Adequately managing the NPL ratio requires understanding the Credit Life Cycle
Banks are required to treat clients fairly and commit to social responsibility, while still aiming to keep a low NPL ratio. To manage this balance, understanding the credit-life cycle (CLC) of a loan is key. This article provides understanding of the CLC and guidance on its main attention points, such that you can adequately manage the NPL ratio.
The CLC is simple to understand, but difficult to manage. The NPL ratio has been decreasing since 2014 (6.7%) – the first available date in the EBA interactive tool. Since the initiation of the European Union (EU) “Action plan” to tackle the Non-performing loans (NPL) ratio, the average NPL ratio in the EU further decreased from 4.4% to 1.8% in Q4 2022 (refer to EBA dashboard). The EBA warns for lower credit quality due to higher interest rates, persisting inflation and macroeconomic uncertainty. Hence, the EBA 2023 Work Programme prioritizes the need to continue its focus on the management of NPLs and the NPL ratio.
Figure 1 – EU NPL ratio since the introduction of the EU action plan (2017). Data from EBA interactive tool 2022Q4.
Adequately managing the NPL ratio requires understanding the CLC of loans. For example, incorrectly and/or incompletely identifying the risks, leads to a sub-optimal risk appetite. Furthermore, a weak EWS framework does not help to early identify counterparties in financial difficulty, resulting in more counterparties becoming non-performing and consequently increasing the NPL ratio. Proper understanding and management of the CLC prevents loans becoming NPL and therewith supports the low NPL ratio.
The four stages of the CLC
The CLC refers to the various stages that a loan goes through, from the time it is originated to the time it is repaid. The cycle consists of the following four stages: risk strategy, origination, monitoring, and administration. This CLC is summarized in the figure below.
Risk strategy
The risk strategy is closely related to the business strategy, compliant with regulation, and concerns how credit providers identify, capture and manage existing and emerging risks. The risk strategy involves the long-term strategic vision and is commonly only mildly adjusted on an annual basis.
Generally, the credit provider first identifies all material risks. Then, the credit provider determines which risk drivers are involved and to what extent. Subsequently, the risk is quantified by translating the risk drivers into risk parameters. The credit provider builds models to measure the severity and likelihood of each risk factor. At last, the credit provider defines its risk appetite and sets warning limits, thresholds and stop limits, including remediation actions.
Origination
Given the risk strategy, the credit provider specifies the loan origination process and defines the credit granting criteria. Proper origination processes can reduce the NPLs. Typically, the credit provider determines the credit risk of the counterparty and applicable product pricing based on four areas:
- Investment criteria: The credit request details are checked against the investment criteria. Credit providers typically have criteria based on loan amount and loan maturities. Furthermore, specific investment criteria for consumers could include the source of repayment capacity, regular expenses and income. Investment criteria to businesses is more focused on financial ratios, EBITDA and equity levels.
- Counterparty information: The counterparty is expected to provide various details such as the purpose of the loan. Furthermore, specific counterparty information for consumers could, amongst others, consist of employment status, evidence of identity and household composition. For businesses, the focus is on company structure, governance, financial reports, business plan and financial projections. Additionally, credit providers consult external scores, when available.
- Risk mitigating factors: The loan application could contain structures that lower the credit risk of the loan. The counterparty could offer (real estate) collateral or a third party guarantee can be offered. The credit provider and counterparty can also agree on (a set of) conditions and (financial) covenants. Finally, the subordination could impact the credit risk.
- Pricing: The appropriate pricing, and consequent profitability, of the loan is an important component of the origination process. Pricing should be such that 1) the associated risks and costs (credit risk, capital costs, funding costs, operational costs, etc.) are incorporated, 2) a potential profit margin is realized and 3) the periodic loan payments are feasible for the counterparty.
Next to the financial credit granting criteria, credit providers perform various financial economic crime checks, for example related to anti-money laundering, terrorism financing and fraud.
Monitoring
Monitoring involves both performance and risk. For the former, the credit provider monitors whether the profitability measures of the loan evolve according to expectations. For the latter, the credit provider monitors the risks on both loan and portfolio level. The loan analysis focuses on identifying the risks of individual loans. For larger exposures and counterparties, the financial situation of the counterparty is regularly reviewed and revised, if necessary.
