December 2023
The sharp increase in interest rates since the start of 2022 continues to feed through to Europe’s real economy. Credit supply conditions have tightened1 and this, together with the effect of higher borrowing costs, mean that credit risks are expected to increase2.
So far, banks’ asset quality has remained robust3, and the ECB views banks under its supervision as well capitalised with robust liquidity and low levels of NPLs4. Even so, there are signs of deterioration, with some jurisdictions already reporting increased NPL volumes and heightened threats to asset quality5.
Banks’ Commercial Real Estate (CRE) portfolios are a particular area of supervisory focus. The ECB has observed a turn in market conditions6, with some CRE portfolios experiencing a fall in asset prices owing to falling collateral values, rising insolvency rates and increasing levels of borrower indebtedness7. This deterioration is underpinned by disruption from the COVID-19 pandemic, altered patterns of work, and uncertainty about long-term demand for office space.
The challenging outlook for CRE – and the fact that many European banks have material exposure to the sector – means it’s no surprise that 2023 has seen CRE portfolios receive increasing attention and ad-hoc requests from supervisors.
That includes the year’s twin on-site inspection (OSI) campaigns on IFRS 9 and BCBS 239, both of which have placed significant emphasis on CRE portfolios. OSIs and deep dive assessments of banks’ CRE exposures continue to be announced in multiple jurisdictions. In our experience these are typically intensive, time-consuming exercises requiring extensive responses from dedicated teams.
Particular areas of regulatory scrutiny include:
- Valuation frameworks and collateral values, including the timeliness of revaluations; the reliability of market values amid limited recent transactions; and the role of independent valuations.
- The treatment of CRE risks in terms of the accuracy of risk classifications, IFRS 9 stage transfers, and impairments.
- The adequacy of data management, aggregation and reporting – supervisors continue to detect data management gaps and examples of credit files not being kept up to date.
- The mapping of sustainable debt service capabilities on the basis of realistic estimates of borrowers’ future cash flows.
- The need to amend the current credit origination/underwriting standards.
- Banks’ interpretations of forbearance, with particular focus on consistent and proactive identification, the appropriateness of measures granted, and ongoing monitoring.
- The application of default characteristics - higher regulatory default settings imply that banks may need to make provisions earlier in future
How can banks prepare for supervisory scrutiny of their CRE portfolios?
In general, the ECB are looking for evidence that banks have implemented robust credit risk management policies and processes8; that they are using early warning indicators to identify any changes in asset quality; that they are provisioning adequately – including the use of overlays; and that loan losses are being recognised through timely impairments9.
Based on KPMG professionals knowledge of recent OSIs and supervisory activity, the following actions as being among the most important for banks to prioritise:
- Update collateral values for properties in critical asset classes (i.e. office space)
- The assessment of current credit origination and underwriting standards
- Review debt service capacity calculations, taking current rental agreements into account
- Check the recoverability of third-party contractual obligations (e.g. sponsors, guarantors)
- Analyse and review current forbearance status for critical creditors
- Integrate segment-specific early warning signals and UTP triggers into credit processes
Economic uncertainty implies that the ECB’s focus on CRE portfolios will continue. The ECB has also been clear that banks failing to remediate weaknesses in their management of CRE risks could face supervisory actions including targeted Pillar 2 requirements, enforcement measures or sanctions.
Therefore banks should ensure they’re prepared for continuing regulatory scrutiny of this key area during the year ahead.
1 Euro area bank lending survey (europa.eu)
2 JC 2023 44 - Autumn 2023 Report on Risks and Vulnerabilities.pdf (europa.eu)
4 Interview with Market News International (europa.eu)
6 Current risks and vulnerabilities in the European banking sector (europa.eu)
7 JC 2023 44 - Autumn 2023 Report on Risks and Vulnerabilities.pdf (europa.eu)
9 JC 2023 44 - Autumn 2023 Report on Risks and Vulnerabilities.pdf (europa.eu)