Ministry of Economy and Finance, France, Assistant Secretary, Financial Department of the French Treasury
European Parliament, MEP, Committee on Economic and Monetary Affairs
Carlos da Silva Costa
Banco de Portugal, Governor
Central Bank of Ireland, Deputy Governor, Central Banking
European Banking Authority, Chairperson
European Commission, Director, Markets and Cases III: Financial Services
Bernard de Longevialle
S&P Global Ratings, Managing Director, EMEA Financial Services Lead Analytical Manager
PwC Italy, Director
UniCredit S.p.A., Head of Group Regulatory Affairs
Preamble: The terms of the debate
The Chair stated that the theme of the discussion would be accelerating the resolution of the non performing loan (NPL) challenge in Europe. This debate is well documented; it could be said that it is a lingering debate that has been taking place for some time within the EU, and it is a challenge for the euro area and the Banking Union to demonstrate that they can solve this issue. A number of risks and drawbacks are attached, including financial stability, lending to real economies, and the macroeconomic conditions in the countries that are affected by high NPLs. This issue is complex, and is at its heart a prudential or a structural issue. There are some debates about insolvency reform, which are issues outside of strict financial regulation, and there are macroeconomic issues around the impact that high NPL ratios have on of bank lending. It is not an easy issue to solve, but it is an issue has to be solved.
There has been an intensification of policy interest and policy initiatives, both at the national and at the European level, over the course of the last months. On March 20 2017, ECB Banking Supervision published guidance to banks on non-performing loans. The guidance, which sets ECB Banking Supervision’s expectations on NPL management going forward, is generally applicable to all significant institutions (SIs) supervised directly under the Single Supervisory Mechanism (SSM), including their international subsidiaries. There has also been a proposal to reform insolvency regimes at the European level, tabled by the Commission, and being discussed at the Council. A number of proposals on how to structure asset management companies (AMCs), either at the European or at the national level, have been voiced quite forcefully by the EBA. Lastly, a number of individual cases are being dealt with within the normal state aid and BRRD frameworks that Europe has.
However, the questions that need to be discussed are whether those initiatives are sufficient; whether they are likely to help Europe to solve this issue; whether they will help to diminish the high NPL ratios that can be observed in some countries in Europe; and whether Europe is going fast enough to address this issue.
1. The issues raised by high levels of NPLs have an EU wide dimension
1.1. The size and scope of the NPL challenge in Europe
A representative of a public authority stated that Europe has a significant amount of NPLs: as of the end of 2016, they are likely to be below €1 trillion. 10 Member States have an NPL above 10%, and comparative studies indicate that when a region goes above a level of between 5% and 6%, this starts to have a material impact on the lending capacity and profitability of its banks.
This ratio has been declining since 2014, which is positive news: the latest figure for the European level was 5.1% in December 2016. A chart exists that compares the dynamics of the NPL ratio post crisis in the US, and in Japan in the 1990s, to the EU’s own figures. It shows that, in the US, there was a spike during the first two years of the crisis. It reached its peak after two years, and then decreased to pre crisis levels in five years. After seven years, the cycle of managing NPLs had been completed. In Japan, it took nine years for the problem to reach its peak; there was a ‘lost decade’ in Japan, and a hesitancy to recognise the problem. When the problem was recognised, it took five years to get NPL levels down to pre crisis levels – i.e. 14 years to complete the cycle.
Europe is in between the US and Japanese examples. NPL levels reached a peak after five years, but the pace of reduction has been very slow. Projecting forwards, the pace of reduction would reach pre crisis levels beyond Japan, more than 14 years after the start of the crisis. The policy priority is therefore to accelerate the reduction in the NPL ratio, and the way in which balance sheets are cleaned.
Regarding whether this is a European or a national problem, the size of the problem makes it European in dimension but it is a concentrated problem, and very diverse in its distribution across Member States. In 10 Member States, the NPL ratio is above 10%, and several countries even below 1% up to 3%. There is therefore an issue of asymmetrical distribution. Another element that gives the problem a significant European dimension is that a lot of cross border business could also create contagions across Member States. The third element that makes the problem a European one is the impact that this has on the transmission of monetary policy. The lending channel is clogged, which has an impact on the ability of monetary policy to affect lending and growth.
Finally, there is also a reputational issue. 2017 marks the fourth year in a row that, at IMF meetings, the European banking sector has been portrayed as one of the top risks to global financial stability. As a European, the speaker would like this to cease, so there is a need to tackle this issue quickly. The more that the EU can find European ways to make progress, the better it will be.
The Chair summarised that this is clearly perceived as an issue for all European banks. However, the question is how this translates into funding conditions for banks, and the economic impact beyond countries that are directly affected by an NPL ratio can be further debated.
1.2. The different dimensions of the problem
1.2.1. A market perspective
An industry representative stated that when Europeans travel outside of Europe, they are frequently asked about Brexit, political risk in France, and low earnings, but NPLs is always an issue that is raised. Questions about NPLs do not come only from investors interested in investing in Italy, Spain or Ireland; they also come from investors who are investing elsewhere in Europe. It creates a stigma among the mature markets that Europe is the only region that has not yet tackled this issue, which is an impression that is difficult to quantify, but which clearly exists.
