Address by Ed Sibley, Director of Credit Institutions Supervision, at the Banking and Payments Federation of Ireland (BPFI) on Non Performing Loans

Introduction

Good afternoon ladies and gentlemen.

I very much welcome the opportunity to discuss Non Performing Loans (NPLs) with you today.  It is a topic that remains of fundamental importance to the Irish economy, borrowers, the banking sector and therefore the Central Bank of Ireland.  More widely, it is a priority across Europe, and is recognised as a significant issue across the Eurozone. This is evidenced by the emphasis the European Central Bank (ECB) has placed on resolving NPLs since the establishment of the Single Supervisory Mechanism (SSM), including the ongoing work of the SSM Task Force on NPLs, in which the Central Bank is very actively involved.

Today, I will outline why NPLs are important and contextualise the current position in Ireland by considering developments and lessons learnt since the onset of the financial crisis - including recognising the considerable progress that has been made as well as the issues that remain. I will also summarise the Central Bank's associated current priorities. 

Why we care about Non Performing Loans

As at 30 June 2016, across the five main domestically-focused banks, €45bn of loans were non performing, representing 19 per cent of their combined loan books.^[1] Eight years after the infamous night of the guarantee, nearly seven years after the establishment of NAMA, and the subsequent transfer of €74 billion of loans, after billions of euros of loans have been restructured and dozens of portfolios sold, there still remains €45bn of NPLs on the retail banks’ balance sheets. The challenge is still significant.

While there has been considerable progress, which I will cover in more detail later, the high levels of NPLs remain a considerable problem.  They are a blight on lenders, on borrowers and the wider economy. They directly impact on the pricing of new and existing lending.  Similarly, they are likely to stifle competition through dis-incentivising new entrants due to the uncertainty of the recoverability of loans. There are sufficient international comparators to be confident that the economic performance and recovery of countries that deal effectively and quickly with resolving NPLs is better than those that do not. Or to put it another way, there is a widely held belief that NPLs act as a drag on economic performance and in the case of the Eurozone, its recovery from the crisis^[2].

Moreover, NPLs cause untold distress and difficulties for borrowers, increasing risks regarding their fair treatment, and, as is the case in Ireland, have significant societal implications. 

For the stability of banks, which is my primary responsibility, they cause issues with investor confidence, raising equity, uncertainty regarding balance sheet strength, additional capital requirements, reductions in net interest income, higher costs of funding, reduce risk appetite and capability for new lending. They are a considerable overhead in terms of costs and management time and increase the volatility of earnings.  Daniele Nouy, the Chair of the Supervisory Board of the SSM has recently stated that the high level of NPLs is one of issues affecting European banks that are impacting on market confidence, as they "weigh down balance sheets, restrict loan growth and curb profitability".^[3]

In short, I hope that we can all agree that high levels of NPLs are hugely problematic. It is our individual and collective responsibility to continue to address this legacy of past mistakes as well as to ensure that the mistakes do not recur.   

In that we can agree that NPLs are so problematic, I am sure we can also agree that there are clear and considerable collective benefits in resolving NPLs.  Nonetheless, from an individual lender perspective, there may be incentives to act more slowly. For example, lenders may hope that underlying collateral values increase, or that borrowers' circumstances miraculously improve beyond what can be reasonably expected. Lenders may not wish to recognise the loss, in part because they gave the loan in the first place.  Lenders may lack sufficient operational capability or appetite, or have insufficient capital and / or provisions to deal with the problem.

Undoubtedly, these incentives and factors were relevant in the history of NPLs in Ireland and why the Central Bank has had to be so interventionist in driving resolution.  My fear is that they are still at play today, albeit to a lesser extent. 

A brief history

There has, however, been considerable progress.  And in this context, it is worth briefly taking stock and discussing some of the key actions undertaken in recent years. 

Of fundamental importance to resolving NPLs is recognition of the actual problem, and the setting aside of appropriate resources to deal with the challenge. An important milestone in this regard was the work conducted by the Central Bank during the Financial Measures Programme (FMP), in particular the loan loss forecasting exercises and the stress tests conducted as part of Prudential Capital Assessment Reviews (PCAR). The work involved an assessment of asset quality, and stress testing the banks' balance sheets to ensure that banks had recognised the issue and had adequate capital and provisions to cover losses. Unfortunately, this resulted in considerable public support being required to ensure that the Irish banks had the appropriate financial resources to deal with the scale of the challenge facing them. This was a critical juncture for the Irish banking system.

