EUROPEAN COMMISSION Brussels,14.3.2018 SWD(2018) 73 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT

Accompanying the document Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 575/2013 as regards minimum loss coverage for non-performing exposures {COM(2018) 134 final}



{SWD(2018) 74 final}



Table of contents 1.Introduction: Political and legal context Background Information on Loan Loss Provisioning 2.Problem definition 3.Why should the EU act? 4.Objectives: What is to be achieved? 5.What are the available policy options? 6.What are the impacts of the policy options? 7.How do the options compare? 8.Preferred option 9.How will actual impacts be monitored and evaluated? Annex 1: Procedural information 1.Lead DG, Decide Planning/CWP references 2.Organisation and timing 3.Consultation of the RSB 4.Evidence, sources and quality Annex 2: Stakeholder consultation 1.Targeted consultation

2.Expert group on banking, payments and insurance (EGBPI) meetings Annex 3: Who is affected and how? Annex 4: Provisioning rules for problem loans across the globe – overview References Glossary and list of abbreviations Term or acronym Meaning or definition Accelerated Extrajudicial Collateral Enforcement (AECE) Measures to enhance the protection of secured creditors by allowing them more efficient methods of value recovery from secured loans. Asset Management Company (AMC) A special-purpose vehicle for cleansing bank balance sheets. A credit institution can transfer non-performing assets (NPA) to an AMC, subject to certain requirements and conditions being met. AMCs are often referred to as “bad banks”. Asset Quality Review (AQR) Assessment conducted by supervisors to enhance the transparency of bank exposures, including the adequacy of asset and collateral valuation and related provisions. BU Banking Union Basel Committee on Banking Supervision (BCBS) Committee of the Bank for International Settlements which provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The most important regulatory frameworks are known as Basel II and Basel III. Representatives of central banks and supervisory authorities from different countries are members of the BCBS. CMU Capital Markets Union Capital Requirements Regulation (CRR) Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. Capital Requirements Directive IV (CRD IV) Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC. Common Equity Tier 1 (CET1) capital The highest quality form of regulatory capital ("own funds") under CRR/CRD IV which implement Basel in the EU. It includes common equity shares (ordinary shares) and related share premium, accumulated other comprehensive income, retained earnings together with most other equity reserves, less prudential adjustments and deductions. Competent Authority (CA) A public authority or body officially recognised by national law, which is empowered by national law to supervise institutions as part of the supervisory system in operation in the Member State concerned. Non-performing loans coverage ratio (CovR) Loan loss provisions for loans and advances to customers as a percentage of non-performing loans and advances to customers. Cure rate (CR) The percentage of loans that previously presented arrears and, post restructuring, present no arrears. EBA European Banking Authority ECB European Central Bank ECOFIN Council Economic and Financial Affairs Council ESRB European Systemic Risk Board Expected loss (EL) The ratio of the amount expected to be lost on an exposure from a potential default of a counterparty or dilution over a one-year period to the amount outstanding at default. Exposure Asset (e.g. a loan) or off-balance-sheet item (e.g. guarantee). EP European Parliament FED Federal Reserve Board Forbearance Forbearance measures are concessions towards debtors facing, or about to face, difficulties in meeting their financial commitments. Foreclosed assets For the purposes of this document, foreclosed assets are defined as assets held on the balance sheet of a credit institution obtained by taking possession of collateral, or by calling on similar credit enhancements. Those assets can be obtained through judicial procedures (“foreclosed” in the strict sense), through bilateral agreement with the debtor (swap or sale) or other types of collateral transfer from debtor to creditor. Foreclosed assets comprise both financial assets and non-financial assets. Foreclosed assets include all collateral obtained irrespective of their classification for accounting purposes (e.g. including assets for own use and for sale). FSC Financial Services Committee GDP Gross domestic product International Accounting Standards (IAS) Rules set by the International Accounting Standards Board (IASB) – an independent body of international accounting experts. The main purpose of the standards is to promote the quality, transparency and comparability – at an international level, too – of financial statements drawn up by various enterprises or by one enterprise for various periods. Publicly traded enterprises domiciled in the EU are required by Regulation (EU) 1606/2002 to prepare consolidated financial statements in accordance with International Accounting Standards. As the IASB is an international association under private law, its standards cannot be immediately legally binding. Each standard has to undergo a recognition procedure in order to become legally binding at EU level or in other countries. Prior to 1 April 2001, the body was called the International Accounting Standards Committee (IASC) and the rules that it issued were called International Accounting Standards (IAS). These rules are still valid and still bear the same name. Any rules published after this date are called International Financial Reporting Standards (IFRS). International Financial Reporting Standards (IFRS) Set of international accounting standards stating how particular types of transactions and other events should be reported in financial statements. IMF International Monetary Fund Loss Economic loss, including material discount effects, and material direct and indirect costs associated with collecting on the instrument. Loss given default (LGD) The ratio of the loss on an exposure due to the default of a counterparty to the amount outstanding at default. Loan loss provision (LLP) Reduction in the carrying amount of an asset to reflect its decrease in creditworthiness. Loan to value (LTV) Ratio used in the context of mortgage lending expressing the value of a loan compared to the appraised value of the underlying real estate. MS Member State Non-performing assets (NPAs) The sum of NPEs and foreclosed assets. Non-performing exposure (NPE) An exposure (i.e. a loan, debt security or off-balance-sheet item) that is not held for trading purposes and that satisfies at least one of the following criteria: (a) it is material and more than 90 days past-due; (b) the debtor behind the exposure is assessed as unlikely to pay his/her obligation in full without selling the collateral guaranteeing the exposure (if any). NPEs include defaulted and impaired exposures. Non-performing loan (NPL) A loan that is not held for trading purposes and that satisfies at least one of the following criteria: (a) it is material and more than 90 days past-due; (b) the debtor is assessed as unlikely to repay the loan in full without selling the collateral guaranteeing the exposure (if any). Non-performing loans include defaulted and impaired loans. NPL ratio The ratio, expressed in percent, between the amount of NPLs and the total amount of bank loans. Probability of default (PD) The probability of default of a counterparty over a 1-year period. Performing exposure (PE) An exposures that does not meet the criteria to be considered an NPE. Recovery Rate (RR) Measures the extent to which the creditor recovers the principal and accrued interest due on a defaulted debt. Significant institution (SI) In the context of the SSM (see below), a bank that meets any of the following criteria: (a) it is one of the three largest banks in a MS participating in the Single Supervisory Mechanism; (b) it received direct assistance from the European Financial Stability Facility/ the European Stability Mechanism (EFSF/ESM) assistance; or (c) it has total assets in excess of €30 billion or 20% of national gross domestic product (with a balance sheet total of at least €5 billion). In exceptional cases, the ECB can declare significant a bank operating across national borders. If a bank is identified as a significant institution, it is subject to direct supervision of the ECB. SME Small- and medium-sized enterprise Single Supervisory Mechanism (SSM) The pillar of the BU that is responsible for banking supervision. It comprises the ECB and the national supervisory authorities of the participating countries. Its main aims are to: (i) ensure the safety and soundness of the EU banking system, (ii) increase financial integration and stability, (iii) ensure consistent supervision. Single Supervisory Mechanism Regulation (SSMR) Council Regulation (EU) No 1024/2013 conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions. Stress test (ST) An exercise conducted by supervisory authorities in order to provide supervisors, banks and other market participants with a common analytical framework to consistently compare and assess the resilience of banks to economic shocks. TFEU Treaty on the Functioning of the European Union Unlikeliness to pay (UTP) The probability that an obligor will not repay his/her debt in full.



1.Introduction: Political and legal context 1.1.The need to address NPLs in Europe Following the financial crisis, the regulatory framework for banks has changed substantially. The European Union has taken the lead in implementing reforms agreed globally at the level of the G20 and in the Basel Committee with the objective of reducing risk in the banking sector, reinforcing financial stability and avoiding that taxpayers have to contribute financially to the costs of failing banks. In addition to these measures, the institutional arrangements for the supervision and resolution of banks in the EU have been strengthened fundamentally with the establishment of the first two pillars of the Banking Union (BU): the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). As a result of these measures, the EU banking sector is in a much better shape today than in previous years. Nevertheless, several challenges remain to be addressed, including how to decisively address the high stocks of non-performing loans (NPLs) and other non-performing exposures (NPEs) . NPLs have piled up in parts of the EU banking sector in the aftermath of the financial and sovereign crises and ensuing recessions. High levels of NPLs in parts of the banking sector pose significant risks to financial stability and the overall economy in the EU, unlike in other major economies such as the United States or Japan which have previously taken a number of actions to reduce the level of NPLs and repair banks’ balance sheets. High NPL ratios can weigh on a bank's short- and longer-term performance through two main channels. First, NPLs generate less income than performing loans – thus reducing bank profitability – and may cause losses that diminish the bank's capital. In the most severe cases, these effects can put in question the viability of a bank with potential implications for financial stability. Second, NPLs tie up significant amounts of a bank's resources, both human and financial. Banks saddled with high levels of NPEs have therefore only a limited capacity to provide new credit to viable businesses. Small and medium-sized enterprises (SMEs) are particularly affected by the reduced credit supply, as they rely on bank lending to a much greater extent than larger companies, thereby affecting economic growth and job creation. For all these reasons, the Commission has for a long time highlighted the urgency of taking the necessary measures to address the risks related to NPLs. While tackling NPLs is primarily the responsibility of national authorities , there is also a clear EU dimension of the NPLs issue. Given the high level of economic and financial integration in the EU, and especially within the euro area (EA), there are important potential spill-over effects from Member States with high levels of NPLs to the economies of other Member States and the EU at large, both in terms of economic growth and financial stability. Weak growth in some Member States due to elevated NPL levels might affect economic growth elsewhere. Also, weak balance sheets of just a few banks can negatively affect investors' general perception of the value and soundness of other EU banks. This can unnecessarily raise the funding costs for the sector as a whole, which may adversely affect the cost of credit to borrowers. Addressing high stocks of NPLs and their possible future accumulation is therefore essential for restoring the competitiveness of the banking sector, preserving financial stability and supporting lending to create jobs and growth. This analysis is shared by a number of reports from European institutions, international organisations, and think tanks. 1.2.Recent evolution of NPLs The general improvement in NPL ratios over recent years continued in 2017, as did the quality of banks’ loans portfolios. The latest figures confirm the downward trend of the NPL ratio, which declined to 4.6% (Q2 2017), down by roughly 1 percentage point (pp) year-on-year (see Figure 1). This reduction was mainly the result of one‐off events that impacted all bank‐size classes, in particular smaller banks. However, the ratio remains elevated when compared to historical norms and to other regions and the total volume of NPLs across the EU is still at the level of EUR 950 billion. The situation differs significantly across Member States (see Figure 2). Several countries still have high NPL ratios (9 had ratios above 10% in the second quarter of 2017), while others have rather low ratios (10 Member States were below 3%). There is evidence of some progress in reducing NPL ratios in the most affected countries, owing to a combination of policy actions and a stronger macroeconomic environment. However, significant risks to economic growth and financial stability remain and progress is still slow, especially where it is needed the most. Structural impediments continue to hamper a faster fall in NPL stocks. Provisioning is often still too slow and insufficient to allow for effectively resolving and preventing any critical accumulation of NPLs in the future. Among other elements, activity on secondary markets for NPLs is also not yet sufficient to substantially contribute to NPL reduction efforts, notwithstanding the increased interest from certain investor groups and the increasing volume of NPL-related transactions.

