ECB Warns Eurozone Banks Lag on Loan Loss Reserves

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Eurozone banks are still struggling to adhere to accounting rules regarding provisions for loan losses, despite some progress in integrating climate risks, according to Claudia Buch, the European Central Bank’s top supervisor. The decade-old International Financial Reporting Standard 9 (IFRS 9) mandates that banks make upfront provisions when granting loans, followed by additional provisions if signs of potential default emerge, rather than waiting for non-payment.

Buch expressed concern over the eurozone banks’ slow implementation of IFRS 9, echoing sentiments shared by other European regulators. While acknowledging advancements, particularly regarding climate and environmental risks, she noted that many banks are yet to meet IFRS 9 expectations.

Although the proportion of unpaid loans on eurozone bank balance sheets has reached historic lows, attributed in part to ECB pressure, new challenges such as rising interest rates and geopolitical uncertainties, including the Ukraine conflict and disruptions in trade patterns with China and the U.S., are raising regulatory concerns.

Buch highlighted banks’ overreliance on broad “overlays,” such as general provisions against new risks and uncertainties not adequately captured by internal models. Some banks employ “umbrella overlays” that overlook sector-specific impacts, while others simply adjust forecasts for economic growth without considering sectoral differences.

She emphasized the underestimation of true default risks due to such practices and criticized banks for inadequate loan reclassifications, echoing concerns voiced by her predecessor, Andrea Enria. IFRS 9 categorizes loans into three stages based on the likelihood of non-payment, necessitating increased provisioning as risks escalate.

Buch stressed the importance of enhancing risk management by leveraging overlays to assess novel risks more accurately, employing simulations and scenarios, and improving loan stage transfers. These measures are crucial for banks to effectively navigate evolving economic landscapes and ensure robust risk management practices.