Subsequent exercises conducted either solely by the Central Bank or jointly with the ECB, as part of the commencement of the SSM in 2014, have been driven by the same purpose, and indeed show the importance that the ECB places on asset quality and by extension, NPLs.^[4]  They will continue to be a key component in our supervisory toolkit in the future.

However, having appropriate financial resources is only one of the critical elements to support NPL resolution. Banks must also have appropriate NPL resolution strategies, governance structures, operational capabilities (including distressed debt workout skills), a variety of forbearance / restructure options, and the appropriate IT infrastructure and management information to support the entire process. Crucially, the culture within an organisation must also support and indeed drive NPL reduction to resolve the issue in a timely, sustainable and cost efficient manner. Effective board oversight and challenge is also crucial.

The work of the Central Bank from 2011 onwards focused on ensuring that these elements were in place, through reviews, remediation requirements and the issuing of guidelines.

Source: Central Bank Regulatory returns based on data provided by AIB, BoI, PTSB, Ulster and KBCI. Note: At Q3 2014 the EBA’s definition of non-performing was introduced. Prior to this date an internal definition was used equivalent to impaired loans and/or arrears > 90 days.

We collectively learnt the critical importance of early intervention to identify and address distress and the fallacy of reliance on short-term forbearance. Short term options may be appropriate during the stabilisation and assessment of the borrower's circumstances or if the borrower’s financial distress is temporary, but if this is not the case then long term sustainable solutions need to be implemented quickly.

I recognise that through the efforts of management and staff within the banks, continually challenged and driven by the Central Bank, and now by the SSM, these elements are now largely in place. Shortcomings in strategies were required to be addressed. Operational deficiencies were required to be remediated. Provisioning shortfalls were largely filled. Guidelines were complied with.  Targets, such as the Mortgage Arrears Resolution Targets (MART), which were imposed to drive resolution activity and to reduce the reliance on short-term forbearance, were met.

Current Position

And there is good news. These efforts have had an effect.  NPLs have been falling since their peak in late 2013, and have halved since that time.  This is not the case across the Eurozone.  There continues to be a sustained and to my eyes sustainable reduction in NPLs in Ireland.   To grossly oversimplify, if we split NPLs into two buckets - one being non-retail loans (to SMEs, corporates, etc.) and the other retail (primarily residential mortgages), we can see that non-retail NPLs reduced by 54 per cent since the start of 2015 - falling by almost €21bn.^[5] Retail NPLs reduced by 27 per cent during the same period, equivalent to €10bn. Over 111,000 PDH residential mortgages have been restructured in Ireland by the retail banks. 89 per cent of these loans are meeting the terms of the restructure.

Further, there is a considerable lag between the point of meaningful engagement between a bank and a distressed borrower, arrears being addressed and the loan moving to a performing forborne status (i.e. no longer an NPL).  There is now a sizeable cohort of NPLs that have been restructured, are currently serving probation periods and upon successful completion will return to performing status. While probation periods do mean that it takes longer for NPLs to reduce, they do serve to demonstrate that the arrangement is potentially appropriate for the borrower’s set of circumstances.  Therefore, we can be confident that the reductions that we have seen over the last couple of years will continue.

And yet, and yet...  €45bn is a huge number.  It still represents 19 per cent of loan books.  Ireland still has one of the highest percentage of NPLs in the Eurozone.  Retail NPLs, which two years ago were approximately 40 per cent of the total NPL stock, are now 60 per cent of the NPL stock, as at June 2016^[6] - in other words retail NPLs are falling at a slower pace than non-retail NPLs.  

While, we welcome the trajectory of the resolution of non-retail NPLs, concerns do remain.  We continue to see issues regarding Board oversight, and, in some cases, a lack of follow through and monitoring of arrangements agreed between banks and borrowers. Consequently, our supervisory focus is now on ensuring that:

• strategies are appropriate, operational capability is sufficient and momentum is maintained,
• the quality of decision-making and restructures is appropriate,
• the arrangements agreed between borrowers and banks are monitored and delivered against,
• provisioning and write-offs remain prudent, and
• lessons learnt continue to inform new lending and risk appetites.  

