Causes and implications of variation in euro area banks’ recent loan loss provisioning

Prepared by Elena Rancoita and Csaba Móré

Published as part of the Financial Stability Review, November 2020.

Banks’ loan loss provisions increased markedly in early 2020 amid the sharp contraction in economic activity, but there was also large variation across banks’ provisioning. In the first half of 2020, significant banks’ loan loss provisions rose to 0.76% of loans (on an annualised basis), more than 2.5 times the level a year earlier, but still below the peak levels of 1.2-1.4% in earlier economic downturns (2008-09 and 2011-13). Much of the increase was driven by the migration of non-financial corporate (NFC) loans to Stage 2, while the Stage 3 loan ratio remained broadly unchanged^[1] (see Chart A, left panel). Provisioning levels were widely dispersed across both countries and banks within the same countries (see Chart A, right panel).

Chart A

Stage 2 migration explains much of the increase in provisions, but with large variation across banks

To some extent, the wide dispersion of provisioning levels can be explained by the pronounced economic uncertainty and the heterogeneous sectoral impacts of the COVID-19 crisis. The scale of the economic shock induced by the pandemic, uncertainty around the recovery and difficulties in gauging the impact of government support measures are making it hard for banks to reliably estimate credit losses at present. Divergence in banks’ provisioning may partly reflect differences in portfolio mix for instance in terms of exposures to sectors highly affected by the pandemic^[2] (see Chart B, left panel, left chart) or to emerging market economies the diversity of the impact of public support measures for borrowers^[3] and differences in the timing^[4] of loss recognition. Furthermore, the current transition to the new, more forward-looking IFRS 9 accounting standard,^[5] alongside other measures, may also have led to additional variation, although authorities have provided guidance to avoid excessive procyclicality.^[6]

Chart B

Differences in exposures to riskier sectors, available pre-provisioning profits and optimism about the economic recovery may partly explain the divergence in provisioning

However, it is possible that some of the variation in provisions across banks reflects inadequate provisioning by some banks, in part due to profitability constraints. In general, banks entered the crisis with low profitability, leaving some institutions with limited capacity to use buffers from operating profits to allow for credit losses, possibly making them reluctant to draw on capital. Notably, many (but not all) banks in the weakest pre-provisioning profit quartile tended to have the lowest provisions (see Chart B, left panel, right chart). This relationship may partly reflect the lower risk profile of banks with lower operating profits, but it is also consistent with analysis of historical data (see Chart 7, right panel), which finds that provisions are positively related to pre-provisioning operating profits even after controlling for credit risk.

Varying levels of optimism about the economic recovery also appear to have affected estimates of future credit losses. Financial statement data show diverse levels of optimism in the macroeconomic scenarios used to calculate expected credit losses under IFRS 9 compared with those produced by central banks^[7] (see Chart B, right panel), which might affect asset migration and loss coverage. In addition, uncertainty regarding the speed of the recovery affects stage migration, lifetime expected losses, and provisions recorded.^[8] The effect of this is also seen in the variation across banks in the development of coverage ratios, with a slight majority of banks (52%) reporting falling coverage of Stage 3 NFC loans in the first half of 2020.^[9]

Looking ahead, the future path of credit losses remains very uncertain, in particular when moratoria and other support schemes expire in the first half of 2021. In their public disclosures, most banks indicate that they expect to book lower provisions in the second half of 2020, assuming that the macroeconomic environment does not deteriorate further. However, a weaker than expected economic recovery and, in some cases, optimistic assumptions underlying banks’ expected credit loss models may render current provisioning levels insufficient. In fact, banks’ annualised half-yearly provisions fall short of projected credit risk losses for 2020 under the baseline scenario (see Chart 3.18 in Section 3.2).^[10] From a financial stability perspective, it is helpful that euro area banks have generally avoided excessive procyclicality in provisioning, but those with less conservative policies may still need to raise provisioning (and coverage) levels so as to ensure investor trust in asset valuations and transparency in financial statements.