NPE governance and operations
In order for credit institutions to be able to address their NPE issues in an efficient and sustainable manner, an appropriate governance structure and operational set-up should be in place.
This section sets out the key elements of governance and operations in relation to an NPE workout framework, covering aspects related to steering and decision-making, the NPE operating model, the internal control framework and NPE monitoring processes.
In the implementation of their NPE governance and operations, credit institutions should take into account relevant consumer protection considerations and requirements, and ensure fair treatment of consumers.
5.1Steering and decision-making
The overarching strategy of a credit institution and its implementation should cover the NPE strategy and operational plan, which should therefore be set, approved and reviewed by the management body. In particular, the management body should:
a) approve annually and regularly review the NPE strategy and operational plan in line with the overall risk strategy;
b) oversee the implementation of the NPE strategy;
c) define quantitative and qualitative management objectives and incentives for NPE workout activities;
d) monitor on a quarterly basis progress made in comparison with the targets defined in the NPE strategy and operational plan;
e) define adequate approval processes for NPE workout decisions (for large NPEs, these should involve the approval of the management body);
f) approve NPE-related policies (including those listed in Annex 4) and processes, review them at least annually and proceed with any necessary amendments, ensuring that the policies and processes are completely understood by the staff;
g) ensure sufficient internal controls on NPE management processes, with a special focus on activities linked to NPE classifications, impairments, write-offs, collateral valuations and the sustainability of forbearance solutions;
h) have sufficient knowledge, experience and expertise with regard to the management of NPEs.
The management body and senior management should dedicate an amount of their capacity and devote sufficient time to NPE workout-related matters in line with Article 76 of Directive 2013/36/EU, in proportion to the risks connected to NPEs within the credit institution. Credit institutions should establish and document clearly defined, efficient and consistent decision-making procedures, with adequate second line of defence involvement at all times.
5.2NPE operating model
5.2.1NPE workout units
In order to mitigate sufficiently any conflict of interest in managing NPEs, as well as to make good use of dedicated NPE expertise across the organisation, credit institutions should establish dedicated NPE workout units (NPE WUs) that are independent from loan origination activities. This separation of duties approach should encompass not only client relationship activities (e.g. negotiation of forbearance solutions with clients) but also the decision-making process. In this context, credit institutions should consider implementing dedicated decision-making bodies related to NPE workout (e.g. an NPE committee).
Where overlaps with the decision-making bodies, managers or experts involved in the loan origination process are unavoidable, the institutional framework and internal controls should ensure that any potential conflicts of interest are sufficiently mitigated.
Credit institutions should have arrangements in place to ensure that regular feedback between loan origination units and NPE WUs is established.
When designing an appropriate NPE WU structure, credit institutions should take into account the specificities of their main NPE portfolios, including the type of exposure (retail, SME, corporate) and the type of collateral.
Credit institutions should consider designing automated processes for NPE WUs for homogeneous retail NPE portfolios. For corporate NPE portfolios, where relevant, and depending on the sectoral concentration of the NPEs, credit institutions should consider a relationship management approach with sectoral specialisation of NPE WU staff. For sole traders and micro-enterprises, a combination of automated elements and a relationship management approach should be considered.
Smaller and less complex credit institutions (e.g. those that are classified in SREP Category 3 or 4) may have in place dedicated workout functions proportionate to their size, nature, complexity and risk profile. Credit institutions should ensure that the design of such functions prevents and eliminates conflict of interest in the management of NPEs.
For proportionality purposes, smaller and less complex credit institutions (e.g. those that are classified in SREP Category 3 or 4), as an alternative to establishing dedicated decision-making bodies related to NPE workout, may cover the necessary requirements in their existing credit or risk committees, as long as conflicts of interest are sufficiently mitigated.
5.2.2Alignment with the NPE life cycle
NPE WUs should be set up to ensure that NPE workout activities and borrower engagements are tailored to the phases of the NPE life cycle.(22) Credit institutions should set up different NPE WUs for the different phases of the NPE life cycle and also for different portfolios, if appropriate. All applicable workout stages should receive adequate focus and should be equipped with sufficiently specialised staff.
