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Europe is facing a non-performing loan (NPL) crisis. Bringing together over 100 senior experts from the EU institutions, national authorities and key market participants, a recent Bruegel conference discussed current options and novel approaches.
The event was held mainly under the Chatham House rule. Thus what follows is a brief, personal and necessarily partial summary. But we nonetheless hope it provides a sense of what has once again become a very lively – and increasingly urgent – policy debate.
There was near universal recognition at the conference that Europe has been far too slow in addressing non-performing loans. The risks associated with continued inaction were seen as significant: if the bad loan overhang is unresolved, a Japanese-style debt deflation looms.
Bank supervision will require complementary reforms
The bad loan overhang is now rightly a priority for the ECB’s single supervisory mechanism (SSM). Our discussion showed broad support for the ECB’s new guidelines on banks’ management of NPL portfolios. In her remarks Sharon Donnery, Deputy Governor of the Central Bank of Ireland, and chair of the ECB’s high level group on NPLs, provided some more detail on implementation. This will require “strong and clear support from Member States to tackle legal and related issues”.
But NPLs were also described as a key factor behind the broader problem of banks’ entrenched low profitability. The diminished earnings outlook of course compromises the capacity to raise much needed fresh capital – in turn undermining banks’ efforts in bad loan workouts.
In addition, banks will need to take a deeper look into their borrowers’ viability. The EU’s new accounting standard (IFRS 9) will force them to adopt a more forward-looking credit quality assessment. In the most affected countries supervisors should be part of the broader debt restructuring effort.
Participants in our conference also felt that specialist investors must complement the workout of distressed loans within banks. However, secondary markets are generally poorly developed and investors’ positions uncertain, which results in wide gaps between valuations. Where information on loans is poor, or poorly communicated, the market will not clear, and the quality of assets that are transacted deteriorates.
A key topic of discussion was therefore which institutions and common norms could facilitate the entry of investors. In the first instance, it will be the responsibility of banks to provide accurate information to bidders. Some significant euro area banks have already implemented the required changes to internal capacity and management. Crucially, the transfer of distressed assets out of bank balance sheets could underpin the much-needed capital raising effort by European banks. A convincing and well-resourced strategy could reassure investors, as well as credit markets.
Servicing companies could share their skills more widely. As regulation still diverges widely national rules could be simplified, and the EU’s capital markets union could set a common framework.
The conference discussion therefore returned to NPL clearing houses, which were proposed by EU Commission officials recently. In some markets clearing houses might be a useful tool in reassuring potential investors; for larger or more heterogeneous exposures originating banks will need to make better efforts in bridging information gaps. In any case, this would be no substitute for asset management companies which could act as a ‘market maker’ in the secondary market.
NPLs represent a shared EU problem - a comprehensive strategy is required
In his published remarks ECB Vice-President Vítor Constâncio called for comprehensive strategies to address the NPL problem, including through a harmonised approach at European level. All options for NPL resolution – ranging from workout within the bank to a sale to external investors – will also require national structural reforms, importantly through a strengthening of insolvency procedures and of the court systems.
Asset management companies (AMCs, often unhelpfully known as bad banks) had a catalytic effect in overcoming market failures in several European debt crises. But typically, these institutions require some form of government support.
Existing EU law already offers scope to establish such AMCs at national level. The Vice-President also suggested an EU-wide AMC could be sensible. Yet, our discussion also highlighted some concerns how such an institution would bridge very different legal regimes, and that some countries have already made more progress than others in addressing their NPL overhang. In the immediate future, a blueprint for national AMCs may be more realistic. This should define the permissible flexibility under the existing EU framework, and encourage countries to establish AMCs.
The Vice-President’s comments echoed the proposal made by Andrea Enria of the European Banking Authority (EBA) earlier in the week. Conference participants generally agreed with the premise that Europe’s NPL burden unsettles potential investors, leading them to stigmatise the European banking system. Common solutions would send a strong signal, and could offer efficiencies in funding and governance in new institutions. Given the ongoing value destruction within distressed debtors speed is of the essence.
A broader use of AMCs – whether at national or European level – could be accommodated within the existing rules on bank resolution and state aid, and should not give rise to a mutualisation of legacy assets.
Several participants nevertheless cautioned that new institutional solutions must not undermine the credibility of the existing framework for bank resolution, nor should they distract from rigorous supervision by the SSM. A faster pace of bank exits, and consolidation was in any case needed.
Designing such a comprehensive strategy should now become an objective for EU ministers. Solutions that bridge the various market failures and regulatory uncertainty are clearly needed, even though an EU-wide strategy should not constrain individual national solutions.
National ownership is critical
The conference discussion of experiences and agendas in four euro area countries underlined once again that there needs to be strong political ownership for this agenda within national authorities. SMEs and larger enterprises present challenges in restructuring, and fresh capital and management is often required. Some of the euro area crisis countries that have undergone comprehensive bank restructuring have progressed to a recovery in lending and investment. Defining a clear EU institutional framework that addresses market failures could move banking systems more broadly to a stronger equilibrium.