Figure 1: EU NPL ratio Figure 2: NPL ratio in EU Member States Source: ECB. Note: Dec-2014 not available for CZ. 1.3.Towards a comprehensive package of measures to address NPLs A comprehensive and credible strategy to address NPLs is an essential and urgent step towards restoring the viability of – and hence investor confidence in – the EU banking sector. Pursuing a comprehensive strategy and taking determined action to address NPLs is also essential for the smooth functioning of the Banking Union and the Capital Markets Union (CMU) and for a stable and integrated financial system. In this way, the resilience of the Economic and Monetary Union to adverse shocks will be enhanced by facilitating private risk-sharing across borders, while at the same time reducing the need for public risk-sharing. Integrating national and EU-level efforts is needed to address the NPL problem, both on the existing NPL stocks and on future NPL flows. Reflecting the EU dimension and building on previous work by the Commission and other competent EU authorities, the Council adopted in July 2017 an Action Plan To Tackle Non-Performing Loans in Europe. It recognises that work in this area must be based on a comprehensive approach combining a mix of complementary policy actions, since the complexity of the problem simply does not lend itself to a single ‘silver bullet’ solution. The Council Action Plan combines various measures by national governments, bank supervisors and EU institutions/agencies that improve the tools and incentives for banks to pro-actively address NPLs either by internal work-out or through disposal. In practice, this means enhancing legal frameworks relevant for both the prevention and resolution of NPLs, including the functioning of secondary markets. However, other measures such as improving the availability and quality of data on NPLs or improving the market infrastructure (e.g. set-up of trading or information platforms) are equally important. If the right pre-conditions are present, tools such as Asset Management Companies are also an efficient way to allow resolution of NPLs while removing NPLs from the banking system in the short term. The Commission has committed to delivering on the parts of the NPL Action Plan within its remit. Accordingly, the Commission announced in its October 2017 Communication on completing Banking Union a comprehensive package for tackling high NPL ratios, to be put forward by Spring 2018. This "Spring package" consists of the following measures: ·A Blueprint for how national Asset Management Companies (AMCs) can be set up in compliance with existing EU banking and State aid rules by building on best practices learned from past experiences in Member States. ·A legislative initiative to further develop secondary markets for NPLs, especially with the aim of removing undue impediments to loan servicing by third parties and to the transfer of loans to third parties. ·A legislative initiative to enhance the protection of secured creditors by allowing them more efficient methods of value recovery from secured loans through Accelerated Extrajudicial Collateral Enforcement (AECE). This refers to an expedited and efficient out-of-court enforcement mechanism which enables secured creditors (banks) in all Member States to recover value from collateral granted by companies and entrepreneurs to secure loans. ·A legislative initiative amending the Capital Requirement Regulation (CRR), with regard to the introduction of minimum coverage requirements for incurred and expected losses on future NPLs arising from newly originated loans, in order to backstop potential under-provisioning of future NPLs and prevent their build-up on banks’ balance sheets. ·A way forward to foster the transparency on NPLs in Europe by improving the data availability and comparability as regards NPLs, and potentially supporting the development by market participants of NPL information platforms or credit registers. The Council Action plan initiatives under the responsibility of other EU institutions, agencies and competent authorities include, among others: ·General guidelines on NPL management applicable to all EU banks; ·Detailed guidelines on banks' loan origination, monitoring and internal governance, addressing in particular transparency and borrower affordability assessment; ·Macro-prudential approaches to prevent the emergence of system-wide NPL problems, taking into account potential pro-cyclicality and financial stability implications of NPL policy measures; ·Enhanced disclosure requirements on banks' asset quality and non-performing loans. 1.4.Commonalities and interdependencies of the various measures The legislative and non-legislative initiatives of the Council Action plan are interlinked and mutually reinforcing. They should create the appropriate environment for dealing with NPLs on banks' balance sheets. Some of them have an impact on the reduction of the current stock of NPLs, and all are relevant for reducing risks of future NPL accumulation. Their impact is expected to be different across Member States and affected institutions. Some will have a stronger impact on banks' ex ante risk assessment at loan origination, some will foster swift recognition and better management of NPLs, and others will enhance the market value of such NPLs. The Commission's three legislative initiatives, namely i) statutory prudential backstops for loan loss coverage; ii) the development of secondary markets for NPLs, and iii) accelerated extrajudicial collateral enforcement mechanisms, mutually reinforce each other and also interact with the other measures of the Council Action Plan. For example, the prudential backstops initiative ensures that credit losses on future NPLs are sufficiently covered, making their resolution and/or disposal easier. These effects would be complemented by better developed secondary markets for NPLs as these would make demand for NPLs more competitive and raise their market value. Furthermore, accelerated collateral enforcement as a swift mechanism for recovery of collateral value would reduce the costs for resolving NPLs. These interactions are described in greater detail in the below box.

Figure 3 Commission's policy initiatives within the NPL Action Plan Box on the reinforcement effects between the Commission's legislative initiatives This box assesses the possible reinforcement effects between the three initiatives of the Spring package, namely i) statutory prudential backstops for loan loss coverage; ii) development of secondary markets for NPLs, and iii) accelerated extrajudicial collateral enforcement mechanisms. As is the usual practice, each individual impact assessment gauges the incremental effects of the proposed measure against a no policy change baseline. The underlying idea of the NPL package is, however, that the effects of each initiative will be mutually enhancing. The exact quantification of these feedback effects is a quite complex exercise as it is subject to strong modelling uncertainty. This box hence provides a qualitative description of the feedback channels and their relative strength. Figure 4: The reinforcement effects between the initiatives of the NPL package Effects of Accelerated extrajudicial collateral enforcement (AECE) on other initiatives As AECE becomes more popular and used by credit institutions, the statutory prudential backstop measures would be less binding. Indeed, banks would tend to restructure, recover or dispose of their NPLs earlier and at a higher rate. They would be less affected by the need to increase provisioning as time goes by, as required by the prudential backstops measures. Given that the AECE feature would follow the NPLs following their disposal to a third party, this would help the development of the secondary market by increasing investor participation and thereby its liquidity (NPL demand-side effects). In particular, shorter time of resolution and increased recovery, as expected with AECE, would increase the bid prices. Moreover, the harmonization achieved by AECE would foster development of pan-European NPL investors, further improving market liquidity. Effects of Statutory prudential backstops on other initiatives The more costly in terms of higher provisioning it becomes for banks to keep secured corporate NPLs on their balance sheets due to the new prudential backstop rules, the higher the incentives for banks to restructure, recover or dispose of NPLs quicker and earlier, and hence the higher the use of AECE directly (by triggering it) or indirectly (by disposing of the NPL to a third party). Holding NPLs on the balance sheet will become costly over time, providing an incentive for banks to dispose of NPLs on the secondary markets at an early stage, when the backstops require less minimum coverage. Once the minimum coverage level required by the backstops becomes more binding, the carrying book value of NPLs will be reduced. Both of these mechanisms would ensure more sellers participation on the secondary market (NPL supply-side effect), thereby reducing the ask price of NPLs. Effects of the development of secondary markets for NPLs on other initiatives Improved investor participation and better functioning of secondary markets would reduce the bid-ask spread and increase the volume of NPLs that are transferred to third parties. Banks would dispose of NPLs more eagerly and at an earlier stage, therefore the provisioning backstop would be less often binding. With a more liquid and better functioning secondary market for NPLs where investors show appetite for NPLs with the AECE feature, there would be additional incentives for credit institutions to use AECE at origination of new loans. This indirect feedback effect would become active once sellers realise that it is easier to dispose of NPLs having the AECE feature to third party investors. The effectiveness of the three aforementioned legislative measures would increase if banks are adequately capitalised in the future. Better capitalised banks will be more eager to sell NPLs in the secondary market or to realise the collateral of a non-performing loan in a timely fashion. Furthermore, statutory minimum coverage requirements would provide strong incentives for banks' management to prevent the accumulation of future NPLs through better NPL management and stronger loan origination practices. This will reinforce the expected effects of the EBA’s and ECB’s work on banks' loan origination, NPL management, monitoring and internal governance practices. Work on NPL information and market infrastructure would further enhance the functioning of NPLs secondary markets. Lastly, measures related to loan enforcement would complement the Commission's November 2016 proposal for a Directive on business insolvency, preventive restructuring and second chance, by increasing the chances that viable businesses survive while non-viable activities are swiftly resolved.