From a rating perspective, there is clearly a material rating impact on those countries that showcase high NPL ratios, at the industry and bank level. This is even true for countries like Ireland and Spain, which have made steady progress in addressing their NPL ratios and which are now demonstrating positive economic growth and dynamic momentum. NPLs remains a tail risk in Europe: it is having an impact on earnings, tying up capital, and attracting management attention. It is even negative in countries where work on upgrading the banks has begun; it is worse in Italy, Portugal, and other countries.
At the European level, supporting the resolution of NPLs should further support the completion of Banking Union. It has also brought into question the effectiveness of European credit management tools and policies. Although the industry representative stated that this is an issue that is difficult to quantify, they would argue that the issue of NPLs is also affecting the consolidated assessment of the European banking industry.
Two days ago, the speaker published a paper that argued that this problem will remain for a long time. Their institution anticipates that NPLs will remain at 16% in Italy, 11% in Ireland and Spain, and more than 15% in Portugal, until the end of 2018. In some countries, such as Italy, there is an incremental of 3 5% per year, but this will drag for multiple years. This financial player welcomes the initiative taken by the ECB in their guidance but, for structural reasons that were well highlighted in the ECB’s paper, due to the lack of financial flexibility within many banks to tackle the problem more aggressively and the absence of strong incentives to address this problem, they do not expect the issue to be resolved any time soon. In this very low interest rate environment, and with low earnings, some banks have an incentive just to wait for this to be done.
1.2.2. A country perspective
A representative of a public body stated that this is not a national problem, but a European problem. The first point is to understand that Europe is in the fourth round of the effects from the financial crisis. The first impact directly affected the balance sheets of banks investing in sub prime mortgages, mostly in Northern Europe, and was solved by nationalisations and the public injection of capital. The second impact came from the decline in domestic demand in the countries most affected by the subprime crisis (which mostly hurt sectors producing consumer durables). At that time, nobody objected to the provision of state aid. The third phase was the sovereign crisis, which had a significant impact on banks, as it closed access to the market. In response, the ECB and the National Central Banks of the Eurosystem provided liquidity and solved the problem.
The current problem is clearly a result of the impact of the crisis on the real economy and the subsequent adjustment, which came back into the financial sector through NPL exposures. It is a different problem, systemic in nature, rather than an idiosyncratic problem faced by individual banks or economies. It needs to be clearly regarded in this context, in order to understand the effect of the real adjustment resulting from the decrease in public and private demand and the double dip that occurred.
The profitability of banks is impaired by NPL exposures. Since banks need to comply with prudential ratios and it is very difficult for them to raise capital in the markets at reasonable costs to cover the capital needs resulting from a carving out of NPLs their lending capacity is diminished. This means that, until all impairments have been absorbed, there will be a standstill in the amount of credit available, or even a decline. This is a major threat to economic growth.
It is important to understand that now, in some European countries, a bank is actually two banks: one with good assets and profitability that is in line with others at the European level, and another one that is a burden, hindering absorption of capital and profitability. If banks are not able to rid themselves of this burden, by carving out and selling these assets, or to create quick impairments for these assets, it will be very difficult for them to increase their profitability or to raise capital in the market. It is therefore critical that the managers of these banks are able to show the market what their business plans will be if they are able to remove these burdens from their balance sheet, with the goal of convincing the investors that it would be helpful to raise capital.
There is also a need to be clear that this issue is a problem, as it means a big dilution for present shareholders, who are not interested in being diluted and paying the price for that. We are in a standstill: new investors are not interested in stepping in without demanding major haircuts because of the uncertainties in the balance sheet, whereas current shareholders are not willing to accept a haircuts that are much bigger than the actual problems that they have on their balance sheet.
1.2.3. A European institution perspective
A representative of a public body stated that the NPL problem in Europe has multiple dimensions. Firstly, it has both a national and a European dimension. Indeed, even European countries with lower levels of non-performing loans are likely to be affected by Europe’s NPL problem, given the interconnectedness across European economies. In addition, the NPL problem in Europe has both a micro and macroeconomic dimensions. Furthermore, clearly both supply and demand factors are at play.
Looking at the impact NPLs on credit supply, European banks with persistently high levels of non-performing loans tend to lend less and at higher rates. Therefore, NPLs hold down economic activity and impair the transmission of the ECB monetary policy stimulus. Specifically, European banks with high levels of NPLs are required to hold additional capital against their impaired assets, constraining their ability to expand their business. In addition, those banks generally experience higher funding costs, given lower expected revenue streams. Moreover, the inherent judgemental nature of provisioning can cause uncertainty as to banks’ actual financial position, leading to negative volatile investor sentiment and therefore affecting banks’ funding costs.
The representative reinforced the point that high NPLs on European banks’ balance sheets weighs on bank profitability. This because impaired loans carried on the banks’ books do not usually generate income streams comparable with performing assets. As a consequence, solving Europe’s NPL crisis is both in the interest of the ECB Banking supervision and banks themselves.
A more complex question regards the impact of non-performing loans on credit demand – in other words, whether NPLs affect investment propensity in business. Firms with existing arrears may have lower incentives to undertake new viable investment projects. As a consequence, reducing the stock of NPLs could contribute to relaunch investment in Europe.
