“Every year [in the last few years] we had a turning point…. now, we have interest rates, which are skyrocketing and the issue on the real estate [market] that we need to appraise and prepare for the future,” said Dorian Rigaud, partner and banking and capital markets leader at EY, during the “Banking sector performance and priorities” presentation on 29 November 2023 at EY’s office in Kirchberg.
According to Ken Mark Agustin, senior manager at EY, the developments of inflation, interest rates and energy prices in the first half of 2022 had a significant impact on the cost of risk in the second half of that year, which reached 35bps for the full year compared to 29bps in 1H22, a level in line with 1H23 at 28bps. ”Since the economy has been stabilising in the first half of 2023, then the cost of risk is expected to be at least contained [in the second half of 2023].”
Importantly, Agustin noted that stage 3, or non-performing loans, declined to 2.4% in 1H2023 against a level of 3.0 % in 2019. The contributing factors were: no “significant default in the portfolios, especially in Luxembourg;” sales of NPL portfolios to “reduce leverage;” and an overall increase of the loan portfolios. Further, Rigaud suggested that the expected number of upcoming real estate European long-term investment fund (Eltif) launches may be a recipient of NPL portfolios.
More evidence of stabilisation of the economy
EY also looked at stage 2 loans (S2) carving out the effects of stage 3 loans. Agustin defined the stage 2 loans as “not yet defaulted but exhibiting a significant increase in credit risk…. and they kind of tracked the level of uncertainty and outlook in the market.”
Agustin observed that S2 loans rose to “more than 11%” in 2020, up from below 8% in 2019 on the back of covid. It declined to 10% in 2021 thanks to government measures. Russia’s war in Ukraine, the uncertainties around interest rates and inflation and the associated higher risk of default contributed to a rise of S2 going back up to 11% in 2022 on average. Not surprisingly, the “stabilising” economy has brought back the level to around 10% in 2023.
Large discrepancies on ECL and overlays assessments
“ECB always looks at S2 progression…as well as coverage,” said Rigaud. “My message is don’t put too much in S2… if you’re not going to impair them, because in the end, you will be challenged on the developing impairment.”
[French banks] are using overlays to make sure they’re not too far beyond or in front of the [other] banks.
As S2 does fully capture the economic risks outlined above, Agustin explained that European banks may make use of overlays, which are an “additional amount on top of the allowance” produced by their ECL (expected credit loss) models covering the underlying risk of the portfolio. He noted that that the overlays level was at a still high 23% in 1H23 compared to 35% at the peak of covid.
Agustin considers a level above 20% as “significant,” given that regulators expect “that reliance on overlays should be reduced over time, because ECL models should be calibrated to capture this risk.”
He pointed out during the presentation that the overlays contribution for some Italian banks can be quite large, while the variability is also significant from one bank to the other as banks “have different ways to apply overlays, because it’s not clearly defined.” Agustin reported that the European Central Bank observed a level ranging from “zero to a 70% contribution of overlays into the coverage ratio.”
Interestingly, Rigaud noticed that the management of some French banks “are using overlays to make sure they’re not too far beyond or in front of the [other] banks.” It then offsets the variability on the outcome of their respective ECL models.
Agustin noted that the “environment risk factor” is the single most important component that is not captured by the IFRS 9 ECL model, as per the ECB. The study noted that the overlays are applied at the ECL, PD (probability of default) or LGD (loss given default) or a combination of those factors.
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .