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Payment Holidays in the EU: Implications for Asset QualityPayment Holidays in the EU: Implications for Asset Quality
Following the outbreak of the coronavirus pandemic (COVID-19), many governments and prudential authorities around the world implemented preventive measures to curb its severe economic impacts on households and businesses. Among such measures, payment holidays (also known as a moratorium, deferral or modification) suspended borrowers’ payment obligations to lenders for a short period. Payment holidays aimed to provide the necessary breathing space to borrowers facing liquidity challenges due to the pandemic. Most of the payment holidays in the EU countries have come to an end as of 31 March 2021, except for Italy and Portugal where they were extended to June and September 2021 respectively [1]. In this article, we take a closer look at payment holidays’ implications for asset quality in the EU.
Table 1 shows the key characteristics of payment holidays implemented in several jurisdictions across the globe [2]. Payment holidays were legislative (applies to all institutions in a given jurisdiction) or non-legislative (based on industry-wide or institution led initiatives), typically delaying both principal and interest payments in the near term, with no penalties or fees charged. Lenders were encouraged to provide payment holidays to “solvent but illiquid” borrowers, meaning borrowers that were not in arrears or default previously, and who were mainly and most affected by the pandemic through unemployment (consumers) or loss of income (businesses) [3]. The exclusion of borrowers with poor credit scores aimed to provide support only to viable borrowers and hence to improve “good” credit lending by lenders. This is because payment holidays are not costless. Payments are delayed, not forgiven. Insolvent borrowers may not service potentially higher debt repayments after a payment holiday. Note however that lenders may or may not have the discretion to determine the eligibility of the borrower for, or the terms of, a payment holiday depending on the legislation.
Table 1: Key features of selected payment deferral programmes.
Source: BIS, Payment holidays in the age of Covid: Implications for loan valuations, market trust and financial stability, May 2020.
Payment holidays have been an effective tool to sustain the flow of credit during the last year of the pandemic. In the EU, a total of almost €1 trillion of loans have benefitted from payment holidays as of March 2021 [4]. Payment holiday rate, measured by the outstanding loan amount with payment holiday as a percent of gross loans to households and non-financial corporates, was 3.5% in major western countries at the end of 2020 [5]. This rate had peaked at 9% in Q1 2020 and subsequently decreased to 6% in Q3 2020. Figure 1 shows that payment holiday rates showed a large variation across jurisdictions: 21% and 16% in Portugal and Italy, whereas only 0.24% and 0.13% in Germany and Netherlands, respectively, at the end of 2020.
Payment holidays also showed variation in their types and benefited groups. From its large database covering most public securitisations in Europe, European Datawarehouse identified payment holidays in consumer loans through maturity extensions, decrease in loan instalment and negative amortization, meaning an increase in current balance when a loan payment is lower than the interest charged. Their analysis shows that the most common type of payment holiday was maturity date extension, followed by increase in current balance and decrease in instalments. In addition, their analysis indicates that the self-employed borrowers were hit most by the pandemic as they accessed payment holidays around 60% more than employed borrowers (14.8% and 9.1% respectively) [6]. This result was also highlighted for Dutch mortgages in LoanClear’s publication on their Dutch Mortgage Arrears Index [7].
Figure 1: Loan moratoria usage in the EU per country as of the end of 2020.
Source: Fitch Ratings
The implementation of payment holidays posed substantial risks to asset quality for banks and non-bank lenders. Following the introduction of the Expected Credit Loss (ECL) impairment framework in IFRS-9 in July 2014, banks were required to recognize the “expected” credit losses at all times to reflect the changes in assets’ credit risks [8]. Under the new framework, ECL provisions depended on loan status (performing (Stage 1), underperforming (Stage 2) and non-performing (Stage 3)) and the associated credit loss assumption: For current loans, it considered the portion of the default probability over the next 12 months, whereas for underperforming and non-performing loans it considered the default probability throughout the life of a loan.
Payment holidays would have three main implications for banks’ asset quality: 1) triggering an increase in credit risk and hence migrating loans to lower stages of asset quality, 2) increasing ECL provisions due to the switch to lifetime ECLs, 3) reduction of interest income in case of loans rolling to default. A sudden and sharp spike in ECL provisions would contract banks’ net income and hence equity. This would disrupt lending to borrowers affected by the pandemic and deepen the ongoing crisis [9].