Credit institutions should consider the following phases in the NPE life cycle, taking into account also the specificities of the products and the nature of the arrears:
a) Early arrears (up to 90 days past due):(23) during this phase, the focus should be on initial engagement with the borrower for early recoveries and on collecting information to enable a detailed assessment of the borrower’s circumstances (e.g. financial position, status of loan documentation, status of collateral, level of cooperation, etc.). The type of exposure and collateral should ultimately determine the most suitable workout strategy, which may involve forbearance measures with a short-term time horizon, to be applied when necessary (including during this initial period, where appropriate), with the aim of stabilising the financial position of the borrower before establishing a suitable workout strategy. In addition, the credit institution should, where appropriate, seek options to improve its position while taking into account the rights and interests of consumers (e.g. by signing new loan documents, perfecting outstanding collateral, minimising cash leakage, taking additional collateral if available). A dedicated arrears management policy should contain guidance on the overall NPE workout procedures and responsibilities, including handover triggers.
b) Late arrears/forbearance: credit institutions should implement and formalise forbearance arrangements with borrowers in this phase. Forbearance arrangements should be put into place only where the credit institution is satisfied that the borrower can afford to make the repayments. In considering whether a restructuring option is viable, credit institutions should have regard to Article 28 (opens EUR-Lex in a new tab) of Directive 2014/17/EU (opens EUR-Lex in a new tab)(24) and other legal provisions aimed at protecting consumers, to the extent applicable. A forbearance arrangement should be monitored for at least one year in line with Commission Implementing Regulation (EU) No 680/2014 (opens EUR-Lex in a new tab), given the increased risk, before it can eventually be transferred out of the NPE WUs if no further NPE triggers are observed. c) Liquidation/debt recovery/legal cases/foreclosure: if no viable forbearance solution has been found due to the borrower’s financial circumstances or cooperation level, credit institutions should perform a cost–benefit analysis of different liquidation options, including in-court and out-of-court procedures, having regard also to the interests of the borrower. Based on this analysis, credit institutions should speedily proceed with the chosen liquidation option, supported by legal and business liquidation expertise. Credit institutions that are engaged in extensive use of external experts should ensure that sufficient internal control mechanisms are in place to ensure an effective and efficient liquidation process. NPEs that have been categories as such for a long period of time should be given special attention in this regard. A dedicated debt recovery policy should contain guidance on liquidation procedures.
Managing foreclosed assets (or other assets stemming from NPEs): collateral repossession generally commences after other attempts by the credit institution to collect the outstanding amounts have failed. The credit institution should have a policy in place that describes the recovery process for foreclosed assets, covering in particular the steps of repossession, valuation of the collateral and realisation of various types of collateral through appropriate means.
5.2.3Grouping exposures
The EBA Guidelines on credit risk management practices and accounting for expected credit losses(25) describe the policies for credit institutions of grouping exposures with shared credit risk characteristics. Homogeneous portfolios should be built up in order to tailor treatments specifically to NPEs. Credit institutions should consider designing customised processes for each portfolio, with a dedicated expert team taking ownership of each. NPE portfolios should be analysed with a high degree of granularity, resulting in clearly defined borrower subportfolios. For these analyses, credit institutions should develop appropriate management information systems and sufficiently high data quality.
For corporate NPE portfolios, grouping by asset class or sector (e.g. commercial real estate, land and development, shipping, trading businesses) should be considered a key driver for NPE WU specialisation. These portfolios should then be further divided in line with the NPE strategy and the level of financial difficulty to ensure that workout activities are sufficiently focused.
5.2.4Human resources
Credit institutions should have in place an appropriate organisational framework relative to their business model and taking into account their risks, including risks stemming from NPEs. Credit institutions therefore should devote an appropriate and proportionate amount of management attention and resources to the workout of NPEs and to internal controls on related processes.