The speaker said that that diverse nature of the NPL problem is reflected in the work of the High Level Group (HLG) on non-performing loans. In addition to ECB Banking Supervision’s guidance to banks in September 2016, they published a Stocktake report on national supervisory practises and legal frameworks related to NPLs for eight eurozone countries, which is planned to be extended to all euro area countries.
The Chair agreed that NPLs are a drag on bank profitability, with provisioning needs and administrative costs of NPL management, and also higher funding costs of NPL management. NPLs lock capital in banks to back unproductive assets instead of funding new projects, with crippling effects on the bank lending channel for the transmission of monetary policy.
1.3. A top priority for the ECB
Financial stability has also formed an important component of the ECB’s work. While a speedy workout of non-performing loans in European banks’ balance sheets would clearly support the economic recovery, an orderly reduction in NPLs is crucial to avoid financial stability concerns. There is no obligation for banks to quickly sell their NPL portfolios, or sell them well below their book value, realising considerable losses. Indeed, the sale of NPLs is only one possible option listed in the Guidance for banks in cleaning up their balance sheets; other avenues to workout NPLs include adopting forbearance measures to restore loan viability. For example, the establishment of dedicated NPL workout units – as envisaged in the Guidance – should assist banks in gaining a better understanding of their NPL portfolios and identifying the most appropriate option available to workout NPLs, also depending on external conditions such as the liquidity of secondary debt market.
However, saying that banks could resort to forbearance measures to work out their NPL portfolios, does not mean that the ECB Banking Supervision will tolerate the delay of necessary actions to tackle asset quality issues. The “extend and pretend” approach too often observed in the past will not be tolerated going forward. What the ECB wants to see, from a supervisory perspective, is a deliberate and sustained reduction in NPLs. There needs to be progress, but this must be sustainable progress, not volatile, and should not be prompted by the creation of any kind of instability. The financial stability dimension is important, given the interconnections between Europe’s banking system and between its various economies.
The ECB looked at all of the countries that have had problems with NPLs over the last few years, and learned many lessons from programme countries as well, in terms of the progress that they made as a result of their supervision. Performing the stocktake was a very interesting process: when the ECB started the work in the SSM, this was not their core objective – which was guidance – but this work drew out very many interesting issues at a national level about judicial frameworks and insolvency frameworks, and particularly about the lack of out of court settlement approaches. These are very important, both for firms and, especially, households, in terms of restoring their position after a period of indebtedness. There is much that the various countries of Europe can learn from each other, and much that they can do in a coordinated way to help to deal with some of these issues.
One other aspect that the ECB has looked at is that, from a supervisory perspective, it is very interested in the health of the banks, and therefore solving the problem from the banks’ perspective. It is also aware of the wider economic impacts of firms and households having debt overhang. Insolvency is a particularly important factor in that, which will need to be addressed to restore firms and households to a position where they can contribute to the economy, economic growth, and in other ways.
Asked by the Chair to speak about the Irish example, the public authority representative replied that following the crisis, there was a significant step up in the general approach to supervision in Ireland. Ireland’s supervision focused very intensely on dealing with this problem, and a very wide range of measures were taken, on a consistent basis and over a number of years. Another important aspect was the creation of NAMA, Ireland’s ‘bad bank’, which took place very early on in the crisis, in 2009. The establishment of NAMA helped a speedy resolution of NPLs by forcing banks to dismiss their impaired assets, while at the same time limiting losses. The context of dealing with bad banks has changed, as a result of the different legislative framework and other changes, but this played a significant role in Ireland’s progress.
1.4. A call for EU action
A representative of a public authority stated that, if European institutions were properly addressing the issue of NPLs, Eurofi would not be discussing it; they also would not be discussing it if this were only a national question. It is also being discussed in the Ecofin Council this afternoon, and as Eurofi is very often aligned with Ecofin’s agenda, the speaker hopes that there will be some communication between the two arenas to come to a solution.
In the previous roundtable, the audience were reminded of what happened in the Ecofin in Nice, in the Eurogroup in 2008; the speaker was there at the time, and remembers. Following this, the CEO of Deutsche Bank called for full transparency on toxic assets, but now the discussion on toxic assets has concluded, and it is NPLs that need to be discussed. This is a problem that requires a European solution: there is no reason to continue discussing Banking and Capital Market Union, or even strengthening the EMU, if Europe cannot get this issue right. The problem is at the root of the whole EU project, and needs to be addressed; if it were a small issue, it would have been solved long ago.
However, the situation is slowly changing. The Asset Quality Review (AQR) in 2014 allowed Europe to map the problem; when this had been done, the SSM clearly looked at it and addressed it. It now appears that there is growing awareness that this issue will not be solved at national level. One of the reasons that it is so difficult to address this issue at EU level is that some people believe that doing so will create moral hazard, but this belief only acts as a reason not to take any action. Doing nothing is not sustainable: the last survey by the ECB demonstrates the risk impact and risk probability, charting low interest rates and NPLs. There is no doubt that this issue should be considered at the European level.
