How should banking supervisors handle COVID-19 crisis?

By | August 20, 2020

Supervisory authorities have generally reacted swiftly to the COVID-19 pandemic, deploying support measures such as debt repayment postponement, stimulus packages, and credit guarantees. In some jurisdictions, supervisory authorities also provided capital, liquidity and operational relief to banks. So far, these measures have helped mitigate some of the short-term financial stability risks. However, in many countries, the crisis continues to put banks under increasingly severe strain, posing unprecedented and profound challenges to banking regulators and supervisors as they brace for a wave of borrower defaults.

Accordingly, supra-national regulatory bodies such as the Basel Committee on Banking Supervision (BCBS), the International Monetary Fund (IMF), the World Bank, the European Central Bank (ECB) and the European Bankıng Authorıty (EBA) continue to issue guidance on how banking supervisors should handle COVID-19 crisis. These authorities generally expect national supervisors to use a flexible approach on a temporary basis throughout the crisis while upholding minimum prudential standards.

The BCBS’ regulatory and supervisory stance

At the onset of the COVID-19 pandemic, the BCBS supported the ability of supervisory authorities to be flexible in undertaking measures, and it subsequently published a set of measures providing banks and supervisors additional flexibility and capacity to respond to the impact of COVID-19.

The BCBS  subsequently decided that the pandemic has entered a new phase which requires the use of capital resources to support the real economy and absorb losses through a measured drawdown of banks’ Basel III buffers. Accordingly, supervisors are expected to act flexibly, giving banks sufficient time to restore buffers and taking account of economic conditions and bank-specific circumstances.

The IMF’s views on the appropriate regulatory and supervisory response

The IMF also published its views on the appropriate regulatory and supervisory response to deal with the impact of the pandemic. It explained that first, banks’ existing capital buffers should be used to absorb the immediate impact of the crisis, but in cases where the impact is longer lasting and banks’ capital adequacy is compromised, supervisors should take targeted actions. Supervisors could, for instance, ask banks to submit a credible capital restoration plan and monitor its execution.

The IMF emphasised that supervisors should adopt a flexible approach. For instance, it asserts that supervisors should be flexible with existing rules while addressing the impact of market volatility on banks’ earnings and capital. It also suggests that supervisory authorities temporarily reconsider automatic triggers of corrective measures in favor of discretionary, risk-based approaches. Similarly, regarding restructured loans, the IMF explained that supervisors should use the flexibility embedded in the regulatory framework.

Joint IMF-World Bank recommendations

The IMF and World Bank published joint recommendations, calling for supervisory authorities to exercise vigilance regarding policy measures that are not consistent with international standards. Drawing from insights of joint IMF-World Bank Financial Sector Assessment Program, the recommendations encourage supervisors to use the flexibility in the framework, while upholding minimum standards.

Furthermore, the recommendations particularly seek to ensure that the key prudential indicators of the banking system are transparently maintained and supervised. For instance, regarding asset classification and provisioning, they urge supervisory authorities to refrain from relaxing the regulatory definition and measurement of nonperforming exposures, capital, liquidity, and asset quality.

The IMF and World Bank argue that vital signs may be missed if part of the loan portfolio is structurally impacted and performance weakens. This particularly applies to jurisdictions where regulators have either frozen the asset classification status and provisioning requirements for loans or changed the definition of non-performing loans by extending the number of past due days.

Measures introduced in the European Union

The ECB has introduced supervisory flexibility regarding the treatment of non-performing loans (NPLs), in particular to allow banks to fully benefit from the various COVID-related guarantees and moratoriums put in place by public authorities. This includes relief from classification requirements and expectations on loss provisioning of NPLs.

The EBA has also provided guidance to the EU banking sector on how to handle classification of loans in default, identification of forborne exposures, and accounting treatment with respect to credit risk under the International Financial Reporting Standard (IFRS 9) framework. The EBA encourages supervisors to fully apply the flexibility embedded in the accounting and regulatory frameworks, particularly with respect to loss provisioning of NPLs which are under public guarantees. The EBA expects supervisors to subject these loans to preferential prudential treatment, as well as exercise flexibilities regarding loans under COVID-19 related public moratoriums and regarding the classification of debtors as “unlikely to pay” when banks call on public guarantees.

On the other hand, in the United Kingdom, the Prudential Regulation Authority expects banks not to automatically classify deferred loans as higher risk or impaired, which would have forced them to book higher loss provisions and reduce their capacity to lend. Instead, it requires banks to use various other indicators to determine whether risk of default has really increased.

Conclusion

The COVID-19 crisis confronts banking supervisors with unprecedented challenges in ensuring that banking systems support the real economy while preserving financial stability. To navigate these uncharted waters they should follow international standards and policy measures introduced by supra-national regulatory bodies. These authorities generally agree that national supervisors should employ the embedded flexibility of regulatory, supervisory, and accounting frameworks while upholding internationally agreed minimum regulatory standards and supervisory principles. In particular, banking supervisors should take action to ensure that banks continue to monitor their asset quality using global standards and build adequate provisions over time.

 

Mete Feridun is a Professor of Finance at Eastern Mediterranean University and formerly a regulatory risk and strategy consultant at PwC UK, as well as a senior regulator at the Prudential Regulation Authority, Bank of England and the Financial Conduct Authority in the UK.

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