Background Information on Loan Loss Provisioning Recent developments in banking systems around the world illustrate the continued importance of proper provisioning. Two such examples are the Asset Quality Review (AQR) exercise in the EU and initiatives of unifying the definitions of NPEs and exposures subject to forbearance measures at the European and international level. Credit quality inadequacies and their resulting losses have always been one of the primary causes of bank failures. Almost ten years after the onset of the global financial crisis, despite ongoing regulatory reforms and rounds of organized stress testing, deleveraging, and balance sheet repair exercises, loan loss provisioning and asset quality remain key issues for banks. Provisioning merits particular attention given its vital role in ensuring the safety and soundness of the banking system. According to IMF staff “[u]nder-provisioning is generally the single greatest distortion in the calculation of capital and capital adequacy”.

Provisioning is a risk management tool to address credit risk by setting aside a given amount (of cash/capital), referred to as loan loss provision (LLP) , as a buffer to absorb incurred and expected losses on a financial instrument such as a loan. LLPs allow banks to recognize the estimated loss in their income (“profit & loss”) statements and balance sheets , even before the actual loss can be determined with full accuracy and certainty as events unfold. When loan losses eventually materialise, banks can draw on LLPs, thereby absorbing the losses without reducing capital and preserving banks' capacity to continue lending to the economy. Losses on credit exposures including NPLs are subject to both accounting standards and prudential regulation. However, neither the international accounting nor the prudential framework does currently provide for a common minimum treatment with regards to incurred/expected losses on NPLs. Accounting treatment: from IAS 39 to IFRS 9 Following the global financial crisis, the G20 leaders, investors and regulators called for actions to improve LLP standards and practices, by replacing the International Accounting Standard (IAS) 39 standard with a new, forward-looking principle. In particular, the International Accounting Standards Board (IASB) received the mandate to set a new standard to allow banks to "fully recognise existing credit losses earlier in the credit cycle" and, as such, to address the flaws of a "too little, too late" provisioning. In response to the G20's mandate, the IASB formulated a new accounting standard for the classification and measurement of financial assets and liabilities, the so called International Financial Reporting Standards (IFRS) 9, which will be applied in the EU starting with January 2018. The most important change of IFRS 9 compared to IAS 39 is the change from an "incurred credit loss" approach to an "expected credit loss" (ECL) approach for determining credit losses of financial instruments other than those measured at fair value through profit or loss. Specifically, the IFRS 9 requires banks to recognise ECLs before having objective evidence of impairment, that is, even if no past "triggering" events (e.g., loss of employment of the borrower, decrease in collateral values, or past-due status) have occurred. Banks will then update the ECLs recognised at each reporting date to reflect changes in credit risk as estimated using a large set of historical, current, and forecast information, including forward-looking macroeconomic variables. The inclusion of these variables into the assessment procedure is expected to favour earlier and possibly higher provisions. The IFRS 9 ECL approach is based on three stages. "Stage 1" refers to performing financial instruments for which the credit risk has not significantly increased since initial recognition. For stage 1 the reporting entity has to determine the expected credit losses from default events over the next twelve months. The amount of expected credit losses is the discounted difference between contractual cash flows and the cash flows the entity actually expects including contractual options and cash flows from the sale of collateral. "Stage 2" refers to non-impaired (performing) financial assets whose credit risk has significantly increased since initial recognition. There is a rebuttable assumption that this is the case when the loan becomes more than 30 days past due. For stage 2 the reporting entity has to estimate the probably of default over the remaining maturity of the financial instrument and calculate the corresponding expected credit loss. "Stage 3" refers to financial assets that are credit impaired, i.e. for which an objective impairment event has occurred and hence the probability of default is "1". Stage 3 is referred to as life time expected losses and is broadly speaking the same as what is done under the impairment approach of current IAS 39. Finally, IFRS 9 requires the reporting entity to write-off a loan when there is no reasonable expectation to recover the loan. A write-off is a "de-recognition" event which implies that the loan will no longer be on the balance sheet of the bank and hence not count towards its stock of NPLs. To summarise, compared to IAS 39 the new IFRS 9 expected credit loss approach will lead to earlier and fuller recognition of credit losses when loans are still performing (Stage 1 and 2). The new rules require banks to build provisions in a timely way only at impairment of the loan. This has the effect of mitigating the risk of cliff effects when many loans become non-performing at the same time (for example during an economic downturn). Regarding loans which are non-performing (Stage 3), the new standard will largely keep the same treatment as IAS 39 and, by itself, cannot be expected to ensure that banks will ultimately create sufficient LLPs for NPEs. Also, IFRS 9 sets more general principles and approaches for determining credit loss provisions as opposed to detailed rules. Despite the available guidance on its application, there is discretion within the new standard which in practice might lead to lower levels of LLPs, in particular when valuing collateral or third party guarantees for secured loans. At the same time not all banks apply IFRS: in several EU MSs and in many third countries national Generally Accepted Accounting Principles (GAAPs) apply which might follow a different provisioning approach than IFRS. Furthermore, some jurisdictions have adopted specific provisioning rules for banks' NPLs, while a few others have adopted provisioning guidelines specifying the implementation of IFRS (see section 3 and Annex 4). Prudential treatment: Pillar 1 and Pillar 2 Current prudential regulation under so-called “Pillar 1” deals differently with provisions depending on whether banks determine their regulatory minimal capital requirements using the Standardised Approach (SA) or the Internal Ratings-Based (IRB) approach. Only under the IRB approach current regulatory provisions are already determined following an ECL approach, although with differences to IFRS 9. For IRB banks, when there is a “provisioning shortfall”, i.e., when regulatory expected losses (EL) exceed accounting provisions, said shortfall is deducted from Common Equity Tier 1 (CET1) capital. As regards credit exposures that are in default (such as NPLs), banks must use their best estimate of expected losses (ELBE) based on the principle that banks would have to recognize additional unexpected losses during the recovery period. It is currently widespread practice to use accounting provisions as ELBE estimates and the treatment of NPLs has been found very heterogeneous among banks. There is no common minimum treatment with regards to incurred and expected losses on NPLs, neither at EU nor at global level. In this respect, several countries have introduced mandatory (prudential) provisioning/writing-off regimes (or have intensified existing regimes), post-crisis. For instance, banks in the United States, Japan or Brazil are required to fully provision and write off NPLs after a set period (see section 3. and Annex 4). Under so-called “Pillar 2” competent authorities (CAs) in charge of supervising institutions in the EU have the power to influence their provisioning policy and to require specific adjustments to the own funds calculations on a case-by-case basis. Accounting powers do however not fall into the remit of CAs which is why it is not possible for a CA to impose a specific provision to be registered in a bank's financial accounts – supervisory powers rather act as a “prudential overlay” which affects solely a bank’s prudential figures, i.e. by decreasing its regulatory own funds with the adjustments being reflected in supervisory reporting and own funds disclosure. Pillar 2 measures can only be applied on discretion of the CA and on a case-by-case basis, following an assessment that the provisioning policy chosen by the institution is not adequate or sufficiently prudent from a supervisory point of view. Under the current rules, no harmonised (minimum) treatment can be imposed by CAs.



2.Problem definition 2.1.What is/are the problems?