Regarding where a solution might come from, AMCs have some experience of these kinds of settlements in a very different context. This is a good solution, but Europe cannot only rely on a national option. Secondly, there have been some proposals regarding a policy mix auction, which is something that should be looked into further, because it would allow Europe to address the issues of market powers and collusion risk. Thirdly, Europe should not wait to address this problem until it has fixed all of the insolvency regimes at the national and at the EU level, and fourthly, the question of the restructuring of banks will need to be addressed. Once this has been agreed, there needs to be political leadership and a political decision; the Parliament would be happy to contribute to solving this problem.
Another public authority representative stated that there is a need to be clear that this problem could impair the recovery, and that it has two dimensions: the creditor and the debtor. As far as the debtor is concerned, non financial corporation indebtedness is composed of two types of companies: companies that are under financial stress but are viable, and companies that are under financial stress and are not viable. If this is not taken into account, then Europe may end up solving a problem for the creditors while preventing the continuity of companies – mostly SMEs - that are economically viable, but are financially stressed. This is why it is very important to understand the balance of interests between both creditors and debtors.
It is also very important to distinguish between the short and the medium term. It would be nice to have a market, and a uniform, harmonised insolvency regime, but this is not something that can be created quickly. The problems that exist at the moment need to be addressed now, while at the same time thinking forward about the structural problems linked to the creation of a real financial integrated market. Europe may be creating a significant threat to the quality and intensity of the recovery that it now sees, and would be making a big mistake by taking a short term view, not understanding that it is up to Europe to solve this problem.
2. Policy measures to accelerate the resolution of the NPL problem
2.1. The EU Commission supports a comprehensive agenda addressing all the dimensions of the NPL problem
A public authority representative stated that the solution needs to involve various actors; there is no need for a debate about who should deal with this issue first. There are lots of competences in the hands of national supervisors, and national insolvency frameworks and out of court settlements. Nevertheless, even if policy tools are in the hands of national authorities, the problem has nevertheless a European dimension.
The second issue is that one building block should not necessarily proceed from another; parallel action should take place at various levels. European and international institutions will be tested, various building blocks will need to be put in place as part of a parallel process. Additionally, legacy issues with NPLs should be dealt with, but there is also a need to identify what to do in future. This is therefore a complex puzzle, with various components.
The proposal regarding restructuring and recovery Is as an important step in harmonising certain elements of pre insolvency restructuring procedures, and in at least harmonising some principles of insolvency law. This text, once adopted, could have important effects on the efficient management of defaulting loans, and at the same time could help to reduce an accumulation of NPLs on banks’ balance sheets. Beyond this directive, there is a lot of action concerning loan enforcement. The Commission is carrying out a benchmarking review, as mandated by the Eurogroup.
Apart from this framework, and beyond micro and macro prudential regulation, the European Commission also has other capacities in which it can address NPLs. For example, through the European Semester six Member States received country specific recommendations on NPLs. This is a recurrent issue in country reports. It should also be recalled that NPLs were part of bank restructuring in the context of financial assistance programmes in Greece, Spain, Ireland and Portugal. The European Commission has been working together with member states on national measures to address NPLs, such as the Italian Guarantee on Securitisation of Bank Non Performing Loans (GACS) measure, and a similar measure was put in place in Hungary following informal consultations with the Commission.
Looking forward, the Commission is looking very carefully at the development of a secondary market. It believes, for instance, that pricing information is very important, and the Commission will consider how to position its action in that respect. The capital markets union agenda covers certain aspects, as it also covers insolvency frameworks and judicial systems. The European Commission is keen to coordinate efforts to offer support to member states, with the caveat that it would like to avoid mutualisation of obligations.
Regarding NPL platforms, when Member States supported the move towards bailing in, they were not really conscious of what this meant. When BRRD was being drafted, bank resolution was seen as a positive alternative to the failure of institutions; now, it has become ‘an evil’. With all the state aid communications still in place, there are some possibilities of state support beyond resolution. It should not be forgotten that liquidity support is always possible through emergency liquidity assistance, and that there are liquidity support schemes for member states and precautionary capitalisation under certain conditions. This is in order to favour viable institutions, because otherwise Europe will put an unviable competitor into the market, to the detriment of all other market players, who are struggling to survive without aid from the national budget.
Finally, there is always the possibility of liquidation aid, provided that a bank is wound down and does not persist in the market to the detriment of other banks. While trying to solve the problems of one bank, there is a need to bear in mind the systemic dimension for the rest of the competitors in the market.
2.2. ‘Leaving the crossroads’
A public authority representative stated that there are two ways to deal with this issue. The first is to maintain the banks as they currently stand, with their lending capacity remaining impaired; the second is to solve the problem. This means giving the banks the possibility of raising capital and lending to the economy while resolving the NPLs issue. To do so, there is a need to know whether or not Europe can provide a backstop facility, in order to give the banks that are not able to raise capital in the markets, or fear the haircut that will be imposed on them, the possibility to solve the problem quickly. To do so, it is necessary to ask the European Stability Mechanism (ESM) whether they have the available capital to provide a backstop; the reason for involving the ESM is because Europe is in a Banking Union and also because Member States have different room of manoeuvre to provide this capital.