The challenge for prudential authorities was to balance the short-term economic benefits of the relief provided by payment holidays with their long-term effects on asset quality, lending ability and overall financial stability. This tradeoff depended largely on the characteristics of the payment holidays and their combination with other support measures. When lenders were obliged to grant payment holidays with flexible borrower eligibility, long duration and full deferral (both principal and interest payments), this would provide the maximum relief to borrowers but highly increase risks, particularly if no public guarantees were in place. On the other hand, both the relief and risks would be minimal in the case of voluntary bank participation, strict eligibility criteria, short duration and partial deferral (principal only), if combined with public guarantees [10]. Moreover, banks had to set aside capital for increasingly likely losses stemming from borrowers that would no longer be able to meet their payment obligations.
To overcome this challenge, authorities paused the asset quality, capital and impairment rules in place [11] stressing the fact that payment holidays related to the pandemic target a wide range of borrowers and that their cash flow difficulties might be temporary. Under the European Banking Authority’s (EBA) new guideline published in December 2020 [12], a payment holiday would not automatically trigger a significant increase in risk and hence would not necessarily migrate a loan to lower stages of quality under certain conditions. The ECL provisions would therefore be estimated without the effect of temporary illiquidity issues faced by the borrowers due to the pandemic [13]. This action by the EBA arguably masked the true toll of the pandemic on banks’ asset quality [14]. With the end of payment holidays, the consequences on banks’ asset quality already started to emerge. The EBA’s quarterly risk dashboard [15] showed that NPL ratios increased in Q1 2021 in the sectors that were the most affected by the pandemic (accommodation and food services & arts, entertainment and recreation). Figure 2 illustrates the fact that the total volume of loans with expired payment holiday increased in most EU countries in Q1 2021 compared to Q4 2020. In the EU, this total increased 16.4% in the past quarter, reaching €674.2 billion in Q1 2021. Despite the increase in volumes, NPL ratios rose in almost all the selected EU countries (Figure 3) which reveals the gradual deterioration in asset quality for these loans. The average NPL ratio in the EU increased to 4.5% in Q1 2021 (from 4% in Q4 2020) for loans with expired payment holiday with large variations across countries [16].
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| Figure 2: Total volume of loans with expired payment holidays in the EU. Source: EBA Risk Dashboard 2021-Q1 | Figure 3: NPL ratios of loans with expired payment holidays in the EU. Source: EBA Risk Dashboard 2021-Q1 |
Banks and prudential authorities are increasingly worried about the situation. Around 65% of the European banks expect asset quality of consumer credits to deteriorate [17]. In a recent press release, supervisory authorities advised national competent authorities, financial institutions and market participants to prepare for this, and emphasized that the economic recovery prospects remain uncertain [18].
For non-bank lenders, payment holidays might have more severe impacts on asset quality as their customers are typically riskier than for banks, hence suggesting higher exposure to the pandemic and more access to payment holidays. Non-bank lenders will also face liquidity challenges as they do not have access to retail deposits or central bank facilities and that they were largely excluded from government-backed loan schemes [19]. These challenges will be exacerbated by the fact non-bank lenders’ customers are typically charged higher interest rates and that their customers may have more difficulties in repaying the accumulated interests after the payment holidays.
Keeping these in mind, phasing smoothly and appropriately out of payment holiday measures will be crucial in minimising the cliff effects and the build-up of distressed debt [20]. The risks for lenders and borrowers will depend on borrowers’ ability to continue their repayments and collateral supports. For banks, the upcoming Q2 2021 EBA Risk Dashboard will shed more light on the real consequences of the pandemic on asset quality.
Conclusion
Among other crisis measures, payment holidays were introduced by several countries to mitigate the negative effects of the pandemic on consumers and businesses. Although payment holidays provided distressed borrowers with short-term economic benefits, they posed holidays substantial risks to asset quality for banks and non-bank lenders. Under the prevailing accounting framework, payment holidays would put pressure on banks, disrupt the flow of credit to borrowers and deepen the crisis. Hence, authorities responded by providing flexibility in the assessment of credit risk which in turn masked the real effects of the pandemic on asset quality. With payment holidays having come to an end in most European countries, these effects are gradually becoming more visible implying tighter financial conditions for lenders and borrowers in the post-pandemic period.
References
[1, 5, 11, 14] Fitch Ratings, EU Banks’ 2Q21 Results to Signal Post-Moratoria Asset Quality
[4] European Credit Research Institute, Moratoria on loan repayments: status-quo and phase out!
[6] European Datawarehouse, Monitoring the Impact of Covid-19: Consumer Loan Insights
[7] LoanClear, First signs of COVID-19 impact, Dutch mortgage arrears are rising
[8] Bank for International Settlements, IFRS 9 and expected loss provisioning
[19] Fitch Ratings, Payment Holidays to Weaken European Non-Bank Lenders' Liquidity
[20] KPMG, With asset quality on the brink, supervisors’ focus on credit risk is growing
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