Asset Quality and NPEs – Where Covid-19 infects banks

In this briefing note, we address the topic of asset quality and its meaning for the health of financial institutions. As it is currently expected that the asset quality in the banking books will notably deteriorate during the coming months, this is an area of increasing focus for bank leaders. The European Central Bank (“ECB”) estimates that, in a severe scenario, up to €1.4 trillion of non-performing loans would potentially be generated. This number would be even higher than during the financial crisis of 2008. Where the deteriorating asset quality threatens the capital levels of an institution, countermeasures need to be assessed and implemented.

Asset quality and its impact on capital requirements

In our briefing on bank capital we talked about the importance of the capitalisation of the financial sector to continue its corporate and retail funding activities. In this context, the CET1 ratio is the most prominent indicator of the stability of financial institutions. A decrease of this ratio would indicate an increased level of stress in banking books. This is based on the fact that the own fund requirements are calculated on the basis of the risk-weighted assets (“RWAs”) of banks, i.e. if we assume a fixed amount of CET1 capital, the CET1 ratio decreases when either total assets increase or the risk-weighting applied to the respective assets goes up. Thus, the “quality” of their assets might become one of the most distinctive features between individual institutions.

A brief look at the asset composition of EU banks gives a clear indication of where the economic shock of the Covid-19 pandemic will primarily strain bank balance sheets: their loan books. According to the European Banking Authority (“EBA”), EU banks reported total assets of EUR 23.7 trillion in Q4 2019. The largest components of the total assets were loans and advances, accounting for roughly 66%. This alone shows that escalating credit risk in the different loan portfolios poses one of the key challenges for banks.

Although the quality of the assets in the loan book depends on a number of different factors, some of these might be of particular relevance in the context of the Covid-19 pandemic. The riskiness of credit exposures, for example, depends on the sectors in which the counterparties operate. As some sectors are considered to be more affected by Covid-19, loans in these sectors will face a higher risk-weighting and thus “consume” more regulatory capital on the balance sheet. Consequently, credit exposure to companies which are active in sectors like accommodation, retail and leasing activities, food and beverages, manufacturing and travel are likely to become riskier and thus inflate institutions’ RWAs.

Another aspect that is important to keep in mind when considering the impact of asset quality on capital requirements is the fact that capital ratios are highly dependent on the applicable accounting frameworks. Hence, the impact of the new accounting standard IFRS 9 on the capital situation of financial institutions in stressed economic environments should not be underestimated. In the past, IFRS 9 was criticised as being too “pro-cyclical” since, in a situation of sudden global economic stress in different industry sectors, credit risk would increase dramatically and consequently could lead to deteriorating capital levels.

The rationale behind this is that under IFRS 9, assets of a financial institution have to be valued by applying an expected loss model, which requires institutions to assess the risk of their assets in a forward-looking way. Banks must allocate all credit risk exposures to one of three credit stages which determine how impairment is to be calculated. IFRS 9 requires banks to provide for the lifetime expected credit loss of exposures where there is a significant increase in credit loss, but a loss event has not yet occurred. If an asset moves to Stage 2 or Stage 3, banks are required to realise an impairment provision, and this means that a deduction of the credit risk adjustment from CET1 capital must take place. In this context, value adjustments have to be made on each reporting date, e.g. if the credit risk of a so-called class 1 asset significantly increases during the reporting period, it will have to be classified as a class 2 asset. Consequently, the institution will have to make a value adjustment and hence realise a loss. This is fundamentally different to the old IAS 39, where value adjustments were only required in case a loss event occurred. The argument for the approach under IFRS 9 is that a significant increase in credit risk constitutes an economical loss for the institution and should therefore be realised immediately.
The risk for financial institutions as well as the real economy lies in the fact that the institutions, by strictly adhering to the requirements of IFRS 9, would have to realise significant short-term losses on their balance sheets which would deplete their regulatory capital and limit their ability to provide funding to corporates and households (regarding the supervisory measures taken to mitigate this risk, please see our briefing “Bank Capital – Why it matters”).

