Although progress has been made in establishing a European banking union, the large stock of non-performing loans in the Eurozone banking sector still presents a major problem. Helen Louri writes that in addition to the ‘three pillars’ of the banking union that are already on the table – the Single Supervisory Mechanism (SSM), Single Resolution Mechanism, and a European Deposit Insurance Scheme – the creation of a ‘fourth pillar’ in the shape of a pan-European asset management company could help tackle non-performing loans and generate much needed increases in investment and growth in the Eurozone.
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The European Banking Union (EBU) was created after the Eurozone crisis to complete the missing elements of the euro architecture and help stabilise the banking sector. Its main pillars (already established) are the Single Supervisory Mechanism (SSM) introducing common supervision, and the Single Resolution Mechanism (SRM) introducing appropriate resolution tools and most importantly the bail in principle. A third pillar on the need for a European Deposit Insurance Scheme (EDIS) is being broadly discussed.
So, which is the most important problem of the Eurozone banking sector that has not yet been addressed properly? The answer is the huge stock of Non-Performing Loans (NPLs). NPLs exceeded 6.6% of all loans in 2016 compared to 1.5% in the US. Total NPLs were close to 1 trillion euro, while uncovered (after considering provisions) NPLs were more than six times the annual profits of European banks.
Especially for a group of six countries (Cyprus, Greece, Italy, Ireland, Portugal and Slovenia) NPLs reach 22.8% and can be interpreted as a clear sign of fragmentation in the Eurozone banking market. By being a drag on bank profitability, NPLs constrain credit expansion, endanger financial stability and delay economic growth. NPLs are also closely related to the problem of debt overhang hindering highly leveraged firms to ask for credit in order to finance investment. In addition, non-viable firms may be kept alive by already committed banks while at the same time viable firms suffer from lack of funding and unhealthy competition. Thus, recovery is further delayed by zombie-lending, as it is often called.
But what creates NPLs? They are caused mainly by (a) macro-economic factors (which characterise recessions) such as lack of growth, increasing unemployment, high interest rate margins, reductions in disposable income and an increasing tax burden, and (b) bank-related factors such as management skills, risk preferences and moral hazard. The recent financial crisis in Europe combined most of these factors and as long as slow growth and high unemployment persist, especially in some countries, NPLs will continue to be a serious problem with spillovers to the whole region.
But even if macro-economic conditions improve and bank management becomes more efficient, the current stock of NPLs is so high that it will need a long period of time to reach acceptable levels. To reduce the NPL stock faster and more effectively, public intervention measures are required. Such measures should help to remove the impaired assets from the banks’ balance sheets swiftly and without triggering requirements for capital injections which will not be easily manageable.
There can be two ways of doing this, both of which should be complemented by appropriate reforms in the legal framework improving transparency. First, the banks can enhance their efforts to manage NPLs on their own through internal NPL workout and external servicing. Enhanced supervisory guidance by the SSM can be helpful in setting ambitious targets and restructuring plans but it is unlikely to be sufficient in current circumstances.
Second, the banks can transfer impaired assets to a third party, such as outright sales to investors, or to a special purpose securitisation vehicle or to an asset management company (AMC). The most important questions related to transferring NPLs are through which mechanism to proceed and at what transfer price. The difference between the net book value (nominal book value minus provisions) of the impaired asset and its transfer price is the loss incurred by the bank due to the transfer. Recording a serious loss of capital may trigger the bail-in process with dire consequences for the bank’s stakeholders. A series of such bail-ins could destabilise the banking sector of a country with further systemic consequences.
An asset management company enjoys synergies especially when restructuring homogeneous types of assets and is better able to negotiate appropriate prices as well as debt/equity conversions. An asset management company can also be more efficient at securitising NPLs adding to the liquidity and the depth of the secondary market while it can extend a visible and credible commitment of a fiscal backstop putting a cap to bank losses. On the negative side, AMCs may face uncertainty about the quality of the assets. A critical remaining issue is the question of loss absorption.
A pan-European AMC (EAMC) as suggested by Emilios Avgouleas and Charles Goodhart (among others) may be the most effective approach for managing the accumulated delinquent assets in the Eurozone. The EAMC can be a holding company of national AMCs and funded through proportionate contributions by member states and private funds. Strong uniform governance links will connect the EAMC with its subsidiaries avoiding redistributive outcomes. The price at which the impaired assets will be transferred can be a combination of their book value excluding provisions, their real (long-term) economic value and their market value.
Thus, a more balanced valuation will take into account the potential rise in market prices once the economy rebounds. Profit and loss agreements between the banks and the AMCs can be accompanied by an ESM guarantee within the framework of the ‘precautionary recapitalisation’ process and a respective conditionality on their business plans. The EAMC has a comparative advantage for establishing a centralised platform (recently announced by the ECB) where information sharing and direct sales of assets can take place, facilitating the function of the secondary NPL market and boosting liquidity.
Consequently, an EAMC could be an efficient way to faster reduce the stock of NPLs and lead to much needed increases in investment and growth in the Eurozone. One could see it as a fourth pillar missing from the current structure of the EBU, but it remains to be seen whether the EBU’s architects can be convinced of its necessity.
Note: This article draws heavily from a longer paper published in the “European Economy – Banks , Regulation and the Real Sector”, vol. 2017(1), pp. 135-143. The article gives the views of the author, not the position of EUROPP – European Politics and Policy or the London School of Economics.
Helen Louri – AUEB
Helen Louri has been a Professor in the Department of Economics at the Athens University of Economics and Business (AUEB) since 2001 and Head of the Department since 2015. She was the Deputy Governor of the Bank of Greece responsible for bank resolution between 2008-2014. She studied at the Athens University of Economics and Business (B.Sc. Econ., 1976), London School of Economics (M.Sc. Econ., 1977) and University of Oxford (D.Phil. Econ., 1986).