2.1.1.Build-up of under-provisioned NPLs Prudent provisioning of NPLs is essential to ensure banks’ financial soundness and by consequence their ability to lend to the economy. Provisioning is a key risk management tool to address incurred and expected losses on credit exposures without reducing capital when those losses materialise thereby preserving banks' capacity to continue lending to the economy (see above Background Information). A prudent provisioning policy is thus key determinant for banks’ financial soundness, in particular in a recession when many loans become non-performing. Prudent provisioning of NPLs has proved to be crucial to effectively resolving bad loans in the European and international experience. Restructuring, selling or dismissing non-performing assets and non-recoverable collateral requires less, if any, additional capital, if sufficiently high provisions for credit losses on NPLs have been made, and therefore becomes potentially easier. Recent analysis confirms that increases in coverage ratios at bank level are usually followed by a higher reduction in NPLs in the following quarters (as illustrated in Figure 5). Insufficiently provisioned NPLs, on the contrary, are more likely to remain on banks’ balance sheets in an attempt by banks to avoid or delay loss recognition (“wait-and-see” approach, see below 2.2.). Delays in loss recognition may cast doubt over banks’ future profitability, solvency and long-term viability, as delays force banks to increase provisions during economic downturns, when cumulative losses materialise and capital requirements become most binding. In addition, heightened risk perceptions on the part of investors and depositors usually translate into higher funding costs. In sum, under-provisioning and loss forbearance as regards NPLs may ultimately result in higher lending rates, reduced lending volumes, and increased risk aversion (see consequences in 2.2.). Figure 5: Quadrant model showing a potential relationship between NPL and coverage ratio trends Source: EBA, Risk Assessment Report of the European Banking System (December 2016) Notes: Starting off with a high stock of impaired assets and a low coverage ratio (quadrant 1), banks may increase their coverage ratio to reflect the worsening condition of the NPL. As the gap between transaction prices offered by potential buyers (“bid”) and net book values (“ask” being the result of the gross carrying amount minus LLPs) at which NPLs are recognised in banks’ balance reduces, banks are better able to dispose of NPLs (quadrant 2). After having decreased the level of impaired loans, thereby freed-up capital and human resources can be used to further reduce the stock of NPLs, in particular “aged” ones with high coverage ratios (moving from quadrant 3 to quadrant 4). 2.1.2.“Pockets of risks” in EU banking sector and potential spill-over effects The gross carrying amount of NPLs in the EU banking system at the end of 2016 amounted to just below EUR 1 trillion, with remarkable discrepancies across banks and MSs. The NPL ratio is highly dispersed across EU countries ranging from 1 % to 46%. NPLs are concentrated in a few MSs: almost 90% of the overall amount of NPLs in the EU is located in 10 MSs (see Figure 6). At the same time, in over one-third of EU countries the ratio exceeds 10% (in order of descending NPL ratio: Greece, Cyprus, Portugal, Italy, Slovenia, Ireland, Bulgaria, Hungary, Romania and Croatia). Figure 6: Gross and net NPLs (EUR bn) Source: ESRB Secretariat calculations based on ECB Consolidated Banking Data Notes: Reference date for gross and net NPLs columns is Q4 2016. Data includes domestic banks, stand-alone banks, except Slovenia (Q1 2016) and foreign controlled subsidiaries and branches. NPL coverage ratios (CovR) in the EU also differ across banks and MSs both in terms of level and evolution and according to the size of banks. Differences depend on a number of factors which are difficult to disentangle (see also below 2.2.3.). One of these factors is the collateralization of NPLs which may play a relevant role in explaining provisioning policies across banks. In principle NPLs secured by collateral are perceived to be less risky. For this reason, banks normally provision less compared to provisioning non-collateralized loans. The quality and the amount of collateral affect loan recovery rates and, therefore, the "expected loss" on a NPL. Consequently, collateralized loans have on average lower NPL coverage ratios. Within the EA, 36% of the gross carrying amount of NPLs are covered by collateral (“secured NPLs”) while 46% are covered by provisions (see Figure 7). Figure 7: Provisioning and collateral (% of NPLs) Source: Constancio, Resolving Europe's NPL burden (2017) based on ECB Supervisory Statistics Note: Countries ordered by NPL ratio; I6 refers to high-NPL MSs: CY, GR, IE, IT, PT and SI; I13 are other EA MSs) Taking at face value, these figures would suggest that 20% of NPLs stock in the EA represents a true risk on banks’ balance sheets, being the residual covered through either collateral or provisions. However, effective loss coverage provided by existing collateral depends, inter alia, on the characteristics of the underlying asset market as well as on the actual accessibility to that collateral. For example, collateral provides for effective protection against losses on NPLs only as long as its present value is not eroded by lengthy and costly enforcement procedures (see Figure 8).

Figure 8: Average time to foreclosure (years) and NPL ratios (%) Source: IMF, Country Report 15/205 The uncertainty about the valuation of NPLs, in particular secured ones, translates into a wide gap in price expectations of investors and banks (i.e. differences between transaction prices offered by potential buyers [“bid”] and net book values [“ask”] at which NPLs are recognised in banks’ balance – so-called “bid-ask spread” or “pricing gap”). The data on the size of that gap is scant but it is thought to be very large. For instance, estimates suggest that, for a fully collateralised NPL, the discount required by a private investor may exceed 40% mainly due to the cost, time and uncertainty of the recoveries. It follows that provisioning levels might not yet truly reflect the actual risk of losses on NPLs. The pace of reduction in NPLs in the EU has been slow. As shown in Figure 5 NPL ratios are now higher than in 2009, and in most cases, they have not returned to pre-crisis levels. A large majority of EU MSs reports NPL ratios to be above those of the United States or Japan. The ESRB noted that in spite of the recent improvement in macroeconomic conditions and the subsequent decrease in flows of new NPLs have helped some countries to start to reduce their NPL stock from the peak levels seen in 2012/13, EU banks have generally not shown satisfactory progress in resolving their stocks of NPLs, which have been piling up on their balance sheets for a number of years. Figure 9: NPL ratio and changes since 2009 (% of gross loans) Source: IMF Financial Soundness Indicators and ESRB Secretariat calculations Notes: Data refers to Q4-2016, except for Cyprus, Portugal, Ireland, Belgium, Denmark, Germany, United Kingdom and Lithuania (all Q4-2015), and Luxembourg (Q4-2014). Data for Denmark starts in 2010. No data is available for Finland. Countries are ordered according to the change in the NPL rate since 2009 Although average provisioning levels have recently increased in certain MSs facing high NPL stocks, loss recognition is often still too slow and insufficient to allow for effectively resolving NPLs and preventing the accumulation of future NPL-stocks. Additional efforts are necessary; especially in some MSs and for some banks, provisioning levels may need to be increased further, reducing, inter alia, the large bid-ask spreads (see Figure 10) and allowing banks to dispose of NPLs more easily at an earlier stage and to higher levels of recovery. Figure 10: Difference between the net book value and the estimated bid price of a sample of collateralised NPLs Sources: ECB calculations based on the World Bank’s Doing Business 2017 and ECB data. Notes: The market price for secured NPEs reflects the expected time to recover the residual value of distressed assets (being lower where foreclosure times are longer and debt enforcement regimes weaker) and the expected return on investment consistent with general profit expectations in distressed debt markets. The blue segments of the bars represent the reported average cost of enforcing claims through individual legal systems, whereas the yellow segments represent the additional discount that results from using an internal rate of return (IRR) of 15%, assumed to represent the premium required by investors for the risk of acquiring NPLs. The cost of debt recovery includes court fees and government levies; fees of insolvency administrators, auctioneers, assessors and lawyers; and all other fees and costs. It does not include operational expenses incurred by the creditor, such as wages and salaries of involved staff members, or the cost of IT infrastructure used to manage NPLs. Inclusion of these costs would reduce net present values even further. The accumulation of NPLs without sufficient loan loss coverage in parts of the EU banking sector creates “pockets of risk”. The EU banking system is fairly integrated, even more in the EA: the percentage of banking institutions controlled by a parent institution outside a MS continuously increased and recently reached 22%. Cross-border banking loans also grew consistently and reached 8.5% of total loans outstanding in the EA. While there are strong benefits from financial integration in terms of risk diversification, disruptions of the financial system in one MS may also affect the financial system in other MSs. Spillovers from weaker banks and weaker countries are possible, posing a threat to financial stability and economic growth of the Union, particularly in the BU. The spillover effects may arise both within the banking sector and between the banking and non-banking sectors. Banking spillovers relate to banks' cross-border lending activities and cross-border ownership links. Moreover, financial interconnections and interdependencies between banks across the BU and existing crisis management mechanisms lead to a more integrated perception of the EA banking sector by market participants (such as international investors), and occasionally, international institutions. Because national economies are also highly interconnected in the EA, negative effects on the growth perspectives in individual MSs can potentially spill-over to other Member States. These indirect channels relate to the overall deterioration of the macroeconomic environment in high-NPL countries, which affects other countries through lower import demand (trade channel) and a loss of value of equity and debt claims on residents of the affected countries (financial channel). 2.2.Consequences of insufficient loan loss coverage

2.2.1.Negative impacts on EU banks’ financial soundness and financial stability Excessively discretional (“too little and too late”) recognition of losses on NPLs has several negative effects in terms of banks’ financial soundness and financial stability. If NPLs are not recognised early and provisioned adequately, banks' true loss absorbing capacity may be called into question, especially during a crisis. As discussed above (see section 2.1.1.), delayed recognition of expected losses or incorrect estimates have an immediate effect on banks' earnings (current expenses are lower than they should be) and significant implications for their soundness. Outright losses can arise that weaken banks’ capital base, potentially bringing capital levels below or close to the minima required – giving rise to insolvency or illiquidity. At that point, banks might have to recapitalise when financing conditions are cumbersome, especially when they and the wider system are in crisis. However, crises are the worst possible moment for a bank to raise capital, as investors may be wary of subscribing new shares when profits are falling and general economic conditions may be poor. Overall financial stability would be at risk if such problems were to arise in a substantial part of the banking system. Moreover, delaying loss recognition damages transparency and increases investors' uncertainty about banks' fundamentals, which may impair market confidence in the sector more generally. Heightened risk perceptions on the part of investors and depositors usually translate into increased risk aversion and higher funding costs (see section 2.2.2.) with potentially negative effects on the provision of credit to the real economy. For all these reasons, an early and transparent recognition of NPLs and adequate provisioning are crucial to ensure banks have clear and sound balance sheets. 2.2.2.Impaired credit provision with negative impacts on real economy financing and growth As already mentioned in section 2.2.1., insufficiently provisioned NPLs may result in reduced bank lending to the real economy thereby potentially dragging on economic growth. There are two main channels through which NPLs could slow down economic recovery. First, banks with under-provisioned NPLs might be impeded to extend fresh credit (credit supply channels) Second, borrowers face reduced incentives to invest. Assets remain under their control rather than being reallocated to more productive uses (non-credit supply channels). Credit supply channels Credit growth remains subdued in most of the MSs with currently high levels of NPLs (so-called Category 3 MSs) (see Figure 11). While subdued credit dynamics reflect low credit demand in a generally soft economy, the weakening of credit supply by high levels of NPLs play a significant role too. Weak credit demand and weak credit supply are closely intertwined: a credit crunch is bound to weaken macroeconomic performance and this will in turn weaken credit demand. Banks’ reduced lending capacity tends to disproportionately affect firms that are most dependent on bank finance such as SMEs. Figure 11: MFI lending to non-financial corporations, EU (2010Q1-2016Q1) Source: ECB, DG ECFIN calculations Several mechanisms are identifiable through which under-provisioned NPLs affect credit supply. Funding costs increase when NPL levels rise, because high NPL levels raise doubts about the true capitalization of a bank. In particular, this effect is likely when provisioning is not considered sufficient to cover loan losses. The increased uncertainty will be reflected in a higher risk premium on banks’ funding and reduced access to financing (such as notably wholesale funding). To the extent that it is passed through to banks’ lending rates, credit supply declines. Higher funding costs and reduced credit supply again translate into less profitability. Overvalued NPLs imply underestimation of risks and potentially worsened allocation of credit, as non-viable businesses are kept artificially alive or restructuring is unduly delayed (so-called “extend and pretend” practices, see section 2.3.1.). In addition, banks might also try to price-in some of their loan losses through raising interest margins for performing borrowers. In either case, lending rates will be higher and credit supply lower. Together, this impedes the efficiency of the banking system. Past experience suggests that ignoring banking problems and delaying losses in the interests of sustaining credit will, on average, lead to a more severe contraction of credit at a later stage. Non-credit supply channels NPLs without sufficient loss coverage can also weigh on economic developments through channels other than credit supply. Loss forbearance, for instance, enables “extend and pretend” practices which may ultimately result in debt overhangs. Overextended borrowers invest too little and supply too little labour, even in the absence of financing bottlenecks. Unless repayment difficulties are temporary or purely strategic, all the distortions identified by the extensive literature on debt overhang arise: overextended companies have little incentive to invest because any return is effectively shared with the banks holding the NPLs; overextended owners will show little enthusiasm in maintaining or improving the houses or apartments that they might lose in any event; and overextended households are unlikely to work harder and longer if the additional income remains insufficient to escape the debt trap. All this reduces economic activity to inefficiently low levels. Debt restructuring and partial debt forgiveness that reduce the debt burden can unlock efficiency gains with scope for debtors and creditors to both benefit; sufficient loan loss coverage is key for these relief measures, as it makes any resulting loss more bearable for the restructuring/forgiving banks.