Financial institutions and regulators alike have realised the risk that a deteriorating asset quality poses for the capital levels of financial institutions. One measure that institutions have used broadly to brace themselves against expected losses in the loan books was the creation of significant loss provisions. In the same vein goes the expectation from the ECB and other regulators towards financial institutions not to pay any dividends or other distributions.

Leaving the impact on the capital aside, when it comes to measuring the asset quality of banks, the amount of non-performing loans (“NPLs”) or, more broadly, non-performing exposures (“NPEs”) have become the most relevant and – at least in Europe – the most notorious parameter. The need to "tackle" the NPE's caused by the Covid-19 pandemic has just been emphasised by a communication of the European Commission. 

The notorious NPE

In Q4 2014, while the financial crisis of 2008 was slowly becoming the subject of recent economic history, its legacy – the NPL volume of European banks – reached its peak at 7.1%. Although this volume was consequently reduced to 3.1% in Q4 2019, the proportion of NPLs still exceeds pre-financial crisis of 2008 levels.

In addition, to the regulatory implications, a financial institution’s NPE level can also impact its stock price performance. Or, to put it differently, an institution with the intention to raise capital on the (public) markets will have easier access to fresh capital if it has comparably low NPE levels.

On the regulatory side, the effects and implications are diverse. One of the most immediate effects is the deduction from an institution’s CET1 capital for the applicable amount of insufficient coverage for NPEs, Art. 36 (1) lit. m of the Capital Requirements Regulation (“CRR”) in connection with Art. 47a to 47c CRR. As the categorisation of an asset as an NPE is primarily based on the default of the relevant obligor, the regulatory capital of an institution might also be impacted by the increased risk-weighting of the relevant asset.

To mitigate these effects to a certain degree and to facilitate government support measures, the European legislator has amended Art. 47c (4) CRR by extending the preferential treatment for NPEs guaranteed or insured by Official Export Credit Agencies to NPEs that benefit from guarantees granted by national governments or other public entities.

Another way to mitigate the impact of NPEs in a crisis situation is actually the classification of an exposure as "non-performing" or not. Put simply, the term NPE is defined in Art. 178 (1) CRR – but also by the ECB in its guidance on NPEs and the EBA for supervisory reporting purposes – by the quantitative “past-due” criterion and the more qualitative “unlikely-to-pay” criterion. The latter criterion in particular allows some flexibility with regard to the classification of an NPE. This is also clarified by regulators like the ECB, BaFin or the Prudential Regulation Authority (the “PRA”) by emphasising the need to treat individual assessments on a case-by-case basis. BaFin, for example, states in its Covid-19 FAQs that if “a liability is postponed on a case-by-case basis, i.e. not in the context of a general payment moratorium, but interest is applied to the amounts postponed in line with the conditions originally agreed (“original effective interest rate”), this by itself will not imply that the obligor is to be considered defaulted.” Comparably, the PRA has clarified that a covenant breach due to Covid-19 may be a possible indication of unlikeliness to pay but should not automatically trigger a default.

However, the flexibility provided within the regulatory framework will not be enough to sustainably keep NPE volumes down. As forbearance arrangements become more evidently long-term, rather than temporary measures reflecting the short-term cashflow impacts of the pandemic, the scope for flexibility will decrease. For example, on 26 August 2020, the PRA published a statement clarifying that tailored forbearance arrangements for mortgage borrowers following the expiry of Covid-19 mortgage payment deferrals mandated by the Financial Conduct Authority are “likely to be as good an indicator of significant increases in credit risk….as forbearance was before the pandemic”.

Managing asset quality and NPEs

Data from past financial crises indicate that delinquency rates peak not at the height of a crisis but rather shortly after the crisis ends. By way of example, in the US the delinquency rates peaked after the recession caused by the financial crisis of 2008 and it took roughly 10 years before they reached the pre-crisis level. Together with the European banks’ NPE levels cited above, this leads to one conclusion: NPEs will grow and they will stay – at least for a while. 

Therefore, for financial institutions, an active NPE management will be key in the next months or even years to reduce the negative impacts of NPEs on the capital ratios. Further, high NPE levels can reduce the business activity of the institutions as they have “less space on their balance sheet”, consequently hurting their profitability as they cannot take on more profitable business.

