Following this September's public hearing on the draft Guidelines (GL) on loan origination and monitoring (EBA/CP/2019/04) at the European Banking Authority (EBA) headquarters, it is crucial for credit providers – including banks – to start implementing the GL (even before they are finalized) given the tight deadline. Here's all you need to know to be ready in time.
The current draft Guidelines require a detailed assessment of the borrower's repayment capacity. They include the review of the credit granting criteria, data information collection, authentication of the credit decision-making process and the establishment of a credit risk culture tone from the top. They ensure that credit is granted to borrowers who will be able to fulfil the terms and conditions of the credit agreement.
Moreover, they encompass specific requirements in terms of credit quality monitoring, identification of deterioration in the repayment capacity of the borrower (by performing regular assessments based on KRIs, early warning indicators (EWIs), stress testing results and sensitivity analyses), and the ongoing improvement of credit quality assessment procedures and associated risk profiling as a result of new credit granting activities.
The GL will also ensure that originated loans are of high credit quality, helping the EBA to improve the financial stability and resilience of the EU financial system.
The final Guidelines are expected in December 2019 for an application date of 30 June 2020.
Who does it apply to?
Unlike the current draft which makes no distinction between credits proposed by banks or by non-banks, the final GL should apply to all credit providers. Instead, the EBA creates a common level playing field independent of the specific nature of the issuing entity.
A closer look
- Asset classes: SME corporate, commercial & residential real estate, professional, project finance (shipping)
- Instruments/products: All credit facilities (excluding debt securities), loans and advances
- Collateral: movable property and immovable property collateral (excluding financial collateral)
- Scope of application: these GL should apply to new lending and also to loans and credit facilities originated before the date of implementation
- Environmental factors and green lending: ESG factors have been included in the risk management policies, credit risk policies and procedures
- Valuation of immovable property collateral: use of advanced statistical models for the purpose of valuation of immovable property collateral for re-valuation and monitoring.
Five core areas
- Governance requirements for credit granting and monitoring
- Loan origination procedures
- Valuation of immovable and movable property
- Monitoring framework
The challenges ahead
Institutions will need to set up strong governance, pricing,
collaterals valuation and monitoring methodologies via a
centralized data infrastructure to store historical data and treat
credit loan data during the credit risk life cycle.
This data must be readily available, up to date and provide a sufficient level of granularity in order to monitor the evolution of the portfolio as well as perform assessments, sensitivity analyses and stress tests.
- A strong credit risk culture for employees involved in the credit decision-making
- Three lines of defense principle regarding credit decision-making
- Homogeneous definition and calculation methodologies within a same group regarding KRIs and EWIs
- Pricing adjustment regarding loans performance
- Clear and updated collateral valuation regularly assessed in terms of enforceability and time to recovery
- Data quality assurance and data quality control
- Review policies and processes for data collection, credit decision-making, monitoring, and approaches used by the valuers for immovable property, internal thresholds and limits regarding credit risk and collateral
- Define a strong monitoring framework reflecting the current situation of the loan and its collateral
- Perform creditworthiness assessments which cover an assessment of the borrower's income, disposable income, financial situation and source of repayment capacity to meet contractual obligations
- Develop, maintain and regularly evaluate quantitative and qualitative EWIs for the timely detection of increased credit risk throughout the loan life
- Perform a sensitivity analysis and stress test on the aggregate credit portfolio and relevant sub-portfolios taking into account the materiality in order to anticipate potential negative scenarios in the future and benchmark the result against the credit risk appetite
- Establish a comprehensive framework related to loan pricing principles which includes cost of capital, cost of funding, credit risk costs, operating and administrative costs, and any other real costs associated with the loan
- Identify specific EWIs in order to detect potential deterioration in credit quality across risk buckets before negative events occur at transaction level, and take immediate action
Process automation is key
If process automation isn't on your agenda yet, then it's time to start thinking about it. Why? Banks will need to collect specifically prescribed and detailed loan information as well as keep an audit trail. To do this, a data infrastructure robust enough to quickly gather and automatically compile data (with little reliance on manual processes) must be set up. This infrastructure must also support the credit granting process for the purpose of credit risk management and monitoring throughout the loan life cycle.
The draft GL appear to require newly originated loans to be granted on the basis of the sustainable financial repayment capabilities of the borrower rather than presumed refinancing at the time of maturity. Entities should identify any shortcomings in gathering data and the quality of their data. These gap analyses can then be used to understand what steps are still required to meet the standards set by the GL ahead of the implementation date just one year from now.
This article was written together with Emilia Salaga.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.