Failure to resolve NPLs timely also tends to trap resources in unproductive uses. Loans might have become non-performing because too much credit has gone into particular sectors, to underperforming entrepreneurs, or to poorly selected projects. In this case, the efficient way forward may involve recovering remaining resources from these failed investments quickly with a view to redeploying them in more promising areas. A prolonged hold out for a recovery of existing projects, or of the value of the collateral backing them, might be inefficient and hold back economic recovery more broadly. 2.3.What are the problem drivers? 2.3.1.Incentives to delay loss recognition and reduce provisioning levels (“wait and see” and “extend and pretend”) LLPs reflect incurred and/or expected losses on future loan defaults and are reported in the bank's annual income statement. On the balance sheet, LLPs cause a decline of the carrying value of the loans and a corresponding decline of the bank's equity (see section 2.1.1.). In particular when their regulatory capital levels are already low, banks may attempt to delay loss recognition and reduce provisioning levels, in order to avoid a breach of capital requirements. Another incentive may be maintaining (or even increasing) the level of earnings to signal financial strength. In this context and more in particular the literature review by Ozili and Outa identified the following two main motives for the under-provisioning of loan losses: -A capital management motive: Banks may time LLPs to ensure that they meet the regulatory minimum capital requirements. This implies that the incentives to reduce provisioning levels are high when regulatory capital levels are already low. Capital management of this kind could reduce the co-movement between reported provisioning levels and the growth rate of GDP, as bank capitalization rates are more likely to be stressed during economic downturns. -A signalling motive: Banks may set the level of LLPs to signal some information about the quality of their loan portfolio, in particular as regards NPLs, and/or to signal information about its future earnings prospect. Banks may, in some cases, prioritise distributions to shareholders over increases in the coverage of NPLs through provisioning. Particularly when the economic outlook is positive, banks may also have incentives to delay loss recognition and hold onto their NPLs in the hope that the assets would recover naturally (“wait and see”). They may in some instances be overly optimistic regarding NPL recognition and their provisioning levels, depending on their assessment of the final expected recovery value (including the underlying collateral) or the sustainability of forborne loans and the assessment of loan management costs for the bank. Finally, banks may have an incentive to refinance or “forebear” NPLs in order to avoid or delay loss recognition on these loans, or in the context of a close relationship with the client (also known as “extend and pretend”). This means that credit is allocated to barely surviving firms (“zombie companies”) at the expense of firms that have a viable future. In this vein, IMF staff assesses the impact of NPL sales on the amount of capital that would be freed for a representative sample of European banks. Micro-level analysis on corporate-bank relations suggest that corporate investment is reduced both by self-restriction by corporates in debt overhang and by a change in behaviour of banks with weak balance sheets. 2.3.2.Excessive discretion in NPL recognition and provisioning policies across the Union LLPs recognised by banks for NPLs in accordance with the applicable accounting framework might not always be adequate from a prudential perspective, which has a different scope, objective and purpose. For instance the IFRS apply to undertakings from various industries and are based on the principles of neutrality and faithful representation of the underlying economic transactions at the reporting date (point-in-time). On the other hand, the CRD/R only applies to credit institutions and investment firms and is based on a risk-based approach, ultimately aiming at the stability of individual institutions through the economic cycle and of the financial system as a whole. IFRS 9 is expected to bring much closer alignment with the prudential standards than IAS 39, and to contribute to address the issue of delayed and inadequate provisions, as it operates on an “expected loss” approach (see Background Information). The new standard leaves, however, room for discretion in determining the expected credit losses on performing and non-performing loans including the underlying valuation of collaterals and, by consequence, in the determination of provisions. IFRS 9 sets more general principles and approaches for determining LLPs opposed to detailed rules. However, the management discretion is not absolute but framed by requirements within the standard, supervisory guidance, supervision and statutory audit. Despite this framing there is nevertheless discretion within IFRS 9 which in practice could lead to lower levels of credit loss provisions, in particular when valuing collateral or third party guarantees for secured loans. Therefore, IFRS 9 cannot fully ensure that banks will ultimately create sufficient levels of credit loss provisions for non-performing loans. At the same time, it is important to recall that LLPs are not always estimated in accordance with the same accounting standards: in several EU countries some banks have to apply national GAAPs (instead of IFRS) which might follow a different approach. 2.3.3.Other drivers for insufficient loan provisioning (out of scope) As also pointed out by stakeholders in the context of the targeted consultation, a number of further factors, which are not addressed here, may influence banks’ provisioning policies. Large discrepancies exist, for instance, in the characteristics of national legal and judicial frameworks as regards collateral enforcement. Differences may emerge within countries, too: while civil law and procedures are formally the same across the national territory, the effectiveness of the court system may vary widely, depending upon local jurisdictional court proceedings. The Commission’s initiative on AECE identifies the associated problems and proposes solutions. National tax regimes can also play a decisive role for provisioning policies. In some countries, charge offs and/or losses as a result of higher provisions are not eligible (or are subject to a certain cap) as deductions for income tax purposes. 2.4.How will the problem evolve?

Without policy intervention, banks will still have incentives and ample discretion to excessively delay loss recognition and reduce provisioning levels. Historical evidence corroborates the argument that a “wait-and-see” approach is detrimental in the longer run. Experience suggests that ignoring banking problems in the interests of sustaining credit in the short run will, on average, lead to a more severe contraction of credit at a later stage. Whilst recovery in the real economy has already been followed by a reduction in NPL levels and ratios, the reduction of the stock of NPLs has been rather slow and the recovery, particularly in some of the high-NPL countries, remains fragile. As the linkages between growth and NPLs work in both directions, it is unclear whether growth would be able to overcome the adverse effects on the real economy caused by the large stock of NPLs. In the absence of action to address the problem of the high stock of existing NPLs together with prudential rules for the flow of new NPLs risks to financial stability may materialise. While the treatment of the existing stock and the new flow requires a different set of actions, the problem for financial stability and growth would evolve as accumulated effect of old and new NPL. Finally, through important cross-over spill-overs in a deeply integrated area like the EU and especially the EA the future NPL problems in one part of the banking sector can have negative impact on other parts of the system. The implementation of IFRS 9 is expected to lead to higher provisioning levels, but given, inter alia, its principle-based approach, it might not suffice to effectively prevent the build-up of insufficiently covered NPL stocks on EU banks’ balance sheets. Supervisory action, in particular the application of Pillar 2 measures, will help address specific NPL-related risks of individual banks. However, it might not prevent the build-up of insufficiently covered NPLs on an EU-wide basis as long as there no harmonised (minimum) treatment (being applicable across MSs and banks). When there is insufficient regulatory framing, banks might accordingly take a passive (“wait and see”) approach. Attempting to avoid or delay loss recognition, insufficiently provisioned NPLs would likely pile up on banks’ balance sheets, which in turn would undermine banks’ financial soundness and pose risks to financial stability at whole. This approach would also affect future lending, which could be granted under suboptimal lending standards, if the stock of NPLs does not imply significant costs for the bank when loans are non-performing. The same cycle could thus constantly be repeated over time to the detriment of financial stability, real economy financing and growth and the public sector might be called upon to support the banks when they are in difficulties.



