The new definition of default – Finance and Banking

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introduction

This alert concerns the new definition of default for prudential purposes which entered into force on 1st January 2021 and is applicable to all European financial intermediaries.

New European rules on default

The regulatory framework

EU Regulation of June 26, 2013, n. 575 1 on the prudential requirements applicable to credit institutions and investment firms (CRR) introduced specific provisions on debtor default in Article 178 and entrusted the European Banking Authority (TSA) with the publication of guidelines on the application of the definition of default and for the European Commission the adoption of a delegated regulation relating to the measurement of the materiality threshold of overdue loans on the basis of regulatory technical standards published by the ABE.

On September 28, 2016, the EBA published the guidelines 2 on the definition of the defect as well as the technical standards relating to the materiality threshold. In order to implement the CRR and the EBA guidelines on the definition of impaired credit exposures, the Bank of Italy has issued a specific communication 3 with reference to the prudential statistical reports and the financial statements of the banks of June 26, 2019.

More recently, the Italian Supervisory Authority provided further clarification on the implementation with a note dated October 15, 2020 4.

The logic of the interventions mentioned is undoubtedly to bring the European banking and financial system into conformity with the principles of supervisory equivalence and regulatory neutrality. The deadline for banks subject to European Central Bank supervision and European non-bank financial intermediaries to apply the new rules has been set for January 1, 2021.

The new definition of defect: conditions and materiality thresholds

The proposed new regulatory structure identifies the objective and subjective conditions for a debtor to be considered in default. Certain materiality thresholds have also been introduced, which must be exceeded for the debtor 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 (“delay criterion“): the debtor has been past due for more than 90 days 5 on any significant credit obligation towards the institution, taking into account all of the latter’s obligations towards the intermediary;

(ii) subjective condition (“improbability of paying“): the institution considers it unlikely that the debtor will meet its credit obligations to the institution, without recourse by the institution to actions such as the creation of collateral.

Once the existence of an arrears criterion has been verified, it will become relevant if certain specific thresholds are exceeded depending on the nature of the debtor (retail trade 6 and non-retail customer):

(i) in absolute value: 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 debtor’s global exposures
vis à vis credit and financial intermediaries belonging to the same prudential consolidation scope 7.

In view of the above, 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, although having no significant arrears for more than 90 days, are, in the opinion of the intermediary, unable to fulfill their obligations. (subjective condition).

In order to mitigate the discretion left to each intermediary in assessing a potential default, the EBA guidelines provide some qualitative and quantitative guidance that intermediaries will need to take into account in bringing an unlikely-to-pay position back into the bank. the category of defects.

Among others, it is worth mentioning the lack of recording of the position in the intermediary’s income statement due to the decrease in the quality of the credit obligation, the transfer of the receivable through the intermediary ( with particular reference to securitization transactions 8), the presence of specific provisions on exposures according to IFRS9 accounting principles, a restructuring of the debt 9, bankruptcy or similar provision or protection of the debtor, a significant increase in the debtor’s financial leverage and a decrease in the sources of his income. When one of the above indicators occurs, all exposures vis à visthe debtor is considered in default.

Additional provisions

(a) Compensation

Different from the past, from 1st from January 2021, the offsetting of any unpaid debts with other open and unused or partially used credit lines from the same debtor will no longer be authorized. Consequently, a financial institution will be required to classify the customer in default even if the latter has credit lines still available with said institutions.

(b) Default contagion rule

According to the new rules, intermediaries will have to probe the relationships between their customers, in order to identify the cases in which the failure of a company can negatively affect the repayment capacity of another debtor linked to it (so-called contagion effect). ), with the consequence that the latter can also be considered as faulty.

A link between different companies may be determined by links of control or of an economic nature (e.g. companies belonging to the same supply chain) ten.

(c) Return to non-default status

Unlike the past 11, the return of debtors to the state of non-default in accordance with Article 178 (5) of the CRR is only possible after the expiration of a period of three months from the moment when the conditions referred to in Article 178, paragraph 1, letter b) and paragraph 3 of CRR ceased to exist (and, therefore, the client has stabilized its position 12).

During this 3-month probationary period, the financial intermediaries assess the debtor’s behavior and overall financial situation and only authorize a return to a non-default state if it is deemed to be effectively and permanently stable.

This article is for informational purposes only and is not, and should not be construed as, professional advice on the matters discussed. For more information please contact Matteo Gallanti or Bianca Macrina.

Footnotes

1 https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013R0575&from=EN

2 https://www.eba.europa.eu/sites/default/files/documents/10180/1597103/004d3356-a9dc-49d1-aab1-3591f4d42cbb/Final%20Report%20on%20Guidelines%20on%20default%20definition%20% 28EBA-GL-2016-07% 29.pdf? Retry = 1.

3https://www.bancaditalia.it/compiti/vigilanza/normativa/archivio-norme/circolari/c272/Com_26giugno2019.pdf.

4https://www.bancaditalia.it/compiti/vigilanza/normativa/archivio-norme/circolari/c285/risposte_quesiti_applicativi/Nota-di-chiarimenti-2020.10.15.pdf?pk_campaign=EmailAlertBdi&pk_kwd=it.

5 The days of delay are calculated from the day following the date on which the amounts due in principal, interest and any costs have not been paid and have exceeded the corresponding thresholds. In the event of suspension of payments defined in the original credit agreement and modification of the deadlines, subject to a specific agreement with the establishment, the counting of the days of delay will follow the new repayment plan.

6 Small and medium-sized businesses and individuals.

7 Competent authorities may agree on a different threshold, between 0 and 2.5%.

8 A position is considered to be in default if the transfer in a securitization transaction is made due to the decrease in the credit obligation loss and has a credit-related economic loss greater than 5% of the gross book value.

9 Restructuring is relevant for the purpose of indicating whether it involves a substantial forgiveness or deferral of principal, interest or charges determining a loss greater than 1% of the original amount of the debt.

10 The customer groups are defined in art. 4, paragraph 1, point 39 of CRR.

11 Before January 1, 2021, the default status ceases to exist when the debtor settles the overdue payment vis à vis the intermediary and / or covers the overrun of the overdraft account.

12 The trial period is extended to one year with reference to customers undergoing debt restructuring (and in this case, the debtor has respected / respected the plan / agreement).

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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