Sharing management and resources with other parts of the value chain (e.g. loan origination) should be carefully reviewed before implementation in order to avoid conflicts of interest and to ensure sufficient specialisation, as discussed above.
Based on the findings of the credit institution’s NPE self-assessment on capabilities, as referred to in section 4.2.1, credit institutions should regularly review the adequacy of their internal and external NPE workout resources and address any human resourcing gaps in a timely fashion. As workout activities may place significant demands on resources, credit institutions should consider if it is appropriate to choose to use fixed-term contracts, internal/external outsourcing or joint ventures for NPE workout activities. However, the final responsibility for these activities remains with the credit institution. In the event that outsourcing is used, credit institutions should ensure that such outsourcing is arranged in accordance with the applicable legislation or regulatory requirements.
Credit institutions should build up the relevant expertise required for the defined NPE operating model, including the NPE WUs and internal control functions, in line with the provisions of the joint ESMA and EBA Guidelines on the assessment of the suitability of members of the management body and key function holders.(26) Staff allocated to key NPE workout tasks should have specific NPE expertise and experience. Credit institutions should implement adequate and dedicated NPE training, including on consumer protection, and should design staff development plans to build in-house expertise using available talent.
Where it is not possible or efficient to build in-house expertise and infrastructure, the NPE WUs should have easy access to qualified independent external resources (e.g. property appraisers, legal advisors, business planners, industry experts) or to dedicated NPE servicing companies.
The credit institution, in alignment with the overall NPE strategy and operational plan, should implement an appraisal system tailored to the requirements of the NPE WUs. The appraisal system should be designed in line with the provisions of the EBA Guidelines on sound remuneration policies(27) and Article 7 (opens EUR-Lex in a new tab) of Directive 2014/17/EU (opens EUR-Lex in a new tab),(28) as well as for retail exposures, those of the EBA Guidelines on remuneration policies and practices related to the sale and provision of retail banking products and services.(29) The appraisal system should be mainly linked to the quantitative elements of the credit institution’s NPE targets but may also include qualitative elements (level of technical abilities relating to the analysis of financial information and data received, structuring of proposals, quality of recommendations or monitoring of restructured cases, as well as effective negotiation skills). The performance of the NPE WU staff should be regularly monitored and measured against these targets either on an individual basis or at team level, as appropriate.
The performance measurement framework for the management body and relevant managers should include specific indicators linked to the targets defined in the credit institution’s NPE strategy and operational plan. The weights given to these indicators within the overall performance measurement framework should be proportionate to the severity of the NPE issues faced by the credit institution.
Addressing early warnings signals and indicators should be encouraged by credit institutions through the remuneration policy and incentives framework in order to ensure that pre-arrears are efficiently addressed and NPE inflows thus effectively reduced.
5.2.5Technical resources
In terms of adequate technical infrastructure, credit institutions should ensure that all NPE-related data are centrally stored in robust and secure IT systems and that they are complete and up to date throughout the NPE workout process.
An adequate technical infrastructure should enable NPE WUs to:
a) Access all relevant data and documentation, including:
current NPE and early arrears borrower information, including automated notifications;
exposure, collateral and guarantee information linked to the borrower or connected clients;
monitoring tools with the IT capabilities to track forbearance performance and effectiveness;
status of workout activities and borrower interaction, as well as details on forbearance measures agreed;
foreclosed assets, where relevant;
tracked cash flow of the loan and collateral;
sources of underlying information and complete underlying documentation;
where relevant, access to central credit registers, land registers and other external data sources.
b) Efficiently process and monitor NPE workout activities, including:
automated workflows throughout the entire NPE life cycle;
ii. an automated monitoring process for loan status, ensuring correct flagging of NPEs and FBEs;
iii. incorporated warning signals;
iv. automated quantitative reporting throughout the NPE workout life cycle as a basis for the analyses to be provided to NPE WU management, the management body and other relevant managers, as well as the regulator;
v. performance analyses of workout activities by NPE WUs, sub-teams and experts (e.g. cure/success rate, rollover information, effectiveness of restructuring options offered, cash collection rate, vintage analyses of cure rates, promises kept rate at call centre, etc.);
vi. evolution monitoring of portfolios, subportfolios, cohorts and individual borrowers.