Figure 12: Problem tree



3.Why should the EU act? 3.1.Legal basis Article 114 of the Treaty on the Functioning of the European Union (TFEU) confers the European Parliament and the Council the competence to adopt measures for the approximation of the provisions laid down by law, regulation or administrative action in Member States which have as their object the establishment and functioning of the internal market. Article 114 TFEU allows the EU to adopt measures (such as prudential requirements for institutions) that relate to the functioning of banking and financial services markets and are meant to ensure the financial stability of the operators on those markets as well as a high level of protection of investors and depositors. 3.2.Subsidiarity: Necessity and added value of EU action The previous section has shown that discretional (“too little and too late”) recognition of losses on NPLs ultimately has several negative effects on banks’ financial soundness and financial stability of the banking system as a whole. Some MSs have established concrete provisioning rules for banks' NPLs, while a few others have adopted provisioning guidelines (see Table 1). In those MSs, as well as several third countries, provisioning requirements played an important role in successfully dealing with both (aged) NPL stocks and (new) NPL flows (see detailed overview in Annex 4). Still, these rules are quite divergent – thereby hampering comparability of capital ratios – and do not cover the risks associated with under-provisioned NPLs comprehensively. Also, MSs have only limited scope to introduce generally applicable and legally binding provisioning requirements. The specification of IFRS, which are global standards and applied by the vast majority of larger banks, is ultimately in the competence of the IASB. On the prudential side again, MSs are not entitled to impose prudential minimum requirements (including with regards to NPLs), such as deductions from regulatory capital, which are directly applicable to credit institutions, as this area (so-called “Pillar 1” of the framework) is subject to maximum harmonisation throughout the internal market. MSs can therefore only regulate prudential provisioning for specialised institutions which are not subject to EU regulation. The current EU prudential framework however does not provide for a common minimum treatment with regards to incurred/expected losses on NPLs. As explained in the Background Information section, CAs in charge of supervising institutions in the EU have the power to influence a bank’s provisioning policy and to require specific adjustments to the own funds calculations on a case-by-case basis (so-called “Pillar 2” of the framework). The application of Pillar 2 measures will help address specific NPL-related risks of individual banks. However, no harmonised (minimum) treatment (being applicable across MSs and banks) can be imposed by supervisors. In absence of an EU regulation, it is therefore not possible to address the issue of under-provisioning of NPEs on an EU-wide and systemic basis. Table 1: Minimum provisioning requirements in EU28 (yes/no) Legislative action on the EU level would require all institutions established in the EU to cater for incurred and expected losses on newly originated loans that turn non-performing at a common prudential minimum level – irrespective of the applicable accounting standards and the location of the bank and its supervisor. Such minimum coverage requirements would act as “prudential backstops” putting automatic EU-wide brakes on the build-up of future NPLs without sufficient loan loss coverage and thus strengthen banks’ financial soundness and ability to lend. EU wide action would also reduce potential spill-over effects within the Union. As set out above (section 2.1.2) the high interconnectedness within the EU (and especially EA) financial system creates a significant danger of spill-overs entailing systemic risks which are better addressed at EU level. On this basis, the EU has a right to act to ensure the financial stability of financial market operators as well as a protecting investors and depositors in banks. Due to the lack of common prudential rules on NPL provisioning actual loss coverage for NPLs may vary across banks in different jurisdictions even if they bear the same underlying risk (defined as a function of the type, location, collateralisation, age etc. of the exposure). This may limit the cross-country comparability of capital ratios and undermine their reliability and thereby the single rulebook, a cornerstone of the Banking Union. Banks with the same risk profile and sharing the same currency would face different funding conditions depending on where they are located inside the EA. Furthermore, on the borrowers’ side, two companies with identical risk profiles and the same currency would face different lending conditions depending on their establishment in the EA. As shown in section 2.2.2, lending availability and costs of credit to non-financial corporates is more tightly related to the level of NPLs in a given MSs. This creates additional financial fragmentation that hampers one of the most important benefits of the financial and monetary union, namely, the diversification and sharing of economic risks across borders. Avoiding the accumulation of future NPLs would reduce those differences, hence contributing to the good functioning of monetary transmission mechanism and a more sustainable financial integration process in the EU. This would also contribute to the completion of the BU by putting all banks on an equal footing, reducing unnecessary differences in banks' practices, increasing comparability, facilitating market discipline and promoting market confidence.





4.Objectives: What is to be achieved? 4.1.General objectives 4.1.1.Reduce financial stability risks As discussed in section 2.2.1, high levels of insufficiently covered NPLs can become a serious threat to financial stability. The first general objective of this initiative is to limit these risks to financial stability by avoiding the build-up or excessive increase of insufficiently covered NPLs in the EU banking system. The risks to financial stability have also an important geographical dimension. While cross-border banking brings important stability and risk-sharing benefits, through its effects on risk diversification, it also strengthens channels of propagation of shocks from one jurisdiction to others. It is thus paramount to ensure that build-ups of under-provisioned NPLs are prevented to arise in any jurisdiction. Pockets of NPL risk represent in fact a risk for other jurisdiction via spill-overs. By introducing statutory backstops, this initiative aims at capping the levels of under-provisioned NPLs that can arise in EU MSs thereby ensuring that no new "pockets of NPL risks" with spill-over potential in stressed market conditions arise. 4.1.2.Support stable financing of the real economy and growth Banks saddled with NPLs tend to face higher funding costs and capital requirements and lower resource efficiency and profitability. This limits their ability to extend new credit. Persistently weak loan portfolios are thus a potential drag on financing firms, households and ultimately economic growth. Indeed, recoveries after financial crises are found to be particularly protracted because the economy faces a credit crunch due to impaired financial intermediation. The impaired credit supply clearly weighs on aggregate demand and investment. Hence, the second general objective of this initiative is to ensure institutions have sufficient loss coverage for NPLs, hence protecting their profitability, capital and funding costs in stressed times. This is particularly important in the EU where financial intermediation is still largely dominated by banking institutions. Coupled with deeper and stronger capital markets thanks to the CMU initiative, this should ensure that stable, less pro-cyclical financing is available to EU households and firms. It is worth noticing that more stable credit provision and higher growth increase debtors' wealth and ability to repay, thereby reducing the probability of a loan being defaulted and the expected losses in such cases while improving banks' balance sheets. In other words, higher growth reduces financial stability risks. Lower financial stability risks reduce funding costs for banks and the economy, thereby fostering economic growth. Hence, the two general objectives of this initiative are mutually reinforcing. 4.2.Specific objectives 4.2.1.Reduce ability to implement “wait and see” and “extend and pretend” strategies The initiative aims at reducing banks' discretion with regards to the recognition of and provisioning for NPLs (problem driver 2). Such discretion has indeed provided room for “wait and see” and “extend and pretend” strategies whose negative effects on banks profitability and, in severe cases, viability manifest itself during economic downturns. 4.2.2.Reduce incentives to implement “wait and see” and “extend and pretend” strategies By removing the possibility to postpone excessively the tackling of NPLs, based on, inter alia, optimistic expectations of future improvement in loans performance, the legislative intervention would incentivise bank management to act proactively and pre-emptively. In other words, knowing that NPLs need to be covered within a limited time frame would incentivise banks to start implementing NPLs resolution strategies even before these become mandatory (i.e. before the date when the minimum coverage requirement becomes applicable). In this way, the initiative will change banks conduct towards more forward-looking practises (i.e. tackling problem driver 1).



5.What are the available policy options? 5.1.What is the baseline from which options are assessed? The baseline for comparing policy options is the current state of play, with no further legislative change at EU level. Loss coverage for NPEs would mainly be determined by two already existing instruments (as explained in detail in the background information): -Application of either IFRS 9, which will better address the issue of delayed and inadequate provisions, or, where applicable, national GAAPs; and

