Tackling the issue of NPLs: a European perspective

Because of the 2008 financial and economic crisis, banks have accumulated billions of non-performing loans (NPLs) on their balance sheets. Even 10 years after this major economic event, the situation is not yet back to normal in some countries.

In the European Union, and in the Eurozone particularly, NPLs are a real concern as they have a direct impact on the resilience and ability of many national banking systems to fulfil their role as financial intermediaries and credit providers, jeopardising economic growth. As per European Central Bank (ECB) data as at June 2016, four Member States (Greece, Spain, France, and Italy) account for the majority of Eurozone bad loans. However, the general trend seems nevertheless to be positive, as highlighted in the recently published EBA quarterly report on risks and vulnerabilities of the EU banking system which shows a decrease in the average ratio, although average ratios are still high compared to the United States (1.5%).

Structural differences between jurisdictions

Does it mean that origination standards in Europe are less prominent than the US, or is the risk level higher? The answer is not so obvious, as financing mechanisms are quite different between the US and Europe. While banks are major economic financial intermediates in both jurisdictions, European banks more commonly use their balance sheets to finance loan portfolios, while in the US banks mainly use the financial markets (i.e. they sell off loans to financial markets after origination). Moreover, state-owned institutions such as Fannie Mae and Freddie Mac allow banks to shed billions of mortgage loans that alleviate US banks’ balance sheets. The effect is to reduce the risk for US banks exhibiting high levels of NPLs.

This highlights the fact that NPLs are not only a banking risk management issue, they also pose political problems linked to the way in which a country decides to organize its funding process. As a consequence, comparing NPL levels in Europe, notably in Eurozone, and the US will not give a full picture of the economic risks. A deeper analysis is therefore required, including a thorough review of the performance of Asset Back Securities and state-owned agencies.

A detailed action plan to deal with NPLs

The current EU economic situation, which is in the midst of a global recovery, particularly favours a policy aimed at reducing the NPL ratio. Against this background, policymakers and banking supervisors consider it’s now time for banks to deal with their core businesses and not to focus on legacy assets anymore. In particular, an EU action plan unveiled by the Council in July 2017 thoroughly describes short or medium term fixes that need to be carried out very quickly to address the NPL issue.

Included in the action plan is the possible introduction by the Commission of statutory “prudential backstops” for provisioning within the Pillar 1 of the prudential regulation expected to be released by the end of March. The action plan is also tasking the Commission to make a Blueprint which will provide practical recommendations for the design and potential set-up of national asset management companies (AMCs) for dealing with NPLs. The recommendations would set out common principles for the relevant asset perimeter, asset-size thresholds, valuation rules, appropriate capital structures and the governance feature. The Commission should also develop a European approach to foster the establishment of secondary markets for NPLs, with a view to removing impediments to the transfer of NPLs by banks to non-banks, as well as to their ownership by non-banks. In this respect the development of the Capital Market Union (CMU) will be a key success factor in growing a necessary secondary market for NPLs, especially where countries such as Italy have started to securitize NPL portfolios to clean up their banks’ balance sheet.

As for the European Banking Authority (EBA), it is expected to issue general guidelines to manage NPLs, enhance disclosure requirements, monitor loan tapes, as well as guidelines on banks’ loan origination (see complete action plan on the link below).^[1] All these initiatives have to be completed within an 18-months horizon.

Finally, addressing the issue of NPLs was one of the first supervisory priorities of the ECB Banking Supervision after it carried out tasks to oversee the Eurozone banking sector. In March 2017, the ECB issued guidance on identification and management of NPLs in order for banks to develop and maintain strategic action plans in situations of excessive NPL build ups. The guidance was welcomed since it framed the way significant institutions (SI) should address their troubled assets. In particular, the Council’s action plan provided that the ECB banking supervision, together with national competent authorities (NCA), should subject less significant institutions (LSI) to a similar guidance on that for SI, in order to maintain a level playing field with the latter institutions.

The ECB draft addendum on the guidance on NPLs published in October 2017 raises issues

Considering the EU action plan, it is particularly surprising that the ECB banking supervision issued a draft addendum to its guidance on NPLs for setting up triggers for prudential provisioning backstops, when the Commission was tasked by the Council to undertake such initiatives.

Recent opinions issued by the European Parliament and the Council of the EU notably stated that the ECB does not have the mandate for its prudential provisioning measures. Rather, it may impose binding capital measures on specific banks but not on the entire banking system.

Besides, this proposal raises a level playing field issue since it does not explicitly encourage to extend the scope of application to LSIs, which are under the direct supervision of national competent authorities (NCAs). If NCAs, who are responsible for the LSIs, decide not to apply the prudential provisioning backstop to them, there might be unintended consequences of LSIs piling up bad loans which would deter major lenders from financing the real economy.

Sound accounting standards reflect the economic reality of asset values

The prudential provisioning backstop measures question the accounting recognition of provisions that reflect the economic reality and may give wrong signals to markets that provisions are insufficient or insincere, even if compliant with the accounting standards. It could therefore supersede the new IFRS 9 which is now in force and will constrain banks to be more forward looking in terms of loan loss provisioning, booking expected losses at inception of a loan.

Accordingly, requiring a 100% level of provisioning after seven years for secured loans and two years for unsecured loans cannot reflect this economic reality, especially when it takes account of the collateral as a risk mitigant. This might divert banks from closely monitoring and strengthening their procedures in terms of risk mitigation and recovery.

Policymakers should work on more harmonization of insolvency procedures

The lack of harmonisation on legal insolvency and recovery procedures between EU Member States is one of the reasons why the ECB issued its prudential provisioning backstop proposal. Since each country has its own procedures in terms of insolvency and recovery, and therefore its proper timeline, the prudential provisioning backstop may penalise certain countries where those procedures are structurally longer than for countries where the legal framework allows faster procedures and recovery. The ECB should not ignore such processes which are intrinsically linked to national legislations.

^[1] http://www.consilium.europa.eu/en/press/press-releases/2017/07/11/conclusions-non-performing-loans/

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