Critical review on the European bank regulators’ definition of default for forborne bank loans

Thumbnail Image
Journal Title
Journal ISSN
Volume Title
School of Business | Master's thesis
Degree programme
64 + 4
I study European Banking Authority’s regulatory definition of default that applies to all euro-zone bank loans and in specific, a default criteria for loans that receive forbearance measures i.e. easement of loan terms. I exploit the explicitness of the regulation to study it through analytical and numerical methods. The primary objective of the paper is to find under which conditions forbearance leads to default under the regulation and what this implies to the economy. I derive general loan valuation models determined by the regulation for loans with unique amortization profiles. I show that, under certain assumptions the regulatory formulas lead to convenient analytic solutions. I derive several models to measure value change under the regulatory guideline by defining different forbearance measures. These forbearance measures include maturity extension, amortizing free period, interest capitalization, grace period, rate reduction and principal forgiveness. The forbearance measures either create material changes to the loan or modify the structure and timing of the cash flows. In addition to deriving the models, I simulate a pool of loans that have similar credit risk to further study the regulation. Using comparable credit risk, but differing fee structures of the loans, I study the impact and consistency of the forbearance measures on these loans and find which cash-flow structures, risk-levels and forbearance measures lead to default. Based on the analytical derivation and simulations I conclude that the regulatory definition leads to consequences that may have not been intended by the regulators. The largest consequence of the regulation is that it creates an incentive for banks to create loans without fees, which may result to welfare loss according to previous literature. The regulation also provides different results for forbearance measures that are otherwise similar and different forbearance measures are optimal depending on the attributes of the loan. The differences seem to conflict with asset pricing literature. Additionally, the regulation is procyclical, which appears to be known by the regulators since they amended the definition of default during the latest economic downturn. The study contributes to the literature on financial regulation and is in line with earlier findings on model-based regulation. The study offers numerous follow-up questions that can be studied.
Thesis advisor
Lof, Matthijs
Koivu, Matti
financial regulation, fixed income, banking, bank loans, credit risk
Other note