Non-performing loans: Early signs…

The stability of the banking sector in the European Union (EU) and in the broader central, eastern and south-eastern European (CESEE) region has overall remained resistant to the COVID-19 pandemic until now, but still, there is growing concern that pressure is now mounting and pointing towards an imminent increase in non-performing loans (NPLs).

The current crisis is expected to be different from the global financial crisis (GFC), as we can anticipate some of the challenges in banks’ asset quality, which may be reflected in NPLs.

It is impossible to know exactly how the current volatility may affect defaults and NPLs, but pressure on individual and business borrowers is expected to intensify. In addition to pressures identified in the corporate portfolios, rising credit risk for the household segment is also expected, as the quality outlook for these credits will be impacted by the likely increases in the cost of living.

The latest ECB Economic Bulletin shows that banks’ lending rates for both households and businesses have increased further, as banks tighten their loan supply and credit standards amid concerns over rising risks. As financial conditions tighten, this is expected to put additional strain on the more-indebted borrowers, but we do not expect borrowers to receive as much state support as during the pandemic.

According to the EBA3, stage 2 loans increased to almost 9.5% in Q2 2022. That is higher than the previous peak in Q4 2020 and could represent the first warning sign of a deterioration in asset quality and credit risk. In recent months, interest rates and credit spreads have also reached levels not seen for a decade. Tighter monetary policy is predicted to continue to push up banks’ wholesale funding costs, further widening credit and government spreads and accentuating the risks to banks’ exposures.

Because of that, the ECB and the IMF have called on fiscal authorities to restrain from introducing large, untargeted support schemes that could limit the inflation-taming effects of monetary tightening. Assuming the current trajectory continues, NPLs therefore seem more likely to materialize than during the pandemic.

Fortunately, the efforts of recent years to reduce EU banks’ NPL levels have been largely successful. Moreover, according to the latest EBA Risk Dashboard, NPLs in the EU/ European Economic Area (EEA) dropped to 1.8% in Q2 2022, the lowest level since the global financial crisis (GFC).

Banks therefore enter this crisis in a relatively robust position. We expect EU regulators to continue pressuring banks to identify signs of borrower stress or distress early, to act on them swiftly, and to keep NPL ratios under control.

To help ensure they are prepared, banks can:

• – Ensure that risk management frameworks covering interest rate and credit spread risks are robust;
• – Identify and address any data gaps relating to CRE loans and collateral valuations;
• – Review the adequacy of early warning indicators for RRE loan portfolios; and
• – Address any weaknesses identified in the management of leveraged loan portfolios.