The banks in some countries of the European Union are sitting on huge stocks of non-performing loans (NPLs). Thus, while the EU average has fallen in recent years, from 6.5% at the end of 2014 to 4.5% at the end of June 2017, it still remains well above the figure for the USA (1.2% as at the end of June 2017). Moreover, in some countries it is in part well over 10%. Over the last few years, progress in reducing these NPLs has been very slow as decreases as a rule clobber banks’ capital ratios in two ways at once: Firstly, the sales losses from the portfolios that need to be sold squeeze the bottom line and thus the capital ratios. Secondly, they mean that the loss estimates for the remaining loans portfolios and/or above all for the NPLs still carried on bank balance sheets rise and so do the credit risk-weighted assets the banks report.
This is possibly precisely the point where the EU Parliament intends to change things. The Committee on Economic and Monetary Affairs proposes that sales losses from a planned multi-year reduction in NPLs undertaken in consultation with the regulatory authorities not be considered in the internal models for estimating credit risk-weighted assets.
When assessing the proposed change, the key question must ultimately be: What is the intention behind it? The proposal should be rejected if the idea is to achieve capital ratios that reflect as truly as possible the real state of affairs and are essentially conservative estimates. If, by contrast, the objective is to grant banks a breather in order to press ahead with the urgently needed reduction in NPLs, then the proposal should be welcomed. Most investors will presumably be able to live with a situation where the capital ratios (which can after all only be evaluated and appraised to a limited extent from the outside) are less a reflection of the real state of affairs, but in return NPLs get reduced more quickly.
Banks that more swiftly reduce their NPL portfolios on the back of the proposed change would probably benefit. However, this assumes that the banks are able to absorb the resulting sales losses. And this is precisely the largest problem of all, as banks’ profitability is under pressure and therefore leaves them little scope for more swiftly reducing NPLs without taking up equity from outside. A change in how sales losses are factored into the calculation of credit risk-weighted assets will only help to a limited extent.