This alert looks at the new definition of default for prudential purposes which came into force on the 1st January 2021 and is applicable to all European financial intermediaries.
New European rules on default
The regulatory framework
EU Regulation of 26 June 2013, no. 575 1 on prudential requirements for credit institutions and investment firms (CRR) introduced specific provisions on debtors' default in article 178 and entrusted the European Banking Authority (EBA) with the issuance of guidelines on the application of the default definition and to the European Commission the adoption of a delegated regulation relating to the measurement of the materiality threshold of past due credits on the basis of regulatory technical standards published by EBA.
On 28 September 2016, EBA published the guidelines 2 on the definition of default as well as the technical standards relating to the significance threshold. With a view to implement the CRR and the EBA guidelines on the definition of impaired credit exposures, Bank of Italy issued a specific communication 3 with reference to the supervisory statistical reports and financial statements of banks on 26 June 2019.
More recently, the Italian Supervisory Authority provided further implementing clarifications with a note dated 15 October 2020 4.
The rationale of the mentioned interventions is undoubtedly to bring the European banking and financial system into line with the principles of equivalent supervision and regulatory neutrality. The deadline by which banks subject to the supervision of the European Central Bank and European non-bank financial intermediaries will have to apply the new rules has been set at 1 January 2021.
The new definition of default: conditions and materiality thresholds
The proposed new regulatory structure identifies objective and subjective conditions for a debtor to be considered in default. Certain materiality thresholds have also been introduced, which must be exceeded for debtor's status to become effective.
In particular, debtors will be considered in default if at least one of the following conditions is met:
(i) objective condition ("past-due criterion"): the obligor is past due more than 90 days 5 on any material credit obligation to the institution by taking into consideration all the obligations of the same to the intermediary;
(ii) subjective condition ("unlikeliness to pay"): the institution considers that the obligor is unlikely to pay its credit obligations to the institution, without recourse by the institution to actions such as realising security.
Once the existence of a past-due criterion has been ascertained, this will become relevant in case it exceeds certain specific thresholds based on the nature of the debtor (retail 6 and non-retail customer):
(i) in absolute terms: the materiality threshold is set at € 100 for retail exposures and € 500 for other exposures;
(ii)in relative terms: the threshold is represented by the amount equal to 1% of the aggregate exposures of the debtor vis-à-vis credit and financial intermediaries belonging to the same prudential consolidation perimeter 7.
In light of the foregoing, an exposure will be considered expired (and therefore classified as non-performing) if it has exceeded both the absolute and relative thresholds for 90 consecutive days.
Otherwise, a declaration of default is also possible with reference to customers who, despite not having significant past due for more than 90 days, are, in the opinion of the intermediary, unable to fulfill their obligations (subjective condition).
With a view to mitigate the discretion left to each intermediary in the assessment of a potential default, the EBA guidelines provide for certain qualitative and quantitative indications that intermediaries will have to consider to bring an unlikely-to-pay position back into the default category.
Among others, it is worth mentioning the failure to record the position in the income statement of the intermediary due to the decrease in the credit obligation quality, the transfer of the receivable by the intermediary (with particular reference to securitisation transactions 8), the presence of specific provisions on exposure according to IFRS9 accounting principles, a distressed restructuring of the debt 9, the bankruptcy or similar provision or protection of the debtor, a significant increase in the debtor's financial leverage and the decrease in the sources of its income. Upon the occurrence of one of the aforementioned indicators, all exposures vis-à-vis the debtor shall be considered in default.
Differently from the past, starting from the 1st of January 2021 set off of any overdue amounts with other open and unused or partially used credit lines of the same debtor will no longer be allowed. Therefore, a financial institution will be required to classify the customer in default even in the event that this has credit lines still available with said institutions.
(b) Default contagion rule
According to the new rules, intermediaries will have to survey the relationships between their customers, in order to identify cases in which the default of a company may negatively affect the repayment capacity of another debtor connected to it (so-called contagion effect), with the consequence that the latter can also be considered as defaulted.
A connection between different companies can be determined by links of control or of an economic nature (e.g. companies belonging to the same supply chain) 10.
(c) Return to non-default status
Unlike in the past 11, the return by debtors to a non-default status pursuant to Article 178, paragraph 5, of CRR is possible only when three months have elapsed from the moment in which the conditions referred to in Article 178, paragraph 1, letter b) and paragraph 3 of CRR have ceased to exist (and, therefore, the customer has stabilised its position 12).
During this 3-month probation period, financial intermediaries shall assess debtor's behaviors and its overall financial situation and shall allow the return to a non-default status only if this is deemed stable in an effective and permanent way.
This article is for information purposes only and is not, and cannot be intended as, a professional opinion on the topics dealt with. For further information please contact Matteo Gallanti or Bianca Macrina.
5 The days past due are calculated starting from the day following the date on which the amounts due for principal, interest and any fees have not been paid and have exceeded the relevant thresholds. In the event that payments defined in the original credit agreement have been suspended and deadlines have been modified, subject to a specific agreement executed with the institution, the count of days past due will follow the new repayment plan.
6 Small-medium enterprises and individuals.
7 Competent authorities may agree a different threshold, ranging between 0 and 2,5%.
8 A position shall be considered as defaulted whether the transfer in the context of a securitisation transaction is made due to the decrease of the credit obligation loss and it has a credit-related economic loss higher than 5% of the Gross Book Value.
9 Restructurings are relevant for the purposes of the indication if they involve material forgiveness or postponement of principal, interest or fees determining a loss higher to 1% of the original debt amount.
10 Groups of customers are defined under art. 4, paragraph 1, item 39, of CRR.
11 Before 1 January 2021, the default status ceases to exist when the debtor settles the past due payment vis-à-vis the intermediary and/or covers the overdraft account overrun.
12 The probation period is extended to one year with reference to customers undergoing debt restructuring (and in this case the debtor has complied/is complying with the plan/agreement).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.