Publication alert: EBA - Guidelines on loan origination and monitoring

We communicate that the European Banking Authority (EBA) has published Guidelines on loan origination and monitoring.

1. Context

As part of the EU’s response to cope with the high level of non-performing exposures, the Council of the European Union defined an Action Plan to tackle non-performing loans (NPLs) in July 2017, which invited the EBA to issue detailed guidelines on banks loan origination, monitoring and internal governance. Within the framework of the Council’s Action Plan, the EBA has already published Guidelines on management of non-performing and forborne exposures, Guidelines on disclosures of nonperforming and forborne exposures and developed non-performing loan (NPL) transaction templates. These previous initiatives aim to tackle problems around loans once they become non-performing.

In this context, after the publication of the consultation paper in June 2019, the EBA has published Guidelines on loan origination and monitoring with the aim to improve institutions’ practices and associated governance arrangements, processes and mechanisms in relation to credit granting, in order to ensure that institutions have robust and prudent standards for credit risk taking, management and monitoring, and that newly originated loans are of high credit quality. The guidelines also aim to ensure that the institutions’ practices are aligned with consumer protection rules and respect fair treatment of consumers. Finally, these guidelines apply to all subsidiaries of European financial institutions even if they are located outside the EU.

2. Main points

• Internal governance for credit granting and monitoring. The EBA set out provisions on credit risk governance & culture, credit risk appetite, strategy and limits. It also focuses on credit risk policies and procedures (e.g. anti-money laundering and counter-terrorist financing (AML-CFT) policies and leveraged transactions) and credit decision making. Major changes set out in these guidelines are the institutions should:
  • Set escalation thresholds of risk appetite by management body to ensure that the remuneration framework is aligned with credit risk appetite.
  • Take into account principles of responsible lending within their credit risk policies and procedures. In particular:
    • Consider the specific situation of a borrower.
    • Design credit products that are offered to consumers in a responsible way.
  • Ensure that the credit-granting criteria are not inducing undue hardship and over-indebtedness for the borrowers and their households.
  • Specify the use of any automated models in the creditworthiness assessment and credit decision-making processes in a way that is appropriate to the size, nature and complexity of the credit facility and the types of borrowers.
  • Set out appropriate governance arrangements for the design and use of such models and the management of the associated model risk.
  • The allocation of credit decision-makers to the organisational and business structure should reflect the cascading credit risk appetite and limits within an organisation and be based on objective criteria, including risk indicators.
  • Define their risk appetite for syndicating leveraged transactions and derive a comprehensive limit framework.
  • Considerate ESG factors and associated risks on the financial conditions of borrowers, and in particular the potential impact of environmental factors and climate change, in their credit risk appetite, policies and procedures.
  • Ensure the establishment of an appropriate remuneration policy that ensures the alignment with the compliance with the risk appetite framework, the credit quality of operations and avoiding the existence of a conflict of interest.
• Loan origination procedures. Institutions and creditors should have sufficient, accurate and up-to-date information and data necessary to assess the borrower’s creditworthiness and risk profile before concluding a loan agreement.
  • Institutions and creditors can consider the use of specific information, data items and evidence suggested in these guidelines to gather the needed information for the creditworthiness assessment.
  • Specific policies are required for the prevention of money laundering and terrorist financing, compliance with ESG factors, leveraged transactions and sustainable financing.
  • Institutions must ensure that the models used in the credit granting processes must be explainable and interpretable.
  • The information requirements on the assessment of the solvency of operations are no longer prescriptive (they are a reference). Additionally, some modifications to these requirements have been included such as:
    • New metrics are included: sources of repayment capacity, composition of households and dependents, expenses for servicing of financial commitments and regular expenses.
    • Differences between micro & small enterprises and medium-size & large enterprises. Requirements are adapted according to the type and size of the borrower (e.g. sensitive analysis applies only for medium-size and large enterprises).
• Pricing. The EBA notes that pricing frameworks should reflect institutions’ credit risk appetite and business strategies, including profitability and risk perspective. Major changes comprise that institutions should:
  • Pricing frameworks should reflect institutions’ credit risk appetite and business strategies, including profitability and risk perspective.
  • Set up a pricing framework according to the type of portfolio/customer: (i) for micro and small enterprises the price should be set at the portfolio and product level; and (ii) for medium and large enterprises the price should be set at the transaction/loan level.
