4.4 Supervisory evaluation of credit risk practices, accounting for expected credit losses and capital adequacy

Competent authorities should be satisfied that credit institutions have adopted and adhered to the sound credit risk practices described in these guidelines. Competent authorities’ evaluation should include, but not be limited to, whether:

• a. the credit institution’s internal credit risk review function is robust and encompasses all lending exposures;
• b. the quality of a credit institution’s processes and systems for identifying, classifying, monitoring and addressing changes in credit risk for all lending exposures in a timely manner is adequate, and management’s experienced credit judgement considers current conditions and forward-looking information, including macroeconomic factors, and is well documented;
• c. the credit institution’s processes reflect the risk appetite of the credit institution in a manner that ensures lending exposures on which credit risk has increased since origination or purchase to a level in excess of the credit institution’s risk appetite are promptly identified and properly monitored, and ECL allowance estimates appropriately reflect the increases in the credit risk of these exposures as increases are identified. Where a credit institution originates or purchases a lending exposure on which credit risk at acquisition exceeds the institution’s risk appetite and which therefore represents an exception to the institution’s lending policies and standards, competent authorities should evaluate whether the institution has established and adheres to appropriate processes and controls for: the initial identification, review, approval and documentation of such exposures; the reporting of such policy exceptions to senior management and, for individually significant exposures, to the management body; and the proper monitoring of such exposures after initial recognition. Competent authorities should also evaluate whether the credit institution’s processes and controls separately identify ECL allowance estimates related to exposures consistent with the credit institution’s risk appetite and those related to riskier lending exposures;
• d. appropriate information about the credit risk of lending exposures, changes in credit risk, the related ECL allowance and changes in allowance estimates is provided to the credit institution’s management body and senior management on a regular (for example, quarterly or, if warranted, more frequent) basis;
• e. forecasts included in credit risk assessments and measurements are not only reasonable and supportable, but are also consistent with forecasts used for other purposes by the credit institution, all of which are made available to competent authorities; and
• f. the credit institution’s policies and procedures for validating the accuracy and consistency of its internal credit risk assessment models are robust.

In making these evaluations, competent authorities may require credit institutions to provide supplemental information, not publicly disclosed, through regular supervisory reporting, ad hoc reporting or on-site examinations. Competent authorities could also use these approaches for obtaining supplemental information when performing the evaluations called for in the principles below.

4.4.2 Principle 2 — ECL measurement assessment

Competent authorities should be satisfied that the methods employed by a credit institution to determine accounting allowances lead to an appropriate measurement of ECL in accordance with the applicable accounting framework.

In assessing the methods employed by a credit institution to estimate allowances, competent authorities should be satisfied that the credit institution is following policies and practices consistent with the ECL measurement principles outlined in these guidelines, including, but not limited to, the following:

• a. the procedures used by a credit institution to measure ECL are robust and timely and take into account criteria such as updated valuations of credit risk mitigants (and, in particular, collateral, the residual risk after taking into account the mitigants, the correlation of that risk with borrowers’ creditworthiness and the potential impact in terms of the effectiveness of protection), cash flow estimates based on assessments of borrower-specific factors and current and future macroeconomic conditions, together with other relevant forward-looking information that affects the expected collectability of the credit institution’s lending exposure;
• b. the framework and methodology for establishing allowances, whether determined collectively or individually, are robust;
• c. aggregate allowances on lending exposures are appropriate in accordance with relevant accounting requirements and in relation to the credit risk exposure in the credit institution’s portfolio;
• d. uncollectability is recognised in the appropriate period through allowances or write-offs; and
• e. regardless of the method used to determine ECL, the credit institution’s internal processes for measuring ECL take account of the credit risk that the credit institution has taken on and changes in the credit risk of the credit institution’s lending exposures.

Competent authorities should scrutinise the use of practical expedients referred to in section 4.3 to determine the appropriateness of ECL measurement.

Competent authorities may make use of the work performed by internal and external auditors in reviewing a credit institution’s credit risk assessment and ECL measurement functions³³ .

4.4.3 Principle 3 — Capital adequacy assessment

Competent authorities should also consider a credit institution’s credit risk practices when assessing a credit institution’s overall capital adequacy.

³³ EBA Guidelines on Internal Governance (GL44) and EBA Guidelines on communication between competent authorities and statutory auditors (EBA/GL/2016/05)

In assessing the appropriateness of the level of allowances for lending exposures as an element of a credit institution’s overall capital adequacy, competent authorities should look at their credit risk practices and take into account that the credit institution’s related ECL processes, methodology and underlying assumptions require the exercise of a substantial degree of experienced credit judgement.

In performing their assessments, competent authorities should consider whether a credit institution has:

• a. maintained effective systems and controls for identifying, measuring, monitoring and controlling the level of credit risk, significant increases in credit risk and asset quality problems in a timely manner;
• b. analysed all significant relevant factors that affect credit risk and the collectability of the portfolio; and
• c. established an acceptable allowance estimation process that, at a minimum, meets the principles set out in these guidelines, including the relevant accounting requirements.

When assessing capital adequacy, competent authorities should consider how a credit institution’s accounting and credit risk assessment policies and practices affect the measurement of the credit institution’s assets and earnings and, therefore, its capital position.

Where competent authorities identify deficiencies when assessing a credit institution’s credit risk practices, they should consider how these deficiencies affect the level of reported allowances and, if the aggregate amount of allowances is not appropriate under the applicable accounting framework, the competent authority should discuss this with the credit institution’s senior management and management body and take further appropriate supervisory action when necessary.

In particular, to the extent that credit risk assessment or ECL measurement deficiencies are significant or are not remedied on a timely basis, competent authorities should consider imposing additional own funds requirements pursuant to Article 104 under Section III, Chapter 2, Title VII of Directive 2013/36/EU.