How Binding Is Supervisory Guidance?


Franco Fiordelisi
Professor of Banking and Finance, Essex Business School
Gabriele Lattanzio
Assistant Professor, Nazarbayev University
Davide Salvatore Mare
Researcher, World Bank

Supervision and regulation are critical tools to ensure the stability and resilience of the financial sector. Yet, supervisory initiatives are rarely examined separately from regulatory actions and relatively little is known about whether banks respond differently to the adoption of a supervisory guidance as compared to a specular regulatory action. The difference between banking regulation and supervision is indeed blurred in the academic literature. The vast majority of existing empirical studies on this matter focus largely on the impact of the former, often not properly articulating the distinction between supervisory and regulatory initiatives and referring to them interchangeably. Yet, the economic and juridical implications of the issuance of a non-legally binding supervisory guidance under the ‘comply or explain’ framework are materially different from those resulting from the passage of a hypothetically identical regulatory intervention.

In our study, we investigate this important question by empirically assessing whether banks respond differently to the adoption of a supervisory guidance as compared to a specular regulatory action. To do so, we study the staggered and distinct supervisory and regulatory implementation of a reform aiming at tackling the pressing issue of increasing levels of non-performing loans (NPLs) held by European banks, generally referred to as the European calendar provisioning. This initiative is unique for three main reasons. First, it leaves aside the existing arrangements characterized by a global harmonized effort toward banking regulation, as the European Central Bank (ECB) first and the European Commission (EC) introduced it as unilateral supervisory and regulatory changes. Second, its underpinning idea subverts the principles established by the Basel capital agreements themselves. Indeed, rather than relying on banks’ internal models and capital adequacy assessments, these new rules impose minimum loss coverage requirements to be achieved through write-downs or deductions from regulatory capital depending mechanically on the time elapsed since the default of the considered loan. Third, the complex process of adoption and enforcement of the European calendar provisioning represents a unique setting to analyze whether banks respond differently to the adoption of a supervisory guidance issued under the ‘comply or explain framework’ as compared to a specular regulatory action.

The European calendar provisioning was indeed originally introduced in the form of supervisory guidance by the ECB in 2017. Later in 2018, the ECB provided banks and market participants with a clear statement of supervisory expectations about the provision of non-performing loans in an ‘Addendum’ of the supervisory guidance issued in 2017. These expectations add to the Supervisory Review and Evaluation Process (SREP), carried out by ECB under the so-called Pillar 2. As such, the guidelines released by the ECB were non-binding from a legal perspective, de facto representing a pure supervisory action enforceable exclusively under the principle of ‘comply or explain’. Subsequently, in 2019, the European Parliament and the European Council claimed their power to set regulations and published a minimum coverage framework for non-performing exposures (NPEs). This regulatory initiative (known as ‘backstop’) formalizes the system of deduction from banks’ common equity Tier 1 (CET1) triggered when the minimum coverage levels set out by the ECB calendar provisioning supervisory guideline are violated. Being a legislative act, this regulatory action is included in the Pillar 1 framework and, as such, is legally binding. That is, following the approval of this regulation banks and supervisors have no residual flexibility concerning the degree to which the calendar provisioning should be enforced.

These staggered supervisory and regulatory actions sparked a heated debate concerning two major issues. First, they brought regulation back in time by foregoing model-based analyses of the risk associated with loan exposures to relying on a basic measure of time elapsed. Second, these interventions called into question the degree to which supervisory guidance issued under the comply or explain framework is perceived to be binding by commercial banks, as compared to the legally compulsory nature of regulatory actions.

Building on this discussion, we empirically analyze whether this non-model-based regulatory initiative is effective in reducing non-performing loan ratios, and, foremost, to what degree banks perceive binding de facto supervisory guidance as compared to the de iure nature of regulatory actions. To address these questions within a causal framework, our empirical strategy relies on a dynamic Difference-in-Differences (DID) approach comparing changes in the riskiness, performance, and loan policies of subsidiaries of European banks operating in developing countries with that of comparable domestic banks. Because European banks consolidate worldwide credit exposures under their domestic regulatory framework, their subsidiaries operating in developing countries are indeed directly affected by the adoption of calendar provisioning rules. Conversely, matched banks operating in developing countries are not exposed to the effects of these supervisory and regulatory actions.

Our analyses show that European banks reacted to the release of the ECB calendar provisioning supervisory guideline by treating it as a binding requirement and decreasing their non-performing loan ratios. The recognition of these losses in banks’ income statements as charge-offs induced an immediate reduction in their regulatory capital (Tier 1 capital) and impaired loan reserves, weakening their capitalization profile. Yet, we document that these persistently higher regulatory costs do not cause a reduction in loan origination. Rather, subsidiaries of European banks appear to shift these increased compliance costs to their customers by charging higher interest rates on new loans. Importantly, we further identify that banks target primarily countries featuring weaker definitions of capital requirements and non-performing loans to implement this form of regulatory cost-shifting, consistent with multinational banks exploiting the regulatory leniency of foreign countries to off-load—at least part of—the regulatory costs imposed by domestic regulations and apply lower bank lending standards.

All in all, these findings suggest that (1) the studied non-model based supervisory and regulatory interventions achieved the intended goal—that is reducing European banks’ NPLs ratios—and (2) supervisory guidance issued under the ‘comply or explain’ framework is perceived by banks as binding while providing supervisors with some flexibility concerning the degree to which such actions should be enforced over time and in the cross-section.

Franco Fiordelisi is a Professor of Banking and Finance at Essex Business School.

Gabriele Lattanzio is an Assistant Professor at the Nazarbayev University in Nur-Sultan.

Davide Salvatore Mare is a Researcher with the World Bank and Honorary Lecturer with the University of Edinburgh Business School.


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