-Supervisory action, in particular Pillar 2 measures allowing bank supervisors to require more provisioning within the limits of the applicable accounting standards on a case-by-case basis. The implementation of IFRS 9 is expected to lead to higher provisioning levels particularly for performing exposures (classified in Stage 1 and Stage 2), whereas for NPEs (classified in Stage 3), the new accounting standard will largely keep the same treatment as IAS 39 and is expected to lead only to a minor increase in provisions of around 5% on average (see section 6.). Given, inter alia, its principle-based approach for determining credit loss provisions (as opposed to non-discretionary rules), it might not suffice to effectively prevent the build-up of insufficiently covered NPL stocks on EU banks’ balance sheets. At the same time, in several EU countries some banks have to apply national GAAPs as their accounting standards (instead of IFRS) which might follow a different provisioning approach. Hence the accounting framework might not ensure that EU banks will ultimately create sufficient levels of credit loss provisions for NPLs. Existing and forthcoming supervisory guidance by the ECB/SSM and the EBA on NPE management will urge banks with elevated levels of NPEs to implement effective strategies for tackling those exposures and can thus be expected to help reduce (primarily the stock of) NPEs on affected banks’ balance sheets. Furthermore, the ECB/SSM will publish supervisory expectations when assessing a bank’s levels of loan loss coverage for new NPEs as part of the supervisory review and evaluation process in the context of Pillar 2. Where the supervisor including the ECB/SSM ascertains on a case-by-case basis that the provisioning policy chosen by the institution is not adequate or sufficiently prudent from a supervisory point of view, it may set binding supervisory measures. The application of Pillar 2 measures will help address specific NPL-related risks of individual banks. However, no harmonised (minimum) treatment (being applicable across MSs and banks) can be imposed by supervisors. In absence of an EU regulation, it is therefore not possible to address the issue of under-provisioning of NPEs on an EU-wide and systemic basis. 5.2.Description of the policy options 5.2.1. Common principles applying to all three options Statutory prudential backstops would influence banks' prudential figures. They would not have any direct impact on the banks' financial statements which would remain to be determined by accounting rules. Statutory prudential backstops would consist of two main elements: (i) a requirement for banks to cover up to common minimum levels the incurred and expected losses on newly originated loans once such loans become non-performing (“minimum coverage requirement”), and (ii) where the minimum coverage requirement is not met, a deduction of the difference between the level of the actual coverage and the minimum coverage from Common Equity Tier 1 (CET1) items. Different coverage requirements, depending on the classification of the NPLs as "unsecured" or "secured" are considered. NPLs or part of NPLs, covered by eligible credit protection as set out in the CRR are considered as secured. On the other hand, NPLs, or parts of NPLs, which are not covered by an eligible credit protection are categorised as unsecured. A loan only partly covered with collateral would be considered as secured for the covered part, and as unsecured for the part which is not covered with collateral. In principle, non-performing unsecured credit exposures and non-performing credit exposures secured by collateral could be treated in the exact same way. However, these types of exposures have different characteristics in terms of risk. Secured NPLs are in general less risky for a bank than unsecured NPLs as the credit protection securing the loan gives the lender a specific claim on an asset or against a third party without reducing his/her general claim against the defaulted borrower. On the contrary, in case an unsecured loan becomes non-performing the bank would not have such specific preferential claim. Recovery rates are on average higher for secured NPLs than for unsecured ones. However, it takes some additional time to enforce the credit protection and, where applicable, realise the collateral. Unsecured NPLs should therefore require higher and timelier minimum coverage by the creditor bank than secured NPLs. However, after a certain number of years without being successfully enforced (i.e. the collateral/guarantee could not be realised), the credit protection should not be seen as effective anymore. In such case, full coverage of the exposure amount of secured NPLs is deemed necessary. Therefore, the time period for unsecured NPLs is not the same than for secured ones. Given the considerations above, the minimum coverage requirement would be a function of: (i) the time period an exposure has been classified as non-performing – since the longer the exposure has been non-performing, the lower is the probability to recover its value; (ii) and, where available, the level of credit protection (collateral and guarantees) held for this NPL (applying the relevant eligibility criteria set out in the CRR for credit risk mitigation purposes) – since credit protection increases the probability to recover the exposures value. The chosen approach should ensure that the level of credit protection follows a prudent approach, in particular regarding assumptions pertaining to recoverability and enforceability. To ensure consistent outcomes across banks, a common methodology, including possible minimum requirements for re‐valuation in terms of timing and ad hoc methods, would have to be developed (e.g. by the EBA). In cases where institutions fail to perform prudent collateral valuation alongside the defined methodology or the valuation has not been updated on a timely basis, the whole exposure should be treated as unsecured from a prudential perspective. The following items would be eligible for compliance with the minimum coverage requirements: a) provisions recognised under the applicable accounting framework ("credit risk adjustments"), i.e. the amount of specific and general loan loss provision for credit risks that has been recognised in the financial statements of the institution; b) additional value adjustments for fair-valued assets; c) other own funds reductions. For instance, institutions have the possibility to apply higher deductions from their own funds than required by the regulation; and d) for banks calculating risk-weighted assets (RWAs) using the internal ratings‐based (IRB) approach, the regulatory expected loss shortfall which is already deducted from own funds. Only where the sum of the amounts listed under a) to d) does not suffice to meet the applicable minimum coverage requirement, the prudential backstops would apply. The difference between the two (uncovered exposure amount or “coverage gap”) from CET1 items would be deducted. The deduction would ensure that the risks associated with NPLs are appropriately reflected in banks' CET1 capital ratios in one way or another.

Figure 13: Main components and functioning of the statutory backstop proposal Source: European Commission, EBA Furthermore, the following common features would apply to all three policy options presented in the remainder of this section: ·Common definition: NPLs would be defined in CRR using the already existing definition established by the EBA for supervisory reporting. ·Pillar 1 deduction: the common backstop would be a Pillar 1 deduction (in case the minimum coverage requirement is not met), i.e. it will apply mandatorily to all banks before supervisors assess whether banks need to hold additional own funds for Pillar 2 purposes. The sequence would be to first apply the accounting provisions in accordance with the applicable accounting framework, then the statutory backstops and last a Pillar 2 requirement in case the supervisor sees a need to go further than the statutory backstops already require. ·Safeguards: the design of a prudential backstop should ensure that it does not lead to any "double-counting" of provisioning or risks. ·Time calibration: given that recovery times for secured and unsecured NPLs differ empirically, the time period after which full coverage for NPLs would be required should be different depending on whether the NPLs are secured or not. In case of unsecured NPLs, banks should fully cover them more quickly than secured NPLs. The FSC report suggests a time period of 2 years for unsecured NPLs after the classification of the exposure as non-performing. For secured NPLs, the proposed time period envisaged by the FSC report ranges from 6 to 8 years. §Time calibration for unsecured NPLs: According to some private stakeholders in their answer to the targeted consultation, imposing a full coverage of unsecured NPLs 2 years after their classification as non-performing would be overly conservative. In some cases institutions will fully recover unsecured loans after three or four years. These stakeholders have argued that it would be unduly strict to require full coverage for NPLs which have been forborne for a period beyond 2 years and where the counterparty meets its obligations. However, a time period of 2 years for unsecured NPLs appears to be justified for two main reasons: I)in a number of third countries requiring full provisioning or write-off of NPLs, non-performing exposures have to be fully provisioned and/or written off earlier than 2 years (see Figure 14 and Annex 4). In the EU, the length after which unsecured NPLs have to be fully provisioned or written-off (where such requirement exists) varies but evolves on average close to 2 years after the classification as non-performing (it is for instance 180 days in Romania and less than 2 years in Spain). Choosing a time period of 2 years before full coverage of unsecured NPLs would be in line with the current practices in- and outside the EU; II)under this option, any amount that has been deducted and which is finally recovered afterwards would be added back to the banks' CET1. In this way, there would be no undue provisioning of loans which are actually paid back. A time period of 2 years would also be in line with the FSC recommendations. All public stakeholders answering to the consultation support such time calibration. Furthermore, the ECB in its role as single supervisor of EA banks (ECB/SSM) considers a timeframe of maximum 2 years for a full provisioning of unsecured NPEs as a benchmark when assessing a bank’s provisioning policy. Figure 14: Provisioning requirements for unsecured NPLs and non-collateralised parts of secured NPLs (days of past due after which a 100% loan provisioning is required; excluding EA countries)

Note: For USA and Brasil data refer to write-offs. Write-offs after 180 dpd in US (only household loans), in Brazil, distressed loans are written off after 180 dpd. In Argentina, Chile, Colombia, Ecuador, Mexico and Peru, for the computation of loan loss provision the applicable regulations differentiate by type loans (Consumer, Commercial, Microcredit and Mortgage loans). For these countries, the figure above reports only the requirement for corporate loans. §Time calibration for secured NPLs: As far as the time calibration for secured NPLs provisioning is concerned, the consultation showed divided views. While private stakeholders held that 6-8 years as proposed by the FSC was overly conservative, public stakeholders support this timeframe. This timeframe seems also proportionate in view of the average foreclosure period which ranges from 3 to 5 years in the majority of EU MSs. Furthermore, the ECB/SSM considers a timeframe of maximum 7 years for a full provisioning of secured NPEs as a benchmark when assessing a bank’s provisioning policy. There are also solid (macro-)economic arguments to choose a time period between 6 and 8 years. Literature on the length of economic downturns caused by financial crises suggests that economic conditions such as GDP growth, unemployment levels and debt increases reach the peak of distress around 5 years after the onset of a crisis. The following recovery to pre-crisis levels takes on average 3 more years. In order to avoid pro-cyclical effects by forcing banks to provision during the depth of the crisis, full provisioning of the secured part should therefore not be triggered before 6 to 8 years after a secured loan is identified as non-performing. Furthermore, the introduction of automatic backstops has the effect of mitigating pro-cyclicality of credit provision by reducing discretion in the application of NPLs recognition and provisioning. In this way, it prevents the emergence of "outlier institutions", i.e. banks whose NPLs levels grow to a level which is endangering their solvency and impairing their ability to provide credit. These institutions' problems typically become manifest in stressed times which leads to further declines in credit provisioning, growth and employment. In its response to the Commission's call for advice the EBA analysed the differences in terms of impact of a full coverage requirement for secured NPLs after 6, 7 or 8 years (for an overview of the methodology and caveats applied see section 6). As expected, the cumulative impact is decreasing with the years by when the full coverage is required for secured NPEs, i.e. the overall cumulative impact is lowest for the 8 yeas calibration. The difference between the three calibration is however small and in the region of 10 basis points (bps). For all these reasons the starting point for the design of all policy options would be: (i) full coverage of unsecured NPLs after 2 years, and (ii) full coverage of secured NPLs after 6 to 8 years. The following three policy options to tackle under-provisioned NPLs are considered in the remainder of this section: I)Option 1: full coverage of unsecured and secured NPLs at the end of defined time periods without any coverage requirement beforehand; II)Option 2: gradual coverage requirement starting after the classification as non-performing and leading to a full coverage of unsecured and secured NPLs at the end of defined time periods; III)Option 3: for secured NPLs, application of haircuts depending on the type of collateral (unsecured NPLs would be treated as under Option 1 or 2). 5.2.2. Option 1: Statutory backstop with end-of-period full coverage requirement As explained under section 5.2.1., statutory prudential backstops would consist of two main elements: (i) a minimum coverage requirement for banks to be compared to the actual coverage by the bank; and (ii) where the minimum coverage requirement is not met, a deduction of the difference between the level of the actual coverage and the minimum coverage (i.e. the uncovered exposure amount) from Common Equity Tier 1 (CET1) items. For both secured and unsecured NPLs, it is proposed under Option 1 that their full coverage would be required at the end of a defined time period, without any gradual requirement beforehand (and therefore no required deduction before the end of the period). As explained in section 5.2.1. above, it is justified to apply a shorter period to unsecured NPLs, as RR are significantly lower compared to secured loans. Therefore the envisaged time period and deduction mechanism are different for both types. Full coverage of unsecured NPLs: International comparison and experience gained in jurisdictions in- and outside the EU suggest that institutions could be required to fully cover their unsecured (parts of) NPLs two years after the identification of the loan as non-performing. This means that, where the minimum coverage requirement is not met and the backstops apply, institutions would have to deduct from their CET1 items the uncovered exposure amount of unsecured (parts of) NPLs. The uncovered exposure amount would be the accounting value remaining after specific credit risk adjustments, additional value adjustments, other own funds reductions and deduction of the regulatory expected loss shortfall related to the exposure (i.e. items a) to d) listed in Figure 13 above). It will ensure full prudential loss coverage of unsecured NPLs. Full coverage of secured NPLs: For secured NPLs, the approach would be based on an assessment whether the collateral securing the loan can be realised in a timely manner. Where the collateral/guarantee has not been realised within a defined time period (following the classification of the underlying exposure as non-performing), the credit protection should be considered ineffective from a prudential perspective. By consequence, the exposure would be treated as unsecured for the purposes of the backstops, irrespective of the collateral valuation. Institutions would therefore be required to fully cover the exposure amount after the defined time period for unsecured NPLs elapsed: in case the minimum coverage requirement is not met, institutions would have to deduct from their CET1 items the difference between the amount covered by the provisions, additional value adjustments, other own funds reductions, regulatory expected loss shortfall and additional deductions (see items a) to d) listed above in Figure 13) on the one hand, and the minimum coverage requirement on the other hand. The requirement to have a full coverage for secured NPLs could apply at the end of the defined time period. 5.2.3. Option 2: Statutory backstop with gradual full coverage requirement

