Europe’s banks are labouring under a huge mountain of non-performing loans. According to information provided by the ECB, at the end of 2015 the 130 biggest banks in the euro area accounted for combined impaired assets of around EUR 1 trillion. At the same time, their shares in gross lending (NPL ratio) are very unequally spread over the individual countries. According to data provided by the European Banking Authority (EBA), the NPL ratio at the end of March was 5.7% throughout the euro area, but in Spain, for example, it was 9.1%, in Portugal 20.5%, in Ireland 23.2% and in Italy 21.4%. By way of comparison: in the USA, NPLs are just 1.5%.
But the large non-performing loans create a lot of work for the banks, tie down an enormous amount of management capacity, have a negative effect on the earnings situation as the credits do not generate any revenues but cause refinancing costs and risk provisioning and above all tie up a great deal of equity. This means that this capital is not available for new credits.
As the general earnings situation at the banks is already under pressure at the moment these NPLs are also not impaired to the extent that would be necessary to be able to sell them in the market. Instead, the banks hope especially in the Southern European countries – so far in vain – that an economic recovery will set in and the credits can then either be serviced again or that the prices at which the NPLs are carried on the balance sheet will recover.
But this approach is a thorn in the flesh of the ECB. It is, therefore, putting increased pressure on the banks to manage these NPLs in a more professional manner and to reduce them systematically. In September it published a corresponding consultative paper. And in its latest Financial Stability Review it dedicates a separate chapter, which it published in advance, to the problem of the NPLs. In this chapter it identifies several problems associated with the reduction of NPLs starting with the existing information asymmetry between banks and potential asset buyers, their highly divergent price wishes, the lack of a legal framework for the prompt realisation of collateral up to and including the lack of equity needed to be able to offset the capital losses.
In the article it also proposes the establishment of state “Asset Management Companies” (AMC), also referred to as bad banks, as a possible measure to resolve the problem. These could buy NPLs from banks precisely when the market is not so receptive for NPLs or when the conditions for assets to be sold to investors still have to be created. As long as the prices are below the loans’ long-term economic values, this is also basically compatible with EU rules for state aid even though transfer prices above the current market values would be paid. As a result, impairments of the book values of these long-term economic values would have to be borne by private investors, providers of equity and junior debt-holders. For the difference between the prices paid by the AMCs and the long-term economic values, precautionary state recapitalisations could then be considered.
The ECB concedes that historically the advantages of AMCs have manifested themselves especially with respect to relatively homogeneous large-volume loans for commercial properties, land and property development as their values are easy to measure and are heavily dependent on macroeconomic developments. However, a large part of European NPLs consists of corporate loans for which the advantages of AMCs would tend not to apply.
To this extent, while the ECB credits the establishment of AMCs with an important role in the reduction of NPLs it does so only if certain conditions are fulfilled.
Like the ECB, I also see the problem of moral hazard here if the state takes over the banks’ NPLs en bloc. To this extent, I believe the establishment of state bad banks is a very helpful instrument for the reduction of the huge mountain of NPLs especially as it could bring prompt relief for the banks. Nevertheless, it should not only bring the banks advantages, but should also have some disadvantages for them. It is conceivable, for example, that the management of a bank that is obliged under pressure from the supervisory authority and investors to have recourse to a state bad bank must be replaced. This would mitigate the moral hazard problems of the management. It would also be conceivable that losses incurred by the AMCs are assumed retroactively by way of debtor warrants from the banks concerned or from the national bank-restructuring fund. This would reduce the risk that it is ultimately the tax payer who has to pay for the banks’ losses.