In order to do this, Europe has two obstacles to overcome: state aid rules and the BRRD. Banks will not proceed with a carve out of problematic assets if the value at which these assets are transferred is lower than the book value and, at the same time, they are unable to fill the resulting capital gap in the markets. This is because they would then be subject to resolution if unable to raise capital to the meet the regulatory minima or subject to state aid rules and burden sharing if prompted to request public support under precautionary recapitalization. They will therefore prefer to remain ‘zombies’ and gradually absorb NPLs through impairments. Unless Europe is prepared to provide a backstop to the banks that are viable but unable to raise capital in the markets, give a waiver from state aid (as far as burden sharing is concerned) and accept a BRRD holiday progress will not be made.
Once this has been done, a second question will arise: knowing how to do it. The question about AMCs is a secondary question if the first question has not been solved. The main issue is the waivers and the provision of a backstop; if there is no backstop and no waivers, no shareholders will be interested in this option, because it will be very costly, and no investors will be interested in making an investment without a bigger haircut, because it will be very uncertain. As such, this is not a problem of individual Member States; it is a European problem.
It needs to be understood that time is of the essence, and the dynamics of the problem mean that the solution needs to be synchronised. The solution that the speaker would have proposed a year ago for the banks in their country would be different now, because each of the banks is able to solve their problem via their own means, but always with the caveat that they stay within a very subdued regime, in order not to have risks that concern the needs of capital and the costs on their shareholders. Ultimately, these are private banks, and need to take care of their shareholders.
The Chair commented that they agree that time is of the essence, and that there is a high cost to inaction. Having a diverse panel is valuable in this respect, when discussing issues about state aid and BRRD. He added that in his view, the question was more about creditors taking a loss than shareholders doing so; everyone accepts that shareholders will take a loss.
The public authority representative replied that it is clear that shareholders recognise that they need to shoulder part of the burden. However, they do not want to pay a price for the uncertainty that is linked to the valuation of these assets. Asking shareholders to accept a 90% haircut on the book price in order to increase capital is burden sharing that is typical of a resolution situation.
2.3. The EU crisis management framework: a possible impediment?
2.3.1. BRRD: a possible obstacle to resolving the problem?
A public authority representative stated that BRRD is an ongoing debate. Politically, everybody agreed that Europe needed to move from bail out to bail in, but people had not realised what this means. Resolution is perceived as a ‘nuclear’ tool, in the sense that the associated reputation risk is too high to be affordable. The other issue is the ongoing discussion about the 8% of total liabilities to be bailed in before assessing any form of state aid which has different interpretations, and underlying this question is the whole issue of EMU: whether strict rules are applied, or whether some ‘cleverness’ is permitted in how these rules are treated.
There is suspicion among Member States, and the kind of discussion that takes place within the Council is replicated in the European Parliament. At some stage, when coming to the final agreement on BRRD, the Parliament was fully agreed about the need for a European dimension, but now it can be seen how it works in detail, this is not so obvious. The problem of whether to allow the discussion on how to fix BRRD to be detached from the whole banking package will recur next week.
The Chair recalled that when BRRD was developed, the issue of phasing in its implementation was overlooked. The public authority representative replied that in the European Parliament, some people now believe that the timing of this may not have been done properly; that Europe should have cleaned up its banks better, with some kind of recapitalisation, before progressing to the implementation of the packages as they now are. This is also linked to the fact that Europe has completely underestimated the political costs of the move from bailout to bail in.
An audience member asked how the investor community can be convinced that BRRD and the state aid framework may be the right instruments for the next crisis. A representative of a public authority replied that this is not exactly a legal issue; the question can be reversed, to ask how the actions of governments and banks look when they are implemented. The speaker does not believe that being outside the regulatory framework would be more convincing for investors. A framework has been put in place, which provides for specific safeguards. Resolution and all of the tools around it were perceived as alternatives to states becoming indebted and going into sovereign crisis. Although no transition has been implemented adequately, this was a democratic process agreed by Member States in the European Parliament. The solution would not be fairer outside of the current legislative framework. There may be an issue of transition, or of politicians being unprepared to endorse this text, but this public authority representative believes that the solution is, in substance, a good solution.
A third public authority representative noted that they are very supportive of the BRRD; this needs to be made to work. However, there are cases in which banks might be viable but nevertheless not well functioning. In this case, the usual resolution tool cannot be deployed, but there is still a problem to be addressed. In the future, Europe will need to consider the experiences it has had over the last few years, and possibly flesh out the concept of restructuring better in the legislation. When restructuring can be worked out before resolution, there is not necessarily a need for state aid.
One of the previous speakers added that restructuring, even on a voluntary basis, is always possible, and there are many banks doing that. Not everything is imposed, and not everything is under state aid rules. The Chair stated that there also needs to be a credible exit strategy: some banks will have to exit the market, and some will have to restructure. The appropriate frameworks need to be in place to do both.
2.3.2. Deviating from the EU rules to really solve the problem should not be an issue for market participants
An industry representative recalled that, following the crisis, the US and Europe were focused on protecting taxpayers, but also enforcing better and stronger market discipline. Conversely, in Asia, Japan, Australia and other markets, policymakers were very adamant in saying that they need more tools than these. Resolution is a very important tool, but the attitude in Europe and the US was that, to some extent, their ‘hands were tied’. There is probably excessive rigidity in the way that the cases and the legacy are viewed.