Working within the SSM, supervisory, inspection and analytical resources will continue to ensure this is the case, and that bank boards continue to oversee and challenge progress. 

Residential Mortgages

Moving on to retail lending - as residential mortgage NPLs are falling at a slower pace than other NPLs, I will spend the rest of my time with you today focused on these cohorts of loans and the associated supervisory views and priorities.

"Residential mortgages are of first-order importance for households, for financial institutions, and for macroeconomic stability. A typical household in a developed economy has one dominant asset — a house, and one dominant liability — a mortgage."^[7]

Given the economic and social significance of mortgage lending, the engagement between banks and borrowers is important.  Both parties have a duty of care to each other. This is even more the case where the loan is not performing.  Two parties enter into these transactions, and both parties need to work together to address problems as they arise.

75 per cent of residential mortgage NPLs today were written in the period 2005-2008.^[8] Our work on macro prudential risks and measures has shown that loans with higher loan to value (above 80 per cent) and loan to income (above three and a half times), which are obviously more likely to have been written during this period, have a statistically significantly higher likelihood of default.^[9] 

The protections of the Code of Conduct on Mortgage Arrears (CCMA) are helping in ensuring the fair treatment of borrowers. Our work has consistently confirmed that where borrowers engage with their banks, there are a suite of restructuring arrangements that can potentially put the loan on a sustainable footing. 

Unfortunately, this is not the case for all loans, and if we are to operate in a system where secured lending is to take place and to be priced appropriately, this means that resolution of some non performing mortgage loans will continue to result in loss of ownership - either voluntarily, as 66 per cent have been to date, or through the courts.  Our work shows that not all those cases who enter the legal process result in loss of ownership. Central Bank data shows that 19 per cent of legal cases that concluded are due to terms and conditions being renegotiated.^[10] Even at very late stages in the process, engagement between bank and borrower can avert loss of ownership outcomes, which are evidentially much more likely if there is no engagement.

So where are we today?

There are over 43,000 Private Dwelling House (PDH) mortgage loans in the five banks more than 90 days past due.  Based on Central Bank loan level analysis, approximately 20 per cent of these accounts do not have any reported resolution activity attached. These are cases that have not been restructured, are not in a loss of ownership process (e.g. voluntary sale / surrender or legal) or have not received a formal proposal from the bank for a sustainable solution. More than two and a half years since the peak level of NPLs, why is this the case? Or looking at buy to let lending, the equivalent figure is 19 per cent.  In the circumstance of rising rents and historically low interest rates, why is this the case, particularly in the context of consistently much higher buy to let NPLs relative to PDH?

In November 2015, bank specific supervisory expectations were outlined with regard to mortgage NPL resolution following the conclusion of the MART. To be forthright, performance was disappointing with most banks falling significantly short of our expectations. This prompts the questions:

• Could more be done for borrowers who are cooperating but whose affordability has been permanently reduced?
• Could more creative sustainable solutions be found, or more creative use made of the solution toolkit that is available? 
• While respecting and meeting the spirits and letter of the CCMA, could more be done to drive resolution in a more timely manner where borrowers are not cooperative?
• Could NPLs be written down faster from a balance sheet perspective? When a loan (or indeed part of a loan) is deemed unrecoverable, it should be written off in a timely manner. This does not prevent the bank from seeking repayment from the borrower for which it has a contractual right to do so, but recognises the economic and accounting reality and helps to address many of the prudential issues I referred to earlier.

Our ongoing supervisory engagement, our inspection work and our analysis of the underlying data shows strong evidence that more continues to be needed to deliver NPL resolution through the three avenues available to lenders - workout, sales or accounting write-offs. 

I do recognise that individual cases may be getting harder, that management attention may have been diverted to other issues, and that the legal process is long. But that does not mean that it is acceptable that the incentives to slow down efforts, which I referred to earlier, should start to impact on the efforts to address this blight.

On the basis that notwithstanding the considerable work that has been done, we are not satisfied that progress and momentum is being maintained at an appropriate rate, our supervisory work will continue to be intensive, and challenging in all the areas I identified earlier, starting at the Board level and working down with regard to strategy, ambition and oversight, and working from the operations up in terms of capability and execution. Targets will continue to be a feature of our approach, and ultimately high levels of NPLs will continue to be reflected in higher regulatory capital requirements.  