The portfolio analysis assesses whether the warning limits, thresholds or stop limits of the risk appetite are breached. If so, remedial actions are initiated. Furthermore, the credit provider monitors the default rates (per industry, country), revalues the credit risk mitigants and recalculates the required capital and best-estimate provisioning.
By identifying potential financial difficulty of the counterparty at an early stage using so-called early warning signals (EWS), credit providers can reduce the impact and number of NPLs. Many arrears can be prevented when the credit provider is involved with the counterparty at an early stage of adverse situations, and help both the counterparty and credit provider in preventing losses.
Administration
The loan administration and payment framework involves the ongoing management of the loan after it has been originated and disbursed. This stage involves the collection of loan payments, the management of the counterparty’s account, collateral and guarantee management, covenants, and tracking of ongoing forbearance measures.
By identifying potential financial difficulty of the counterparty at an early stage using early warning signals, credit providers can reduce the impact and number of NPLs
Main attention points in the CLC
The following stages in the CLC are key for a bank to differentiate itself from competitors, be compliant with regulations and manage the NPL ratio:
- Risk identification and appetite: The credit provider’s risk appetite requires the identification of the relevant risks in the strategy and the portfolios. The risks range from credit risk and market risk to operational risk. To define an appropriate risk appetite, one should take into account the current and future portfolio composition, including growth ambition and funding plans, and the desired capital position.
- Origination: The publication of the guidelines on loan origination and monitoring (EBA/GL/2020/06) describe stringent requirements for loan origination.
- Data-driven: Credit providers aim to provide retail loans within a day using automatic and data-driven credit origination. Credit providers must still ensure that a proper risk assessment is performed using data of high quality – such that the origination remains within the risk appetite and financial economic crime is prevented.
- Regulatory compliance: Credit providers must prove that their origination practices comply with regulatory guidelines. They must consider all of the suggested credit granting criteria and substantiate the final criteria for origination. Furthermore, lending to businesses must be substantiated with a review of the counterparty’s business plans and financial projections. This is particularly challenging for smaller (e.g. SME) counterparties, and therefore, credit providers may apply different loan origination requirements based on the size, nature and complexity of the counterparty under the principle of proportionality to address these regulatory requirements.
- Acceptance/pricing models: The creditworthiness of counterparties and the pricing are determined using acceptance/pricing models. These models should be consistent with the other models used by the credit provider (e.g. for capital and/or provisioning). The models are built using quantitative analyses and must be updated on a regular basis.
- Third party origination: In the search for yield and market share, credit providers are using third-party platforms for credit origination. The regulator requires credit providers to be fully in control of the outsourced origination activities. This implies that the third-party origination should comply with the credit provider’s origination policy.
- Early Warning Signals: EWS are used to identify counterparties that may get into financial difficulties. These counterparties are placed on the Watch List, intensifying the monitoring process and client communication, in many cases preventing arrears and losses. The challenge is to build proper EWS models, driven by qualitative input from the account manager, to machine learning models, based on transactional data.
- Monitoring framework: The monitoring framework should capture all important KPIs for the credit provider’s decision makers and must comply with the rules set in regulation. The monitoring framework must be concise but complete and come with clear dashboards and management reports. Furthermore, warning and stop limits and remediation actions must be defined for most KPIs. Credit providers must be fully compliant to the guidelines on loan origination and monitoring per 30 June 2024, also for the loans originated before 30 June 2021. The loans originated after 30 June 2021 should already comply to the guidelines since 30 June 2021.
To maintain low NPL ratios requires that each step of the CLC is fully understood, properly implemented and closely connected with each other
To conclude
Since the introduction of the EU action plan and EBA’s enhanced loan origination and monitoring, the NPL ratio has been steadily decreasing. To maintain these low NPL ratios – or at least remain in line with the risk appetite – requires that each step of the CLC is fully understood, properly implemented and closely connected with each other. Consequently, all attention points mentioned above must be adequately addressed.
What can Zanders offer?
Zanders is well-experienced in all steps in the CLC, and can support the credit provider on all attention points described above. Zanders has supported various clients in defining their risk appetite, including the risk identification, and provides support on many quantitative challenges – including (acceptance/pricing, capital and provisioning) model development and validation, and data analyses (for EWS) – and qualitative topics, including policy development and checks on compliancy (of third parties) to internal and external policies.
If you would like to hear more on this topic, please reach out to Jimmy Tang or Wouter Moeijes via +31 88 991 0200.