Considering the situation pragmatically, over time, Europe might implement a flexible approach regarding the BRRD and state aid rules. This does not constitute a major credibility issue, because, providing that the direction still exists, the market will understand that Europe is in a build up period, and that many of the tools and instruments adopted by the EU institutions were defined at a time where there was less understanding of what resolution means.
2.4. Way forward for the SSM after the publication of its guidance to banks on NPLs
The Chair stated that supervision is key, in terms of having transparency and proper provisioning for NPL exposures in banks. The SSM has done very significant work in this respect; people are generally aware that the guidance was published.
A public authority representative stated that they support the concept of parallel progress. Europe cannot wait any longer to address this issue, and it cannot wait until all of the insolvency frameworks are harmonised. Additionally, regarding the AQR, these issues have remained a priority for the ECB ever since. Even though it has taken them some time to prepare the guidance, the work that the ECB’s supervisory teams are doing on a daily basis with banks continues. This is often not seen very publicly, but this active and intensive supervision is clearly very important.
Regarding the guidance itself, the ECB has been completely transparent about this. The guidance followed a very extensive public consultation process, during which people could make known their comments on the proposals, a public hearing, and other efforts to increase transparency. The ECB received about 700 comments: a very large amount of feedback. Both the comments submitted in written form and those provided during the public hearing have been carefully reviewed and incorporated in the final Guidance, when appropriate. There has also been a lot of engagement with the market about the guidance. It also draws on supervisory practices that exist in many member states already, so it is very well tested, and the ECB has seen countries in which these types of intervention work.
Regarding the issue of the banks that are inside and outside of scope, given that this is ECB supervision, the primary addressees are the significant institutions. All of the national competent authorities have worked together on the guidance with the ECB and so, in many cases, they are already applying – or could in the future also apply – the guidance themselves, such as to LSIs. There are clearly options to extend the reach of the guidance.
A central principle of the Guidance is ‘tone from the top’. The resolution of non-performing loans rests firmly with the institutions themselves. In many cases, particularly in some of the programme countries, the phenomenon of ‘extend and pretend’ – as it is called in Ireland – has been seen. The banks do not really engage with the problem; the board is not paying enough attention, for instance. Management bodies must take full ownership of this problem. This includes the development, and approval of a strategy and operational plan to deliver the progress required. Furthermore, frequent and regular reporting to the board is necessary to ensure progress versus agreed targets is achieved. However, in order to develop ambitious, yet realistic strategies to reduce NPLs, boards first need to gain a clear understanding of the full context in which they operate. It is clear, at present, many boards have not yet established this. From the bottom up, banks also need to examine the drivers and scale of non-performing loans. In doing so, they are expected to adopt an extremely granular approach. A careful assessment of the external environment, the resources available to debtors, as well as the internal operational capacities, will contribute to the identification of the most appropriate strategy to reduce non-performing loans.
To ensure effective implementation, the ECB Banking Supervision also expect banks to review their governance structures and operational arrangements against the benchmark laid down in the Guidance. Drawing from international best practice, the Guidance prescribes that banks should establish dedicated NPL workout units, separated from the loan granting functions. The main rationale for this important separation is the elimination of potential conflicts of interest and to ensure the presence of staff with dedicated expertise and experience in NPL management. This separation of duties should encompass not only client relationship activities (e.g. negotiation of forbearance solutions with clients), but also the decision-making process. In this context, dedicated NPL committees should also be established.
The issue of targets is also a very important aspect; it was subject to a lot of scrutiny during the consultation process, and discussed heavily in the background when the ECB was preparing its guidance. Given the existing heterogeneity across the European banking sector, setting generic quantitative targets for NPL reduction in the strategies would have inevitably resulted in unrealistic targets for a number of banks. By contrast, if adapted to suit all situations, targets would have not been very ambitious. Therefore, the ECB explicitly decided not to set a single threshold for NPL reduction. Rather, taking into account the specificities in which banks operate, targets are required to be set using a portfolio-by-portfolio approach. The standard – outlined in the Guidance - prescribes that banks must articulate their NPL targets along three dimensions – (i) across time, (ii) by portfolio and, (iii) by implementation option chosen to drive the projected reduction. Clearly defined quantitative targets in their NPL strategy, approved by the management body, will ensure ‘extend and pretend’ situations will not persist. The targets will require banks to segment non-performing loans and effectively manage them towards likely resolution outcomes (depending on borrower cooperation and business viability).
Allowing for bank-specific quantitative targets for NPL reduction does not mean that ECB Banking Supervision will not implement consistent supervisory standards. The Joint Supervisory Teams (JSTs) have already started to engage with banks. While assessing the degree of implementation and the ambitiousness of banks’ strategies the ECB is treating all banks in the same way and benchmark them against their peers, in line with “the tough but fair” supervision principle. In the spirit of proportionality, the supervisors’ intrusiveness will depend on the scale of NPLs in banks’ portfolios. In this context, JSTs are organising onsite inspections of banks with high levels of NPLs to assess their progress. Also banks with high levels of NPLs concentrated in certain segments of their activity will be asked to implement portfolio-specific NPL reduction strategies, despite having an overall NPL level not considerably above the EU average.
