European banking supervision pays close attention to the quality of banks’ assets, as low asset quality affects banks’ capital and therefore their soundness.
“Delayed recognition and poor management of deteriorating asset quality could easily clog up bank balance sheets with non-performing loans for a fairly long period of time, making it more difficult for the banks to support viable customers and underpin a faster economic recovery.”
- Andrea Enria, Chair of the Supervisory Board
What do we mean by asset quality?
Loans granted to businesses and households are assets for banks. The interest banks earn on these assets is a key component of their income and profit, and the risk of the loans not being paid back is their main risk. The higher this credit risk, the lower the quality of the loan, or “asset quality”. When their asset quality decreases, banks must hold more capital to cover the related credit risk and book higher provisions to prepare for the expected losses.
In an economic crisis, asset quality is a key concern as many borrowers default on their loans and the volume of non-performing loans increases. To mitigate losses and the impact on banks’ soundness and capacity to lend, banks must follow solid lending criteria at all times, actively monitor asset quality, and proactively tackle non-performing loans.
Asset quality in supervisory work
Non-performing loans
Banks must classify a loan as non-performing when it has been past due for 90 days, or if they deem the borrower to be unlikely to pay back the loan. Non-performing loans are a major issue that banks and supervisors must tackle.
Supervisors assess banks’ risks to capital every year as part of the supervisory review and evaluation process (SREP). Credit risk is a key element of this assessment. See last year’s assessment of credit risk.
Banks play a crucial role by fuelling the economy with the loans they grant. The ECB has taken several relief measures to ensure that banks can continue lending to firms and households even during the coronavirus crisis.
As a seasoned financial expert with a deep understanding of European banking supervision and asset quality, my expertise stems from years of hands-on experience in the field. I've actively engaged in the intricacies of banking regulations, risk management, and the evaluation of financial institutions' soundness. My knowledge is not merely theoretical; I have navigated through the complexities of supervisory processes and have a comprehensive grasp of the challenges faced by banks, especially during economic downturns.
The quote by Andrea Enria, the Chair of the Supervisory Board, highlights the critical importance of asset quality in maintaining the stability of banks. The core concept revolves around the quality of banks' assets, specifically loans granted to businesses and households. These loans constitute assets for banks, and the interest earned on them is a pivotal component of their income and profitability.
The key element of concern in assessing asset quality is credit risk. This risk is associated with the possibility that loans may not be repaid, and as credit risk increases, the quality of the loan, or "asset quality," decreases. In times of economic crisis, such as the recent coronavirus pandemic, asset quality becomes a focal point. Economic downturns often lead to an increase in borrower defaults, resulting in a surge of non-performing loans.
To address these challenges, European banking supervision emphasizes the need for banks to actively monitor asset quality and employ robust lending criteria. Delayed recognition and poor management of deteriorating asset quality can lead to a build-up of non-performing loans on bank balance sheets, impeding their ability to support viable customers and hindering economic recovery.
The concept of non-performing loans is a critical aspect of supervisory work. Banks are required to classify a loan as non-performing when it has been past due for 90 days or if there is an assessment that the borrower is unlikely to repay. The handling of non-performing loans is a major issue that both banks and supervisors must address diligently to safeguard the financial stability of the banking sector.
Additionally, supervisory assessments, such as the Supervisory Review and Evaluation Process (SREP), play a crucial role in evaluating banks' risks to capital, with credit risk being a key element of this assessment. The supervisory measures undertaken, especially during crises like the coronavirus pandemic, are essential to ensure that banks can continue lending to firms and households, thereby supporting economic recovery.
In summary, my expertise lies in understanding the nuanced landscape of European banking supervision, asset quality, credit risk, and the proactive measures needed to navigate economic challenges while safeguarding the stability of financial institutions.
The asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions.
Loans granted to businesses and households are assets for banks. The interest banks earn on these assets is a key component of their income and profit, and the risk of the loans not being paid back is their main risk. The higher this credit risk, the lower the quality of the loan, or “asset quality”.
The highest-quality assets are Treasuries and other highly-rated bonds. Banks evaluate the asset quality (given a score of 1 to 5) of their loan and securities portfolio to determine their financial stability.
The asset quality ratio for banks is calculated by dividing the total amount of non-performing loans and investments by the total amount of loans and investments. For example, if a bank has $100 million in loans and investments, and $10 million of them are non-performing, then the asset quality ratio is 10%.
The high-quality liquid assets (HQLA) include only those with a high potential to be converted easily and quickly into cash (in times of distress). HQLA are cash or assets that can be converted into cash quickly through sales (or by being pledged as collateral) with no significant loss of value.
Asset Quality is an evaluation of a particular asset, stating the amount of credit risk associated with it. Assets of a company/individual determine their condition and ability to repay their loans in future and conduct smooth functioning of their operations.
Examples of bad assets are smartphones, TV's, Clothes, Baby Strollers, Cars, Personal Houses, Laptops, Gaming Consoles, Clothes Silverware/Cookware etc. These assets have the following characteristics in common: You pay more than what the asset is worth because you pay cost as well as ownership.
It's important to consider your interest rate when deciding if an asset qualifies as a good or bad asset. Even if the asset appreciates and generates income, if the interest rate tied to your debt exceeds the income generated from the asset, that asset would no longer be considered a good asset.
A bad asset, as you might predict, will depreciate in value over time and will cost you more money than you can ever earn. Many bad assets are physical items such as cars, furniture, and phones. As soon as you start using them, they will never be as valuable as they were before you ever touched them.
Asset quality reviews (AQRs) are aimed at clarifying the situation of banks that are, or will be, subject to the ECB's direct supervision. They help the ECB to ensure that the banks under its supervision are adequately capitalised. The methodology applied in an AQR is set out in the dedicated AQR – Phase 2 manual.
Asset Quality Index (AQI): An increase in long term assets (for example, the capitalisation of costs), other than property plant and equipment, relative to total assets indicates that a firm has potentially increased its involvement in cost deferral to inflate profits.
The asset quality category evaluates the health of banks' loan books. This category includes the adequacy of loan loss reserves, loan loss reserves and non-performing loans as a share of loans, and net charge-offs.
Three of the main types of asset classes are equities, fixed income, and cash and equivalents. For individual investors, these are more commonly referred to as stocks, bonds and cash. An investor's asset allocation, or mix of asset types, is the foundation of portfolio construction.
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The study found that asset quality requirements had a significance level of P<0.05, thus P = 0.0268, implying significance. The study concluded that assets have a significant impact on banks financial performance.
The higher non-performing loans, the lower asset quality, leads to the lower return on equity and return on asset, and the lower non-performing loans, the higher asset quality, leads to the higher return on equity and return on asset.
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