c) Define, analyse and measure NPEs and related borrowers:
recognise NPEs and measure impairments;
ii. perform suitable NPE portfolio analyses and store outcomes for each borrower;
iii. support the assessment of the borrower’s personal data, financial position and repayment ability, at least for non-complex borrowers;
iv. conduct calculations of (i) the net present value and (ii) the impact on the capital position of the credit institution for each restructuring option and/or any likely restructuring plan under any relevant legislation (e.g. foreclosure law, insolvency law) for each borrower.
The adequacy of the technical infrastructure, including data quality, should be assessed by an independent internal or external audit function on a regular basis.
5.3Control framework
The management body should be responsible for establishing and monitoring the adequacy and effectiveness of the internal control framework. In particular, effective and efficient internal control processes should be implemented for the NPE workout framework in order to ensure full alignment between the NPE strategy and operational plan on the one hand and the credit institution’s overall business strategy, including the NPE strategy and operational plan, and risk appetite on the other hand.
Internal control functions should regularly submit to the management body written reports on NPE management highlighting major identified deficiencies. These reports should include, for each new identified major deficiency, the relevant risks involved, an impact assessment, recommendations and corrective measures to be taken. Where necessary, the heads of internal control functions should be able to have access to and report directly to the management body in its supervisory function to raise concerns and warn the supervisory function, where appropriate, when specific developments affect or may affect the institution. This should not prevent the heads of internal control functions from reporting within regular reporting lines as well.
The management body should follow up on the findings of the internal control functions in a timely and effective manner and require adequate remedial actions. A formal follow-up procedure on findings and corrective measures taken should be put in place.
The internal control framework should involve all three lines of defence in line with the EBA Guidelines on internal governance.(30) The roles of the different functions involved should be assigned and documented clearly to avoid gaps or overlaps. Key outcomes of second- and third-line activities as well as defined mitigating actions and progress on those needs should be reported to the management body regularly.
In the implementation of the control framework, larger and more complex credit institutions should apply all three lines of defence; the second line of defence does not have to be NPE specific and may be performed by the credit risk (control) function.
In the implementation of the control framework, smaller and less complex credit institutions (e.g. those that are classified in SREP Category 3 or 4) do not necessarily have to have three fully fledged NPE-specific lines of defence, but they have to ensure that any conflict of interest is sufficiently mitigated.
5.3.1First line of defence controls
Credit institutions should ensure that the first line of defence is embedded into the procedures and processes of the operational units, mainly the NPE WUs, that actually own and manage the credit institution’s risks in the specific context of NPE workout.
In order to ensure that adequate control mechanisms are implemented, credit institutions should have internal policies in place on the NPE workout framework. The managers of the operational units are responsible for ensuring that these internal policies are implemented, including through their incorporation into IT procedures. Annex 4 to these guidelines sets out key elements of NPE framework-related policies that should be implemented in credit institutions.
5.3.2Second line of defence controls
Second line of defence functions should perform controls on a continuous basis to check that NPE management in the first line of defence is operating as intended. To adequately perform their control tasks, second-line functions require a strong degree of independence from functions performing business activities, including the NPE WUs, and should have sufficient resources. They should have an adequate number of qualified staff. The qualifications of staff should be reassessed on an ongoing basis, and staff should receive training as necessary.
The second line of defence controls the implementation of risk management measures by the NPE WUs and should have a special focus on:
a) monitoring and measuring of NPE-related risks on a granular and aggregate basis, including in relation to internal/regulatory capital adequacy;
b) reviewing the performance of the overall NPE operating model, as well as elements of it (e.g. NPE WU management/staff, outsourcing/servicing arrangements, NPE reduction targets and early warning mechanisms);
c) assuring quality across NPE loan processing, monitoring/reporting (internal and external), forbearance, impairments, write-offs, collateral valuation and NPE reporting (in order to fulfil this role, second-line functions should have sufficient power to intervene ex ante on the implementation of individual workout solutions);
d) reviewing the alignment of NPE-related processes with internal policy and public guidance, most notably related to NPE classification, provisioning, write-offs, collateral valuations, forbearance and early warning mechanisms.