The speaker concluded by stating that the non binding aspect has also been subject to much comment; some people have questioned how, if it is non binding, it can have teeth. While the Guidance is at present non-binding, any deviations from the principles set out in the Guidance would need to be justified. The Guidance now works as a basis for the supervisory dialogue with banks and is being incorporated in the annual Supervisory Review and Evaluation Process (SREP), thereby becoming business as usual supervision. In addition, banks with high level of NPLs on their balance sheets will be subject to additional reporting requirements and expected to disclose additional information related to NPLs.
2.5. Developing secondary markets and servicing capacities
The Chair stated that there are no aggregated binding targets for all banks, but an individual path for each bank, either to restructure their loans or to sell them in order to diminish the NPL ratio. The issue about whether banks have to be pushed, or even forced, to sell their loans is also linked to the existence of secondary markets and whether there are buyers of those loans in the market. These are not very likely to be other banks, but might be funds or any other bucket of participants, private or public.
It is important to spend some time discussing the current situation in secondary markets for NPLs in Europe. These are under developed, and the volumes are small in comparison to the stock of non performing exposure. It would be interesting to have a market perspective on why these are not so deep and fluid, why they have such a big spread, and why it is therefore difficult for buyers and sellers to agree on prices.
An industry representative stated that clearly, there is a secondary market that is very thin, without many potential buyers. The starting point is also the need to address the difference between the net book value and the potential market price of the transaction from the supply side. This needs to be disentangled, because this gap is explained by a number of factors; it is not just a gap that can be explained by referring to one single item or cause. The size of this gap is very difficult to gauge: it depends on the vintage of the portfolio and the asset class. Clearly, the longer the vintages are, the wider the gap is. Moving from large files to SMEs or individuals will widen the gap in some countries, but this depends on a number of factors.
One of the main causes is data quality and variability. Discussing these sales means talking about vintages that go back to the early 2000s. In that period, almost nobody was concerned with the importance of retrieving and having good data, with good quality and availability, and this explains part of the gap. The burden of proof in this area is on banks, and there were a number of initiatives taken by the regulatory and supervisory side to help in that respect, looking to the future. It is common knowledge that banks are investing a lot in order to improve the capability of their data consolidation system. The second main cause, especially for people from outside Europe, is the length of legal proceedings in some countries. Even in Europe, some countries – such as Italy – have taken decisive steps to make sure that the time of recovery is reduced.
Another important issue, which is sometimes overlooked, is the cost. The issue of NPL sales usually gives rise to discussion of the ‘usual suspects’, which are the very big distressed asset funds that have this capacity. There are several smaller potential buyers that make up the market, or may be entering the market, but these do not have the capacity to put in place proper services and recovery practices. A public solution could be very helpful in this respect, even in the current regulatory framework, without involving the issue of state aid or related issues. Public intervention can help in allowing smaller players, as opposed to the ones that now make up the market, to enter this market, contribute to enhancing the discovery price[?], and narrowing the gap between the bid and the ask.
The other important factor is the regulatory incentive, or disincentive. Six months ago at the previous Eurofi, the industry representative was invited to speak about NPLs in the context of resolution, and said that in order to tackle this issue from the private side, two things are necessary: time and capital. Capital is increasing, due partly to the intervention of supervision. Time is important: for instance, one of the very important aspects of ECB guidance is that it is focused on governance and strategy. NPL strategy has been linked to SREP, allowing the right pressure to be created within a wider supervisory framework, and not ‘squeezing’ the market via too tight deadlines by not communicating amounts. In a case like this, there would be a need to be sure that there is only a fire sale solution, and there have been a few examples of this.
When talking about the regulations, it is also important to stress that in the current regulatory framework there is already the possibility of providing some incentives for sales. When an entity sells NPLs, there is clearly a price gap: they take a hit on capital in the price, and therefore the profit in the P&L at the beginning, and then need to recalibrate their loss given defaults (LGD). This could lead to problems, because as the debt is then brought forward, there is a double capital impact. Article 179 of the CRR allows, under certain conditions, for the possibility of avoiding the LGD and stabilising it. Even there, the burden of proof is on banks, provided that they are able to demonstrate that that sale, or part of it, meets the conditions of article 179 of the CRR. Discussion with the supervisors is very constructive in this context: banks have to prove that it is extraordinary, and there are certain conditions to be met. There are some actions that can be taken within the current regulatory framework.
The speaker fears that, now the EBA is writing the new guidelines on Probability of Default (PD) estimation, LGD and the definition of default, the current version of the guidelines could overcome the possibility of reverting to article 179. It is important that that consistency and incentive to sell, which is already present within the current regulatory framework, remains preserved in some form.