  • Consider differentiating between their pricing frameworks, depending on the types of loans and borrowers. For consumers and micro and small enterprises, the pricing should be more portfolio and product based, whereas for medium-sized and large enterprises the pricing should be more transaction and loan specific.
  • Set out specific approaches to pricing promotional loans, when risk-based and performance considerations specified in this section do not fully apply.
  • Include as a part of the pricing the cost of capital, cost of financing, operational and administrative cost, cost of credit risk, any other associated costs and, new according to the draft Guide, the consideration of competition and market conditions.
  • Regarding the monitoring process, all material transactions below costs should be identified and properly justified, in line with the policies and procedures established by the institution.
• Valuation of immovable and movable property. When a credit facility is secured by an immovable or movable property collateral, institutions should ensure that the valuation of the collateral is carried out accurately and based on its internal policies and procedures. Among the changes it is highlighted that institutions must:
  • Have a procedure for the valuation, monitoring and review of the value by type of guarantee.
  • Take into account ESG factors affecting the value of the collateral (e.g. the energy efficiency of buildings).
  • When institutions use external valuers, they should establish a panel of accepted external valuers to ensure that they have relevant expertise in relevant segments of the property sector. These institutions are responsible of the setting up and maintenance of this panel.
  • Ensure an adequate rotation of valuers. although the final version of the Guide set out that there is a flexible limitation of 2 appraisals to carry out the rotation of appraisers and the entity is able to establish the limit.
  • The EBA has further revised the guidelines to allow the use of advanced statistical models for the valuation of immovable property collateral at the point of origination, according to the requirements of the CRR/CRD and Mortgage Credit Directive (MCD).
• Monitoring framework. Institutions should have a robust and effective monitoring framework, supported by an adequate data infrastructure, to ensure that information regarding their credit risk exposures, borrowers and collateral is relevant and up to date, and that the external reporting is reliable, complete, up to date and timely. These guidelines incorporate the following requirements:
  • Proportionality criteria have been included, therefore individual monitoring and in particular, regular credit reviews and qualitative monitoring factors apply to corporate borrowers (medium and large companies). In general, it is required to monitor the consumers, micro and small businesses at the portfolio level.
  • Sensitivity analysis is required in credit reviews for medium and large enterprises; however, the requirement of monitoring the stress testing has been eliminated in these guidelines, as the EBA Guidelines on stress testing are regulated.
  • In addition to monitoring credit and financial metrics, institutions should take into account information related to qualitative factors that could have a relevant influence on the repayment of a loan.
  • Institutions engaged in syndicating leveraged transactions should implement internal standards and monitoring functions for these activities and establish a dedicated framework to deal with failed syndications in terms of holding strategy, booking and accounting practices, regulatory classification and subsequent capital requirements calculation (i.e. transaction that were not syndicated within 90 days following the commitment date).
  • Performing regular credit reviews of borrowers that are at least medium-sized or large enterprises, with a view to identifying any changes in their risk profile, financial position or creditworthiness compared with the criteria at the point of loan origination.
  • High risk operations are aligned with the article 128 of CRR2. No specific KRIs are required to identify them.
  • Monitoring concentration measures against the values specified in their credit risk appetite, policies and procedures, including, where relevant, by product, geography, industry, collateral features, and quality of portfolios, sub-portfolios and exposures.
• Other aspects to consider. In the final version of these guidelines, EBA has clarified the following aspects:
  • Application of the guidelines at the subsidiary level for European financial institutions, including those are located outside the European Union.
  • Exclusion of refinanced/restructured transactions from the scope of these guidelines.

3. Next steps

• The Guidelines will apply from 30 June 2021. However, institutions will benefit from a series of transitional arrangements:
  • The application of the guidelines to the already existing loans and advances that require renegotiation or contractual changes with the borrowers will apply from 30 June 2022.
  • If institutions do not have all the relevant information and data to be used for the monitoring of existing borrowers or credit facilities granted before the application date, they should collect missing information and data until 30 June 2024.
• The deadline for competent authorities to report whether they comply with the guidelines will be 2 months after the publication of the official EU languages translations.