There are, however, approaches and instruments that can be used to actively manage the balance sheet or the risk impact of NPEs on the capital requirements of financial institutions. In principle, it is possible to differentiate roughly between three approaches: (i) credit risk mitigation techniques (“CRM”); (ii) securitisation; and (iii) “de-risking”, i.e. the use of an asset protection scheme or a bad bank.


CRM provides banks with a means of managing their credit risk by reducing the risk-weighting applied to an exposure depending on the form the CRM takes. For example, a bank may seek a guarantee from a guarantor with a lower risk-weighting than the borrower. If the guarantor is a government, state-owned or supranational institution (e.g. EIB, EIF) or the guarantee is cash-collateralised, then the bank may be able to achieve a 0% risk-weighting for the exposure. It is worth noting that in the case of government involvement, state aid rules must be observed which usually require approval from the European Commission. Notwithstanding, there have been transactions in recent years (e.g. in Germany) where state-backed guarantees have been used to recapitalise financial institutions in connection with overall restructurings / rescue measures. As well as the risk-weighting reduction, the use of CRM also allows for the ongoing relationship between the bank and the borrower and can be used for a limited time to address temporary strains on a borrower’s risk-weighting.

True Sale securitisation is a common financing structure for portfolios of financial assets and can be used as a means of transferring NPE’s off a financial institution’s balance sheet. The NPL securitisation market continues to develop across Europe in markets including Italy, Ireland, Portugal and Spain. Whereas in Germany, NPE securitisations were last done on a considerable level around 2006. The European authorities have recognised the role which securitisations can play in reducing banks’ NPL exposures and, on 23 October 2019, the EBA produced an opinion on the regulatory treatment of NPLs recommending a number of changes to the Capital Requirements Regulation and the Securitisation Regulation (“STS”) designed to remove identified constraints on the further development of the market. The Basel Committee is also working on proposed technical amendments to the Basel Framework relating to the capital treatment of NPL securitisations which are expected to come into effect by January 2023. These changes can be expected to support the continued growth of the NPL securitisation market.

While CRM and securitisation provide institutions with techniques to help reduce the amount of regulatory capital they have to hold, another option is to look to de-risk their balance sheets. The easiest way to achieve a de-risking of the balance sheet is the sale of assets. However, in the context of NPEs, the disposal of assets typically leads to a loss-realisation and, therefore, at first reduces regulatory capital.

One concept already discussed publicly in the light of the Covid-19 pandemic is that of “Bad Banks”, i.e. a financial institution which is founded to take on the “bad assets” of one or more other institutions. Bad Banks have particularly been used after the financial crisis of 2008 to help institutions to clean up their balance sheets. As they require substantial public funding, they were, however, not universally favoured. Also, the transfer of the assets to a Bad Bank causes a loss-realisation at the transferring bank, i.e. it reduces equity. Another rather commercial aspect to be considered is the fact that the transfer of the assets can also lead to a loss of the client relationship.

To be faster in de-risking bank balance sheets, some form of a Bad Bank solution was just recently discussed by the Chair of the ECB’s Supervisory Board, Andrea Enria. One approach could be to use asset management companies to take on the non-performing exposures from the bank balance sheets and by that restore the banks’ ability to lend more freely.

Following the financial crisis of 2008, another concept applied was the so-called Asset Protection Schemes (“APS”) which could also be used to deal with the overall impact of the pandemic on NPEs. APS help to release capital without the need to sell the assets but rather achieve this synthetically. Consequently, it does not trigger an initial loss-realisation. Moreover, the client relationship remains with the financial institution. However, like the Bad Bank, an APS typically requires public funding.

Both concepts have their legal and commercial pros and cons but offer opportunities to de-risk the financial sector in a comparably flexible way without rewarding excessive risk taking in the past. One approach could be to set up a Bad Bank or APS only for “Covid-19 exposures”. By taking some of this rather specific exposure from the balance sheets of the financial sector, capital needed for the recovery of the economy could be freed up.

The management of NPEs, particularly the “Covid-19 exposures”, in the coming months requires close attention and often bold decision making that considers the relevant economic, legal and regulatory complexities. And although this poses one of the toughest upcoming challenges for institutions, there are several approaches that allow institutions to actively manage their asset quality and thereby improve their long-term perspective.   

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