FINANCE, RISK and regulation

“Back to basics” to enhance core banking processes

Max Malonukhin (Senior Consultant) and Thibault Thomas (Senior Manager) from Avantage Reply Luxembourg. (Photo: Avantage Reply Luxembourg)

Max Malonukhin (Senior Consultant) and Thibault Thomas (Senior Manager) from Avantage Reply Luxembourg. (Photo: Avantage Reply Luxembourg)

“School is back in session!” and as pupils go back to study their core subjects, the bankers will have to do their own studying of the 2020 EBA Guidelines on Loan Origination and Monitoring. These guidelines bring a number of far-reaching requirements to the age-old process of credit granting.

What is it about?

“Lending money” is as ancient as civilisation itself. Back in ancient Greece and Rome, pawnbrokers lent against the collateral from borrowers to reduce lender’s credit risk. This fundamental idea has remained unchanged ever since. What has changed is the demand for and accessibility of such loans to everyday consumers. Banks today must assess both the collateral and the creditworthiness of prospective borrowers. However, such activities differ greatly among banks in their sophistication, granularity and standardisation. Such divergences can lead to gaps in prudent credit-granting processes, as seen from the events leading up to the 2007-2009 financial crisis and the levels of non-performing loans seen in Europe post-crisis.

To tackle this issue, the European Banking Authority (EBA) developed and published detailed guidelines for banks on loan origination and monitoring (EBA/GL/2020/06). The main idea is to improve loan-granting practices by putting in place robust and prudent credit-granting standards. Published in May 2020, the guidelines bring together the prudential framework and consumer protection aspects of credit origination, while providing around 250 new regulatory requirements that banks need to implement. In particular, the guidelines:

1.     Further clarify and improve the internal governance and control framework for credit-granting

2.     Provide general and specific requirements for creditworthiness assessment of borrowers (incl. lending to consumers and micro- to large-sized enterprises)

3.     Outline minimum regulatory expectations for how banks should price their loans

4.     Present approaches to the (re-)valuation of immovable and movable properties

5.     Specify the ongoing monitoring arrangements to be put in place for loans

Originally, the date of application was set to 30 June 2020, but in light of the COVID-19 pandemic, the EBA postponed the application by a year. Additionally, the final paper introduced some transitional provisions for specific requirements to help banks remediate the COVID-19 impacts before implementing them.

Will this impact banks based in Luxembourg?

In short, yes. The question is not “will it?”, but more importantly “when and to what extent?” Considering the application timeline, some aspects (i.e. monitoring of existing loans) will not be fully in force until 30 June 2024. This is due to new granular data requirements, which banks may not have available and will therefore need time to collect. However, the biggest aspects, such as governance and loan origination procedures (approx. 70% of total requirements) will come into force on 30 June 2021. These aspects alone will require banks to take a very close look at their internal processes and procedures across their three lines of defence to answer the following questions:

·      What are the responsibilities of the management body in relation to the credit-granting process and are they aligned with the minimum standards?

·      Are all of credit risk appetite, strategy and risk limits in alignment across the institution?

·      Are policies and procedures detailed and specific enough to address the needs of different sectors and clients? Do policies and procedures consider the principles of responsible lending and consumer protection?

·      Do we put enough emphasis on the borrower’s realistic and sustainable future income and cash flows rather than focusing on collateral?

·      Are our (re-)valuation practices for immovable/movable properties in line with regulatory expectations?

·      Are our practices in assessing creditworthiness of consumers and small- to medium-sized enterprises (SMEs) in line with best market practices?

·      How are the Environmental, Social and Governance (ESG) factors incorporated into credit-granting processes? How can we demonstrate it to the Commission de Surveillance du Secteur Financier (CSSF)?

·      Does current data infrastructure allow the institution to conduct ongoing data collection and monitoring of borrowers?

·      At what frequency and at how thoroughly should we monitor and revaluate the bank’s exposure to credit risk?

These fundamental activities (i.e. borrower and collateral assessment) have evolved and become more sophisticated in nature. However, up until now, focus was on satisfying clients’ ever-changing expectations while doing it across a more diverse pool of borrowers. Somewhere along the way, due to the prevailing economic environment and/or newly developed business models (i.e. originate-to-distribute), banks “forgot” the importance of the prudent credit-granting framework. As a result, banks granted credit to “less than ideal” clients (i.e. subprime), which led to the Great Recession of 2007-2009. These newly released guidelines call on banks to revisit their loan origination practices. Starting from governance and all the way to how banks assess, grant and monitor their loans, these guidelines go “back to basics” of their core banking activities.

More information about Avantage Reply Luxembourg here.