Option 2 would be the same as Option 1 with the following modifications. On the one hand, abrupt and potentially harmful cliff-effects should be avoided and potentially pro-cyclical effects should be limited. On the other hand some time for viable forbearance and possible recoveries (in particular in case of collateral held for NPEs) should be given before the requirements effectively bite. To achieve both goals, a gradually increasing scaling factor would be applied to the minimum coverage requirements. Banks would have to follow a gradual path towards the required coverage level with the effect that banks would have to anticipate the requirement, which under Option 1 would be applicable only at the end of the time period. Under option 2, either a linear or a progressive path could be applied. In case of a linear path, the minimum coverage level would equally increase over the years during the different time periods set for unsecured NPLs and secured NPLs. In case of a progressive path, the amount to be covered each year would be lower at the beginning of the time period and would increase over time. Progressively phased in minimum coverage levels would reflect the observation that loan recoveries in most cases happen during the first years after its classification as non-performing, especially for secured NPLs. The same applies for viable forbearance measures. A progressive path would therefore be better aligned with the observed recovery practices. Institutions would have 2 years to fully cover unsecured NPLs and 6 to 8 years until full coverage of the gross exposure amount of secured NPLs has to be reached. In such a scenario, coverage levels could for instance be set as shown in Table 2: full coverage requirement is reached in two years for unsecured NPLs and in 8 years for secured NPLs; for both it follows either an end-of-period (no scalar), linear or progressive path. Table 2: Illustration for minimum coverage levels for unsecured and secured (parts of) NPLs applying no scalar (Option 1), a linear one or a progressive one (Option 2) Vintage Unsecured (parts of) NPLs Secured (parts of) NPLs No scalar Progressive Linear No scalar Progressive Linear Min coverage after 1y 0% 35% 50% 0% 5% 12,5% Min coverage after 2y 100% 100% 100% 0% 10% 25% Min coverage after 3y 0% 17,5% 37,5% Min coverage after 4y 0% 27,5% 50% Min coverage after 5y 0% 40% 62,5% Min coverage after 6y 0% 55% 75% Min coverage after 7y 0%/35%*/50%** 75% 87,5% Min coverage after 8y 100% 100% 100% Notes: * If a progressive scalar for unsecured (parts of) NPLs was applied (as secured NPEs would be considered as unsecured after 6 years); ** If a linear scalar for unsecured (parts of) NPLs was applied (as secured NPEs would be considered as unsecured after 6 years). Figure 15 visualises the different paths of the minimum coverage requirement under the end-of-period deduction (Option 1) and the gradual deduction (option 2) for secured exposures reaching 100% coverage after 8 years. Figure 15: Different paths of the minimum coverage requirement in the end-of-period deduction (option 1) and gradual deduction (option 2) approach (secured exposures) reaching 100% after 8 years Source: EBA (2018) 5.2.4. Option 3: Statutory backstop with prudential haircuts Option 3 is only considered for secured NPLs, as this approach is based on the value of the collateral or guarantee. The treatment of unsecured NPLs would remain the same as under Options 1 or 2 (end-of-period or gradual coverage level requirement).

For secured NPLs, the method to determine the amount to be deducted would be more risk-sensitive than under Options 1 and 2. At the same time, option 3 would allow to address risks associated with the effectiveness of credit protection for NPLs in a more targeted way. In a first step, specific minimum levels of prudential haircuts on the collateral/guarantee values (as determined in accordance with the applicable accounting standards and prudential requirements) of a secured loan would be applied. More specifically, the magnitude of the applicable haircut would depend on the form of the credit protection and the actual length of time to its realisation. Forms of credit protection for which credit assessments by a recognised ECAI are available, operate in liquid markets and show well-established, publicly available and sufficiently stable market prices would be subject to relatively lower initial haircut levels. In a second step, the level of haircuts would gradually increase with every subsequent year starting from the second year after the classification as non-performing. The longer the realisation of collateral takes, the more additional haircuts would apply. It will thereby reflect the increasing uncertainty as to the ultimate recovery values , accumulating maintenance costs and discounting. Table 3 sets out possible minimum haircut levels for selected forms of collateral (including a concrete example for commercial real estate) based on international practice for a time period of 6 years. The haircuts increase over time, therefore increasing the minimum coverage level requirement. Table 3: Possible minimum haircut levels for selected forms of collateral over time Form of Credit Protection Initial Haircut Level Additional Haircut per year to realisation Applicable Haircut after 8 years Financial collateral 20%-40% 5-15% 60%-100% Immovable property (e.g. Commercial RE) 30%-60% (40%) 5-20% (7,5%) 70%-100% (40%+5*7.5%=100%) Other collateral 40%-50% 5-20% 80%-100% 5.3 Discarded option: granting binding accounting powers to supervisors In the current EU rules, supervisors do not have binding accounting powers or a mandate to adopt binding accounting regulations. The power is provided to national jurisdictions for national GAAPs in the context of the implementation of the Accounting Directive (Directive 2013/34/EU). With the exception of one MS (Spain), accounting powers are not granted banking supervisors. According to the SSM Regulation, also the ECB as competent authority for the EA does not have such powers, and is not entitled to change institutions' financial statements. At EU level, it is the European Securities and Markets Authority (ESMA) which is responsible for promoting a consistent application of IFRS and coordinating national regulators’ enforcement practices. Under this option, EU legislation would give regulatory and horizontal accounting powers to supervisors, both to adopt accounting texts and to enforce them. Competent authorities would be empowered to set stricter standards and require higher provisioning of NPLs in the financial statements, and, consequently, in the prudential reporting. National supervisors would be able to address all banks in their jurisdiction, and not only be able to act on a case-by-case basis. This option would entail a very significant change to the current European framework and go much beyond the scope of solely tackling the NPLs issue. Accounting powers would encompass other aspects than NPLs provisioning; assessing potential unintended consequences to grant such powers to supervisors would require a much broader reflection outside the mandate of this impact assessment. Granting new accounting powers to supervisors would be highly challenging in terms of human and financial resources (recruitment and training). It would also imply modifications of the SSM Regulation, which would be politically and legally challenging, or to leave the competencies to national authorities. In such case, it would not only increase the complexity of the institutional framework but also fail to harmonize the treatment of NPLs within the EU; NPLs provisioning would be tackled through statutory measures across institutions, but would remain country-specific. Besides, financial statements are used for other purposes than prudential reporting. Market participants assessed them for investments purposes, or economic analysis. They are also the basis to determine the fiscal result. Any direct modification to the financial statements would have to be duly justified in regards of all aspects beyond prudential matters. More generally, accounting standards have different objectives than banking regulation. They apply to all kind of companies, and mainly aim to present a faithful, transparent and neutral picture of financial performance and financial position at a certain reporting date. Contrary to the banking rules, accounting standards do not have an objective of financial stability over the cycle and are not inherently risk-based. Amending the accounting framework in the pursuit of prudential objectives might have undesirable effects and would lead to undue complexity for all stakeholders. Moreover, IFRS were adopted to improve the efficiency of the single European capital market. Supervisory induced modifications to IFRS would impede comparability and defeat the purpose of the single capital market where banks compete with other types of entities. Therefore, the option to grant supervisors direct accounting powers has been discarded.



6.What are the impacts of the policy options? Benefits and costs of the three proposed options are assessed under this section. They are compared with the baseline scenario and in respect of their effectiveness in terms of the objectives set out in section 4. Thereby, two specific objectives to i) reduce ability to implement “wait and see” and “extend and pretend” strategies and ii) to remove incentives to "wait and see" and "extend and pretend" strategies will be assessed against the background of the general objectives to i) reduce financial stability risks, and ii) support stable financing of the real economy and growth. Other considerations will also be taken into account, such as the rel