We will also continue to challenge and engage on provisioning.  The work undertaken at the beginning of last year, which found significant issues in provisioning models, will continue to be repeated.  The recently released CSO figures show the volatility of Irish housing prices (with a peak to trough very nearly at the 55 per cent we had used as a conservative estimate in previous exercises).  We therefore still do not expect there to be significant provision releases based on house price movements, but instead to the extent there are any, that they be driven by actual restructures, sales or write-offs.  This is particularly important in the context of the implementation of the IFRS9 accounting standard.

Looking forward

Ireland's public and private sector debt remains highly elevated.  Ireland has the fourth highest level of household debt to disposable income in the European Union.^[11]  As a debtor nation, while low interest rates remain challenging from a bank profitability perspective, they have undoubtedly provided breathing space for repair and reduction in the level of indebtedness.  This continued breathing space should not be wasted and efforts to reduce NPLs to more normalised levels need to be redoubled. 

While we face into considerable uncertainty, there is still a window of opportunity for institutions to build on the progress in recent years and continue to drive NPL resolution in the short to medium term. It is difficult to discern what challenges may arise in the future that may make this task even more difficult. 

I return to the relationship between borrowers and banks.   The very large numbers of borrowers whose debt has been restructured are highly likely to have been in some form of distress, although not all associated loans will have been non performing.  They are therefore likely to have higher loan to values and loan to incomes than non restructured loans. They are also likely to be much more vulnerable to economic shocks, interest rate rises, or changes in their own circumstances than other borrowers. Notwithstanding the exemptions carved out by the Central Bank's macro prudential mortgage rules, large numbers of these borrowers will remain with the banks they are with today in the long term - in some cases, extending into retirement.  

Banks need to continue to treat these borrowers fairly and consistently with other borrowers over the long term, as the length of this relationship is a factor of historical decisions taken by both the bank and the borrower.  In this context, it is also important to recognise that the cost of restructures are born by both the bank and the borrowers - with the cost of credit for the borrower increasing in many of the restructures, for example, arrears capitalisations and term extensions (which account for 43 per cent of current restructures).

European Wide Initiatives

The issue of NPLs is not just a local concern. NPLs are also high on the supervisory agenda for the ECB, including for the SSM, given the elevated levels of NPLs across the Eurozone. Indeed, Euro area significant institutions held nearly €950bn of NPLs at the end of 2015, equivalent to about 9 per cent of euro area GDP.^[12]

In recognition of this concern, last year the SSM established a Taskforce on NPLs, chaired by my predecessor, Sharon Donnery, now the Deputy Governor, Central Banking at the Central Bank. Two weeks ago, the SSM launched a public consultation on guidance to banks on NPLs, developed by this Taskforce. Banks will be expected to comply with the guidelines once implemented.

Indeed, much of the guidance will be very familiar to you, and is consistent with the points raised earlier.  For example, it covers requirements for a granular, robust and credible strategy, strong governance and effective operational arrangements, management information, key performance indicators, and conservative recognition and associated provisioning policies.  While much of it is familiar, there will be areas where continued improvements are required. 

We will continue to support and influence the ongoing work of the Taskforce through sharing the experiences that we have unfortunately gained in Ireland, as well as learning from practices across the Eurozone and beyond to apply back into Ireland.

Lessons learnt and Prevention

Lending money is inherently risky. Indeed, banks would not be serving their economic purpose if risk appetites were so conservative that loan losses were reduced to near zero. Not all new loans will be repaid. There will be macro and individual borrower shocks that result in loan losses. Lenders may make judgements that overtime prove to be incorrect.  This is right and perfectly normal in a functioning market economy. 

Consequently, it will continue to be for fundamental importance that lenders work with borrowers when they face financial difficulties, and that they continue, at a minimum, to respect and comply with the relevant Central Bank's codes of practices. 

We must not forget the lessons from the bubble years and the more recent past, such that we never again have such a catastrophic and systemic failure of lending standards and practices.  Some memories do appear to be surprisingly short, both within the banks and outside them.  We have already seen some evidence of a return of more aggressive lending practices and cultures, and issues with risk appetites, the pricing of loans relative to risks and the effectiveness of Board oversight over new lending.  

