With the new Law on the Measures and Actions during the State of Emergency, promulgated on 24.03.2020, provisional measures were introduced, foreseeing the non-application of delayed payment sanctions for obligations of private law subjects, including interest for default and penalties. Until the state of emergency is lifted, it is also envisaged that the non-monetary consequences of nonfulfillment, such as premature payment claim, termination of contract and seizure of property, will not apply. In addition to a number of other uncertainties, regarding the implementation of the adopted text, it also raises important questions for the banking and financial sector, related to meeting regulatory requirements for compliance with capital requirements. One of these questions is how should loans that are not subject to delayed payment consequences be treated and will they be subject to additional provisioning. In this regard, it is important to be noted that the discussed Art. 6 from the Law on the Measures and Actions during the State of Emergency does not provide vacation or grace period for the payment of installments under the respective credit agreements. They are due within the terms of the contracts. The Law only allows the non-application of delay consequences, i.e., even if no loan payment is made, no interest for default and penalties shall be required, the Lenders shall not invoke premature payment claim, the credit agreements shall not be terminated etc. Under the thus adopted legislative framework, credit institutions are faced with the question of whether or not the non-performance of loans, which could occur due to the non-application of the delay consequences, would be considered overdue and would it therefore lead to an increase of their provisioning, as required by the applicable accounting standards.

When is a loan considered for such in default?

In general, the European Supervisory Authorities consider a loan to be non-performing when there are indications that the Borrower may not repay the loan due to financial difficulties or when more than 90 days have passed without the Borrower making the agreed upon payments. In the worst case scenario the Borrower is completely unable to repay the loan and so the Bank has to adjust its value in its balance – sometimes this value equals zero. That is called “writing off a loan”. When the value of the non-performing loans exceeds a certain level, the Bank’s yield worsens. Banks are obliged to allocate funds, i.e., to maintain provisions as a security mechanism in case they need to devalue or write off loans.

Will the adopted measures under the conditions of a state of emergency lead to an obligation of the banks to maintain additional provision?

A partial clarity regarding the position of the Regulatory Authorities on an European level is provided by a statement by the European Banking Authority, adopted on 25.03.2020.

With its position, the European Banking Authority expresses its support for the measures taken and proposed by the national governments and the European Authorities in regards to the systematic negative economic impact of the COVID-19 pandemic in the form of public (legislative, like the adopted in Romania and Hungary) or private (initiated by the banks or financial institutions themselves) moratoria and non-application of loan contracts payment delay unfavorable consequences. With the adopted statement, the European Banking Authority clarifies some aspects of the functioning of the prudential framework in force with the aim of providing clarity in the banking sector, regarding questions related to: (i) the classification of loans in default, (ii) the identification of forborne exposures and (iii) the accounting treatment

The European Banking Authority calls for flexibility and pragmatism in the implementation of the prudential framework and capital requirements, clarifying that in the case of moratoria and the adoption of measures for the non-application of delayed payment sanctions, the loans shall not be automatically classified as a loan in default or as a forborn exposures. Emphasis is placed on the importance of the adequate risk measuring and the carrying out of individual assessments of the Borrowers’ paying abilities by the credit institutions.

It is envisaged that mitigating factors should be taken into account when identifying non-performing loans, which would allow for an assessment of the objective risk of economic loss. As indicated above, in accordance with the criteria applicable so far, a single credit is generally classified as a loan in default in the event that 90 days have passed since the non-payment of its regular installment. The purpose of the deadline is to provide sufficient time for its restructuring, if possible and necessary. This is particularly important in light of the measures introduced as a result of the COVID-19 pandemic. In its clarifications, the European Banking Authority explicitly recommends that the 90-day period be extended by the period, for which a moratorium or exceptional measures, allowing for deferral of payments on the relevant loans are applied.

It is expressly stated that the loans should be renegotiated so that the Lender’s financial position does not worsen (i.e. the net present value of cash flows of the loan remain the same after its restructuring). In this case, if the Borrower is likely to fulfill his/her obligations under the renegotiated terms, the exposure need not be classified as in default. This restructuring should be viewed as a measure to provide relief from the negative effect on Borrowers, who are temporarily unable to service their obligations due to the spread of COVID-19. It is explicitly stated in the process to ensure maximum consumer protection. In particular, customers should fully understand the consequences of the adoption of any measures, hidden fees shall not be applied and the measures overall shall not have a direct negative impact on the customer’s credit rating.

Next point – under the current circumstances, the measures proposed by the governments and the credit institutions to cope with the unfavorable system impact on the economy by the COVID-19 pandemic, should not automatically lead to a reclassification under the definition of forbearance  – i.e. such, that lead to the assumption that regardless of the financial difficulties of the Borrower, the credit itself is not qualified as non-performing. For the purposes of supervisory reporting, the definition of forbearance is designed to be reported when credit institutions offer specific measures to help a specific borrower who is experiencing or likely to experience temporary financial difficulties with their repayment obligations. The individual assessment of the borrower’s financial difficulties and granting measures tailored to this financial situation of the borrower are at the core of the EBA’s definition of forbearance. In this sense, public or private moratoria imposed, or restrictive measures applicable universally, aimed at limiting the negative consequences from non-performance, do not automatically lead to requalification of certain exposures as forborn. In this particular case, adequate risk evaluation by the credit institutions, as well as individual  assessment of the captioned loans and the payment capability of the Borrower is recommended, by considering the specific situation context, arising from the COVID-19 pandemic.

The opinion of the European Banking Authority is synchronized with the position of the European Securities and Markets Authority (ESMA), which on its part also issued instructions for applying the International Accounting Standards IFRS 9, in the hypothesis of non-performing credits due to imposed national measures, following the pandemic. In the opinion on the application of the accounting standards, it is explicitly pointed out, that the latter imply enough flexibility to reflect correctly the specific circumstances, related to the imposed measures, by taking into account the qualitative and quantitative characteristics of the receivables.

What is next for the banks and financial Institutions’?

By considering the consequences of the measures imposed, the banks’ and financial institutions’ focus should be on the real risk assessment and the preparation of individual payment capability evaluation of the Borrowers. The recommendation of the 90-days period, upon which expiration the loan is considered non-performing, to be extended by the moratorium or emergency measures duration, enabling postponement of the due payments on credits, is aimed at allowing the credit institutions better flexibility in their approach and maintain surplus provisions only by considering loans, whose individual evaluation assumes risk of non-fulfillment.

In any case, the recommendations of the European Banking Authority should be concretized by a decision on a national level, reflecting the adopted and applicable measures in Bulgaria, related to the pandemic, and the applicable at this moment legislative framework. In this sense, by considering Art. 6 of the Law on the Measures and Actions during the State of Emergency, it is important to take into account that the envisaged non-application of delayed payment sanctions, including interest  for default and penalties, does not represent public moratorium and does not provide a grace period for payments on credits in the sense of the adopted European Banking Authority recommendations.

Our recommendation to the credit institutions at this stage is: the individual evaluations (implying consequential proving of essential circumstances for provided preferential treatment, e.g. during financial audit or regulatory inspection) to be inclusive of a formal Request (Declaration, Statement, Notification) by the Client and to be well-grounded.

You can address questions on particular issues to Att. Tsvetelina Stoilova (ts.stoilova@popovarnaudov.bg) – Senior Associated Partner and Head of Banking and Finance practice at Popov, Arnaudov and Partners Law Office