Risk control and compliance functions should also provide guidance on the process of designing and reviewing NPE-related policies and procedures and on the controls being established across NPE WUs. These functions should be involved in the design and review of the policies before they are approved by the management body.
5.3.3Third line of defence controls
The third line of defence, the independent internal audit function, should have sufficient NPE workout expertise to perform its periodic control activities on the efficiency and effectiveness of the NPE framework, including the first- and second-line controls.
In determining the frequency, scope and scale of the controls to be carried out, credit institutions should take into account the level of NPEs and whether significant irregularities and weaknesses have been identified by recent audits.
Based on the results of its controls, the internal audit function should make recommendations to the management body, bringing possible improvements to their attention.
5.4Monitoring of NPEs and NPE workout activities
The monitoring systems should be based on the NPE targets approved in the NPE strategy and related operational plan, which are subsequently cascaded down to the operational targets of the NPE WUs, with feedback loops to pricing of credit risk and provisioning. A related framework of NPE-related key performance indicators (KPIs) should be developed to allow the management body and other relevant managers to measure progress.
Credit institutions should define and monitor NPE-related KPIs. The NPE-related KPIs, should include, but not necessarily be limited to (see also Annex 2):
a) NPE metrics;
b) borrower engagement and cash collection;
c) forbearance activities;
d) liquidation activities;
e) other (e.g. NPE-related profit and loss items, foreclosed assets, outsourcing activities).
5.4.1NPE metrics
Credit institutions should closely monitor the relative and absolute levels of NPEs and FBEs, as well as foreclosed assets (or other assets stemming from NPE activities) and early arrears, in their books.
Credit institutions should carry out such monitoring activities at transaction/borrower level, and portfolio or subportfolio levels, as appropriate, considering aspects such as business line, borrower segment, geographical area, products, concentration risk, level of collateralisation and type of collateral provided, and debt-service ability.
Credit institutions should monitor the level of impairments of NPEs in order to provide the management body with comprehensive information on coverage. The analysis should include data on the aggregate level as well as the levels for different NPE portfolios. The selection of NPE portfolios should consider aspects such as type of exposure, including secured/unsecured, type of collateral and guarantees, geographical area, number of years since NPE classification, time to recovery, and the use of the going and gone concern approach. Coverage movements should also be monitored and reductions clearly explained.
Credit institutions should benchmark indicators related to the NPE ratio and coverage against the available indicators of peers in order to provide the management body with a clear picture of the competitive position and potential shortcomings.
Credit institutions should monitor their deviations from the budget, in order for the management body to understand the drivers of significant deviations from the plan.
Key figures on NPE inflows and outflows should be included in periodic reporting to the management body, including transfers from/to NPEs, non-performing FBEs, NPEs under probation, performing FBEs and early arrears (≤ 90 days past due).
Credit institutions should consider if it would be useful to establish migration matrices to track the flow of exposures into and out of non-performing classification.
Credit institutions should estimate the migration rates and the quality of the performing exposures month by month, so that actions can be prioritised and taken promptly to inhibit deterioration of portfolio quality. Migration matrices can be further broken down by exposure type (retail mortgage, consumer, real estate), by business unit or by other subportfolio to identify whether the driver of the flows can be attributed to a specific subportfolio.
In their monitoring activities, credit institutions should use internal information (e.g. from internal score systems) and external information (e.g. from rating agencies, credit bureaus, specialised sector research or macroeconomic indicators for specific geographical areas) and should refer to a particular point in time or observation period. Annex 3 includes examples of such internal and external information.