The other important major component of this gap is the expected return of the investor. There is a lot of debate about this being very high; in most cases, this is in the double digits, and dilutes the shareholders, which creates a problem. However, this will not necessarily be the case, provided that the other components are also addressed. Secondly, if banks are able to ensure that, via an important sale, they unclog their balance sheet and de risk it, and are able to restore a certain level of profitability in the near future, then they can close the gap between the potential dilution of the shareholders via the internal rate of return of the buyer and the expected return that the shareholders can benefit from in the future. It has to be emphasised that if a bank can maintain an expected rate of return in high single digits, by restoring sound and safe profitability going forward, the dilution effect should be mitigated.
The Chair commented that this is true for banks that have the prospect of returning to viability, but it could be argued that some other banks’ business models are broken. The industry representative replied that if this is the case, the problem is not the NPLs.
Another representative of the industry stated that the development of the secondary market at the European level follows a logical path. In countries such as Spain and Ireland, there has been around a 30% decrease in the stock of NPLs over the last few years. In Italy, a decrease in the NPL stock only began in 2016. Developments in the secondary market follow a similar path: usually in the first period, there is a local player increasing capabilities, because banks start to outsource the management of their portfolios or investors start to buy portfolios, and they need service. Then, foreign investors begin to look at the market, with consolidation and new incumbents coming into the market. In Spain, we went through those three phases. In Italy, the process is still at its beginning. There is room for improvement, because another €140 billion of transactions is expected between now and 2019, of which €60 or €70 million has already been announced to the market for this year.
In order to reduce the difference between countries and the expectations of banks that are selling portfolios, and investors that are buying, three or four factors are relevant. One is the legal framework. When clients ask the speaker’s institution to create benchmarks comparing the pricing of servicers or of portfolios, they always have to explain to them that it is not really possible to compare countries. In Spain, there is a good foreclosure regime; in Italy, there is not, and it is necessary to wait five to seven years to get money from collateral. To reduce the price gap, data is very important, as is provisioning, and in the last few months, also due to regulatory pressures, banks have been increasing their provisioning levels to reduce this gap.
The other important issue is the structure of the operations. Until one year ago, there was only pure sale of portfolios, but now, securitisations and public guarantees on notes are going to begin. Some banks are creating their own ‘bad banks’, dividing the good from the bad, so Europe is moving towards a structure that will help reduce these price gaps. Finally, regarding the development of secondary markets, the ECB guidelines push banks to decide which strategy is better. If outsourcing a portfolio is better, they are forced to think about this strategy. On the other hand, this also forces a bank to set some clear targets in terms of reduction of their NPL stock. This will probably be a further incentive towards the development of secondary markets.
2.6. An Asset Management Company (AMC) at the EU level would be a welcome initiative
A public authority representative stated that the SSM have done very useful work in the area of addressing and decreasing NPL ratios. Supervisory pressure is an essential component of the response: there needs to be a ‘push’ element on the banks to gain momentum and make things happen. However, if the secondary market is very shallow and liquid, and there are few buyers, it could be difficult for the banks to follow up on the supervisors’ requests and reduce their stock of NPL within a very compressed timeframe. To accelerate the pace, there also needs to be a pull factor on the other side, and an AMC is a tool that can be used for this.
Having an efficient insolvency regime with the right tools would be very good to avoid a future build up of NPLs, but the goal now has to be something that takes the assets off the banks’ balance sheets and cleans them, and to have somebody who specialises in working out these assets and selling them on the market. The cases that have occurred in Spain and Ireland in which this has been successful contained both elements: supervisory pressure and the AMC.
The EBA has tried to build a proposal on this. It started from the idea that, as this is a European problem, it should have a European solution; a common way of addressing the issue. Ideally, the starting point could be considering a European AMC; if there is liquidity promised in the market, and these assets can be pooled at the European level, there could be a critical mass factor. However, it is true that these assets are very different and that a Finnish mortgage cannot be compared to a Greek mortgage. Servicing would probably need to continue at the national level, but the speaker has also had contact with investors who are not active in this market now but would be interested in a European vehicle providing them with some diversification opportunities. This option should still be considered, although he does not feel that it is getting a lot of traction in political circles. A European solution would help the funding of this vehicle, and the governance of the whole process.
In general, what is necessary – and this can be achieved through developing a common blueprint for national asset management companies – is to have clear criteria on how the process should develop. Regarding engagement with BRRD and state aid rules, it is important to understand how Europe can frame a process in the context of the precautionary recapitalisation mechanism, which is respectful of the current legislative framework of the state aid rules, but at the same time offers the right incentives to all players to move forward.
A full suspension of the state aide and bail –in rules would be quite difficult, after having issued them a few months ago. On the other hand, a full private solution is not feasible, and Europe will need to walk the ‘narrow path’ in between these options. Trying to incentivise the banks to do what needs to be done creates clear and certain entry criteria, in which all the banks are requested to enter into the scheme and transfer the assets to an AMC. On the other side, there is a clear understanding of how the state aid rules would be applied, what the methodology for pricing would be, and how the involvement of creditors in burden sharing would be deployed.
Several people have also mentioned data as a critical factor, and this is indeed crucial. The EBA has recently received a letter from Vice President Dombrovskis, which gives them a mandate to develop a common standard framework for data dissemination and disclosure in this area. This will be crucial in developing a deeper and better functioning secondary market for these assets. Europe needs a common framework, via which it can put more pressure on the process and accelerate the dismissal of NPLs.