successful tools in repairing banks’ balance sheets.

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A number of ideas have been proposed in order to support the recovery of the EU banking sector. Andrea Enria, chair of the ECB’s Supervisory Board, suggested the creation of an EU-wide asset management company or “bad bank” in 2017, when he was head of the EBA, as a way to offload non-performing loans from the previous crisis. He recently floated the idea again, although it has been strongly resisted by the Commission. The creation of a bad bank is complicated, in particular in the interaction with relevant state aid and BRRD rules. However, as advocated by Mr Enria, an EU approach has clear benefits too: clarity and simplicity for both banks and investors in understanding the interaction with other rules and requirements, enhanced credibility of the initiative and of due process in its implementation; lower funding costs and higher operational efficiency and a critical mass on both the supply and the demand side. José Manuel Campa, chair of the EBA, has also recently suggested a united approach to shield European banks in the form of a precautionary recapitalisation of solvent banks by creating a troubled assets relief programme (TARP) similar to that used in the U.S. following the 2008 financial crisis. Mr Campa proposed that the EU Recovery Fund, the creation of which was recently jointly proposed by France and Germany, could play a role in the establishment of such a programme.

Although a variety of targeted measures have already been taken in response to the COVID-19 pandemic, as set out in this booklet, it is clear that the discussions about the next stage of banking regulation and supervision in the post-Covid-19 era have only just begun.

RELEVANT SOURCES

• FT article - EU needs to create ‘bad bank’ for €1tn toxic loan pile, says EBA chief, 30 January 2017

• FT article - ECB pushes for eurozone bad bank to clean up soured loans, 19 April 2020• Reuters article - EU must present united front to shield pandemic-hit banks: regulator, 25 May

2020• Financial Stability Review, 26 May 2020

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DEFINITIONS AND ACRONYMSAFM Autoriteit Financiële Markten (Dutch Authority for the Financial Markets)AML/CFT Anti-money laundering / Counter-terrorist financingAT1 Additional Tier 1 AVA Additional valuation adjustment BRRD Bank Recovery and Resolution Directive (Directive 2014/59/EU as amended)BCBS Basel Committee on Banking Supervision CCP Central counterparty CCyB Countercyclical capital buffer CET1 Common Equity Tier 1CJEU Court of Justice of the European UnionCommission European Commission Council Council of the EUCRD Capital Requirements Directive (Directive 2013/36/EU as amended)CRR Capital Requirements Regulation (Regulation (EU) No 575/2013 as amended)CRR II Regulation (EU) 2019/876 amending CRRDNB De Nederlandsche Bank N.V. (Dutch Central Bank)EBA European Banking Authority ECB European Central Bank ECL Expected credit lossEIOPA European Insurance and Occupational Pensions AuthorityESMA European Securities and Markets AuthorityFRTB Fundamental review of the trading bookFIU Financial Intelligence Unit GACS Fondo di Garanzia sulla Cartolarizzazione delle Sofferenze (Italian Guarantee Fund

on the Securitization of Bad Debts)G-SIB Global systemically important bankHQLA High-quality liquid assets IASB International Accounting Standards BoardIMA Internal Models ApproachIOSCO International Organization of Securities CommissionsITS Implementing technical standardsLCR Liquidity Coverage Ratio MiFID II Markets in Financial Instruments Directive II (Directive 2014/65/EU as amended)MREL Minimum requirement of own funds and eligible liabilitiesNPL Non-performing loanP2R Pillar 2 requirementP2G Pillar 2 guidance PEPP Pandemic emergency purchase programme PELTRO Pandemic emergency longer-term refinancing operation Quick Fix Regulation Proposal for a Regulation amending the CRR as regards adjustments in response to

the COVID-19 pandemic (COM(2020) 310 final)RTS Regulatory technical standardsSFTR Securities Financing Transactions Regulation (Regulation (EU) 2015/2365 as

amended)SICR Significant increase in credit riskSRB Single Resolution Board TARP Troubled assets relief programmeTLTRO Targeted longer-term refinancing operationVaR Value-at-Risk

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MARIKEN VAN LOOPIKPartnermariken.vanloopik@debrauw.com T +31 20 577 1308

MAURITS TER HAAR Senior Associatemaurits.terhaar@debrauw.com T +31 20 577 1841

EXPERTS

JENNIFER DE LANGESenior Legal Advisorjennifer.delange@debrauw.com T +31 20 577 1647

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