The ECB’s Single Supervisory Mechanism (SSM) has just announced further steps in its approach to dealing with non-performing loans (NPLs) in response to continued excessive stocks of legacy risks on banks’ balance sheets. As the SSM has not issued any generally binding rules or automatic measures in this regard, critics are asking themselves whether banks with problem loans are being given too much leeway. Look more closely, however, and it is clear that the new rules have far more clout than it might appear at first glance. In the medium term, the ECB expects full coverage for NPLs after no more than seven years – and much sooner in the case of unsecured loans. 

The economic crisis has left some banks in the euro area with an enduring legacy. Although economic activity has picked up again, NPLs are still putting the pressure on balance sheets. Considerable progress has been made in recent years thanks to the efforts of a number of institutions and the favourable economic situation. That said, while the average NPL ratio of large banks in the euro area has fallen by more than one-quarter since the end of 2015, stocks are still far too high. In addition, the pace of reduction is not uniform across the euro area. In around one-third of euro area countries, the average NPL ratio of large banks remains in double-digit territory. We cannot content ourselves with this.

That is why the SSM has created a comprehensive supervisory framework for NPLs. It had already set out its expectations regarding risk provisioning for new problem loans back in March, which will limit future risk build-ups. Last week, the ECB outlined how it expects banks to scale back the risks stemming from existing problem loans.

These new rules are the previously missing puzzle piece in the overall NPL reduction strategy. And they have three core strengths.

First, the rules are ambitious. They are clearly aimed at reducing legacy risks at all banks within a reasonable timeframe under the direct supervision of the SSM. And all participating countries support this.

Second, the rules are flexible. The SSM has opted for a bank-specific approach to dealing with NPL stocks. There are good reasons for this. The distribution of legacy risks varies greatly, not only from country to country but also from institution to institution. An institution whose credit portfolio contains only a small percentage of NPLs requires a different strategy and timeframe to those for an institution with a starting NPL ratio of 40% or more. Using a one-size-fits-all plan, some institutions would be overburdened whilst others would get off too lightly.

Thanks to the bank-specific approach, it is not the weakest institutions that set the pace. Every institution needs to meet the requirements set out for its operations – if not, supervisors will take firm, decisive action.

Third, the rules are consistent. Flexible as they may be, they also ensure that comparable results are expected from similar banks. In other words, while the approach is bank-specific, it is comparable across banks. Banks with the same starting conditions are also treated equally.

The rules are also consistent in terms of their effect. This is due to the fact that the aim over the medium term is to achieve the same coverage for existing NPL stocks as for new problem loans – essentially, this will mean full coverage. This consistent treatment of all NPLs is key to ensuring that banks do not drag their heels when it comes to reducing legacy risks.

Ambitious, flexible, consistent. The new rules provide supervisors with a firm foundation for tackling NPLs. Responsibility for finding the best risk-reduction strategy still rests with the banks. The SSM cannot be expected to lay down a generally applicable rule because, at the end of the day, it has no legislative powers – it implements statutory provisions in isolated instances only. But what it can do is keep twisting the knife so as to ensure that de-risking continues.

The new rules will make an effective contribution to further scaling back crisis-era legacy risks. This is also of major significance for the further development of the European banking union. For it is only if we successfully de-risk that, in the medium term, we can lay the ground for a backstop for the European Single Resolution Fund and, ultimately, for a common European deposit insurance scheme.