At the micro level, effective credit risk management within banks is critical to ensure that new lending decisions are made in a prudent and conservative manner. This requires strong credit governance arrangements, clear, considered and granular risk appetites - understood and overseen by the Board, sufficient resources and skills, effective second and third line functions and so on.   Supervisors are constantly engaging with and challenging banks to ensure that all of these components are in place and we continue to find weaknesses that need remediation. 

Macro prudential instruments are also important in mitigating risks, both bank focused (such as counter-cyclical buffers) and borrower focused - such as the mortgage measures introduced last year.  As has been well documented, the mortgage measures are currently being reviewed by the Central Bank. While it would not be appropriate for me to comment on the review process which will be completed in November, I do want to reiterate that the design and calibration of the mortgage measures is based on published economic analysis and available empirical evidence, including Central Bank research showing positive relationships between high original LTVs and LTIs and increased default rates.  ^[13] They are in place to protect both banks and borrowers from excessive and unsustainable levels of indebtedness, which has caused such problems in the past and that we continue to work to resolve.  

Conclusion

Supervisors cannot directly resolve NPLs. However, we can and will continue to drive the actions that are needed in the banks to bring NPLs in Ireland down to more normalised levels. Much progress has been made, but we cannot rest on our laurels.  Uncertainty of the future is increasing and there is no excuse for any of us to ease up on our efforts to address the high levels of NPLs that are still such a problem for the Irish economy and society. 

Furthermore, the fact that, despite all the work of the last six to seven years, NPLs remain so problematic in Ireland and across the Eurozone, demonstrates the catastrophic consequences of sustained, systematic imprudent and unchecked lending.  Consequently, the Central Bank has taken and will continue to take decisive action to safeguard borrowers and financial stability alike at both a macro level and a micro level.   

We forget the lessons from this crisis at our peril. All of our actions need to both address the legacy of the crisis and mitigate and reduce the risk of recurrence.

I thank you for your attention.

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^[1] Q2 2016 regulatory returns using EBA’s definition of non-performing.

^[2] See also https://www.imf.org/external/pubs/ft/sdn/2015/sdn1519.pdf

^[3] Nouy, D (2016) 'The European banking sector in 2016: living in interesting times', transcript, ECB, 7 September 2016, https://www.bankingsupervision.europa.eu/press/speeches/date/2016/html/se160907.en.html.

^[4] On 4 November 2014, the Central Bank became part of the SSM. This is the system for prudential supervision system of credit institutions in the euro area, comprised of the ECB and the national competent authorities (NCAs) from euro area countries. This resulted in a number of supervisory responsibilities and decision making powers moving to the ECB. Credit institutions are categorised into Significant Institutions and Less Significant Institutions. The former are supervised by Joint Supervision Teams (JSTs) led by the ECB and are comprised of both ECB and Central Bank staff, while the latter continue to be directly supervised by the Central Bank.

^[5] Central Bank of Ireland Regulatory returns using EBA’s definition of non-performing.

^[6] Central Bank of Ireland Regulatory returns.

^[7] See Campbell JY. “Mortgage Market Design”. Review of Finance. 2013;17 (1) :1-33.

^[8] June 2016 loan level data from 5 banks for Irish mortgage NPLs using EBA’s non-performing definition.

^[9] Hallissey, N., R. Kelly, and T. O'Malley (2014): "Macro-prudential Tools and Credit Risk of Property Lending at Irish banks," Economic Letters 10/EL/14, Central Bank of Ireland.

^[10] PDH Mortgage Arrears and Repossession data from Q1 2013 to Q2 2016 from banks and non-bank entities.

^[11] http://www.centralbank.ie/polstats/stats/qfaccounts/Documents/Quarterly%20Financial%20Accounts%20for%20Ireland%202016%20Q1.pdf

^[12] Constâncio, V (2016) 'Challenges for the European banking industry', transcript, ECB, 7 July 2016,  https://www.ecb.europa.eu/press/key/date/2016/html/sp160707_1.en.html

^[13] Hallissey, N., R. Kelly, and T. O'Malley (2014): "Macro-prudential Tools and Credit Risk of Property Lending at Irish banks," Economic Letters 10/EL/14, Central Bank of Ireland.