Potential revival of risks for some loans despite continued improvement in asset quality

June 13, 2022

During 2021, the asset quality of euro area banks improved while stocks of non-performing loans (NPLs) continued downward and inflows into riskier asset stages slowed. In the fourth quarter of 2021, the aggregate NPL ratio reached its lowest level since 2008, which was 2.1% of total loans or 58 basis points lower when compared with the corresponding quarter in 2020. This decline had been sustained throughout the previous two years of the pandemic while the ratio of “underperforming” stage 2 loans remained stable at elevated, end-2020 levels of about 9%, well above pre-pandemic levels. Loans subject to forbearance measures, have stabilised at around 1.5% of total loans since the second quarter of 2021. The drivers of the reduction in NPLs were disposals and securitisations of loan portfolios between late 2020 and early 2021. Cure rates of loans brought back to performing forborne status remain low, which underlines the importance of a functioning, liquid secondary market for NPL sales and securitisations as the primary measure for reducing larger NPL volumes.

Although the increase in “underperforming” stage 2 loans peaked in 2021, the total volume is still higher than pre-pandemic levels, and it has continued to rise in some industries that are still affected by the pandemic. Based on four-quarter moving averages, new flows into stage 2 loan classification have stabilized between 1.3% and 1.4% per quarter. Still, this is 70 basis points more than pre-pandemic levels. Since the beginning of the epidemic, credit quality has improved across most corporate sectors and for household (HH) loans. Credit risk, on the other hand, is still rising in several industries that have already shown vulnerabilities to economic shocks during the pandemic. These industries are nonetheless vulnerable to a weakening economy, increased interest rates, the worsening of supply chain bottlenecks, and rising energy prices because of their pre-existing vulnerabilities.

Debtors of corporate loans, which moved from stage 1 to stage 2 during 2021 have better corporate fundamentals than projected. Compared with the pre-existing stock of stage 2 loans, loans that are newly transitioned to stage 2 are less leveraged and more profitable. Concerns about cliff effects associated with the phasing-out of pandemic support to corporates, which would have left corporates in distress, have therefore not materialised despite the expiration of most moratorium schemes and a halt to additional state-guaranteed funding. Individual industries, particularly those most hit by the pandemic, have seen major decreases in profitability, as well as higher leverage ratios, leaving areas of vulnerability on bank balance sheets. Parallel to this, euro area banks have grown their exposure to leveraged lending, which is at an all-time high since 2008 and has risen sharply since 2017. Despite the fact that outstanding sums from euro zone banks are manageable, activity is concentrated on a few significant institutions.

The euro area banks’ aggregate provision coverage ratio has remained constant, despite indicators of misalignment between coverage and credit risk at both the bank and sector levels. For “underperforming” corporate loans, the minimal amount of additional provision and collateral coverage for increases in credit risk is reducing as risk increases for specific sectors. For loans to counterparties with a greater projected risk of default (PD), banks typically provide more or request additional collateral coverage, as this indicates a higher likelihood of loss materialization. Observing PD buckets across sectors, the increase in coverage ratios is small compared with the corresponding relative growth in counterparty credit risk in stage 2 loans. This upfolds downward trend for marginal loan coverage per unit of risk in several sectors, which leaves exposures to riskier counterparties within the stage 2 classification relatively less protected against loan default, increasing tail risks of uncovered losses for stage 2 loans.


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