5.4.2Borrower engagement and cash collection
Once NPE WUs have been established, key operational performance metrics should be implemented to assess the units’ or employees’ efficiency relative to average performance and/or standard benchmark indicators. If no such indicators exist or are available, key operational performance should be monitored by measuring the effective results against the targets set in the credit institution’s NPE operational plan.
5.4.3Forbearance activities
To resolve or limit the impact of NPEs, credit institutions should explore the possibilities with regard to granting forbearance measures. Credit institutions should monitor two aspects of the forbearance activities, efficiency and effectiveness. Section 7 specifies the requirements relating to the application of forbearance measures.
The main objective of forbearance measures should be the return of the borrower to a sustainable performing repayment status, taking into account the amount due and minimising expected losses. This objectives should take into account the importance of ensuring the fair treatment of consumers and compliance with any consumer protection requirements that may be applicable. The credit institution should monitor the quality of the forbearance activities to make sure that they are not used to delay impairments or an assessment that the exposure is uncollectable. The monitoring should cover forbearance activities in relation to both performing and non-performing exposures.
5.4.4Liquidation activities
If no sustainable restructuring solution can be reached, credit institutions should still resolve the NPE. Resolution may involve initiating legal procedures, foreclosing assets, debt to asset/equity swap, disposal of credit facilities by sale, transferal to an asset management company or securitisation. Where the price obtained from the foreclosure of immovable property affects the amount owed by a consumer, credit institutions should take into account, when deciding on the liquidation measure and next steps, the provisions of Article 17(5) (opens EUR-Lex in a new tab) of Directive 2014/17/EU (opens EUR-Lex in a new tab),(31) to the extent applicable.
Liquidation activities should be monitored by the credit institution to help inform strategies and policies. Credit institutions should monitor disposals and monitor realised sales/transfer prices against net carrying amounts.
Credit institutions should monitor the volumes and recovery rates of legal and foreclosure cases. Performance in this regard should be measured against set targets, in terms of number of months/years and loss to the institution. In monitoring the actual loss rate, institutions are expected to build historical time series for each loan portfolio to back up the assumptions used for impairment review purposes and stress test exercises.
For exposures covered by collateral or another type of guarantee, credit institutions should monitor the time period needed to liquidate the collateral or to enforce a guarantee. Credit institutions should also monitor potential forced sale haircuts upon liquidation and developments in certain markets (e.g. property markets) to obtain an outlook on potential recovery rates.
Monitoring the recovery rates from foreclosure and other legal proceedings should help credit institutions to reliably assess whether the decision to foreclose will provide a higher net present value than pursuing a forbearance option. The data regarding the recovery rates from foreclosures should be monitored on an ongoing basis and feed into potential amendments to credit institutions’ strategies for handling their debt recovery/legal portfolios.
Credit institutions should also monitor the average duration of legal procedures recently completed and the average amounts recovered (including related recovery costs) from these completed procedures.
Credit institutions should carefully monitor cases where the debt is swapped with an asset or equity of the borrower, at least by using volume indicators by type of assets, and ensure compliance with any limits set by the relevant national regulations on holdings. The use of this approach as a forbearance measure should be backed by a proper business plan and limited to assets in relation to which the institution has sufficient expertise and the market realistically allows the determined value to be extracted from the asset in the short to medium term. The institution should also make sure that the valuation of the assets is carried out by qualified and experienced appraisers.
5.4.5Other monitoring items
Credit institutions should monitor and report to their management bodies the amount of interest income stemming from NPEs. In addition, a distinction should be made between the interest payments on NPEs actually received and those not actually received. The evolution of loss allowances and the related drivers should also be monitored.
If foreclosure is a part of a credit institution’s NPE strategy, it should also monitor the volume, ageing, coverage and flows of foreclosed assets (or other assets stemming from NPEs) at a sufficient level of granularity to take into account material types of assets. The performance of the foreclosed assets vis-a-vis the predefined business plan should be monitored and reported to the management body and other relevant managers on an aggregate level.