NPLs overwhelm Europe’s economy

Trillion euros in corporate and household NPLs in Europe is too much for the banking sector to regain profitability and effectively power the economy.

The banks want to sell them, but there is a lack of demand for debt. A debate on how to clear debts in Europe awaits us.

“In the majority of states impaired loans are too high (…) We are waiting for someone to place their portfolio on the table,” said Stefan Ingves, Governor of the Bank of Sweden and head of the Basel Committee on Banking Supervision at the 6th European Financial Congress in Sopot.

Experts at the International Monetary Fund (IMF) calculated that at the end of 2014 non-performing loans (NPLs) in the portfolios of EU banks had a value of EUR1 trillion, or 9 per cent of the EU’s GDP. In the Eurozone they amounted to EUR932bn, or 9.3 per cent of the Eurozone’s GDP of 2014. This is twice as much as 5 years earlier.

The scale of impaired loans in European banks was revealed after the European Central Bank carried out a comprehensive assessment of their balance sheets at the end of 2014. It turned out that impaired loans for the non-financial private sector is a third higher than the banks had previously admitted.

The differences between individual countries are huge, because in the Cypriot banks every second loan is impaired, in Greek banks NPLs constitute 43 per cent of total loans, while in Sweden they stand at just over 1 per cent. When it comes to the portfolios of individual banks, the situation is also very diverse. In 16 institutions from the Eurozone, the NPLs ratio exceeds 30 per cent.

We should recall that according to data of the Polish Financial Supervision Commission, at the end of 2015 this ratio was 7.5 per cent in Polish banks. Therefore, Poland is slightly above a medium rate, since according to data of the European Parliament, the average NPL in EU countries at the end of September 2015 was 5.9 per cent of the portfolio.

Poland owes its sharp fall in NPL, particularly in the consumer loans segment, to the sale of portfolios by banks. According to KPMG estimates, in 2015 banks sold debt worth PLN15BN which means an increase of 55 per cent in the course of two years.

The Kruk group, the largest Polish debt collector, says that last year it bought debt of a nominal value of PLN4.9bn for PLN489.3m, of which over a half was in Poland. On this basis one can conclude that Polish debt is valued at approx. 10 per cent of its nominal value. In 2014 Kruk paid on average 15 per cent of the nominal value.

However, debt is not getting cheaper. Although the majority of data on transactions is confidential, the KPMG report assumes that approx. EUR8bn of impaired loans from Italian banks were bought for EUR1.9bn, or almost one quarter of the value.

“The lack of willingness to deal with NPLs is because people don’t want to accept that something which was worth 100 is now worth 50. The cost is already calculated in the system but nobody wants to pay for it,” said Stefan Ingves.

While the value of impaired loans in Poland at the end of 2015 stood at PLN72.8bn, or approx. 4 per cent of GDP, in Italy the figure was 12 per cent, and in Hungary 8.7 per cent. In nominal terms, the largest amount of impaired loans, approx. EUR350bn, is in Italian banks.

NPL damage the economy and banks

The NPL ratio clearly divides Europe into north and south. In Estonia the ratio is 2.2 per cent and is lower than in the Netherlands, Denmark and Germany. The Czech NPL ratio is 3.4 per cent, which is lower than in Belgium, and Denmark. However, the ratio in Slovenia, Hungary and Romania are already close to Italian standards, where the share of bad loans reaches 16.9 per cent. Bad loans are mainly loans granted to the corporate sector, particularly small and medium-sized enterprises.

What are the consequences? Inhibition of bank lending and a decline in economic activity related to this. Bad loans tie up capital that could work effectively through increased lending. They lower the profitability of banks, increase their financial costs and thus lead to a deterioration in the credit offer, argue the IMF analysts.

And apart from this, impaired loans “distort” the transmission of monetary policy to the real economy, because even historically low interest rates are not reflected in the price of credit offered by the banks.

IMF analysts believe that the solution of the problem is crucial for a return to growth of lending and the availability of credit, especially for small and medium-sized enterprises, for whom – so far – the capital market has no tailored offer to obtain finance.

“Impaired loans are a serious impediment in granting new loans to economic entities, and in certain countries in the general functioning of the banking sector,” said Yves Mersch, members of the management board of the European Central Bank, during the European Financial Congress.

European banks cope with them much worse than their counterparts in the USA. At the end of Q1’16, US banks had USD58.6bn loans overdue by 30-89 days which was the lowest value for almost 10 years and almost three times lower than the peak recorded at the end of 2008. At the end of Q1’16, the ratio of all doubtful loans was 1.58 per cent, while six years ago the figure was 5.46 per cent, according to the American insurer of deposits FDIC.

Since the beginning of the crisis till the end of 2013, European banks sold NPLs valued EUR64bn, while in the USA such transactions had a value of EUR469bn in the same time period. Although last year the sales growth of impaired loans picked up in some countries, e.g. in Ireland up to EUR25bn and in Italy to EUR18.9bn, there is no solution of the problem in the nearest future.

Why banks cultivate impaired loans

Since high NPL ratios mean lower profitability of the bank due to charges to provisions for impaired loans, higher capital requirements and higher costs of financing, why don’t banks want to get rid of them? One of the reasons was the low supervision requirements regarding the level of provision for NPL. In the EU the average ratio is 44 per cent, and until recently this was even much lower. In Poland, after a review of the quality of assets at the end of 2014, the Polish Financial Supervision Commission ordered banks to increase the provision and currently it is among the highest in the EU at 58 per cent. However, there are also countries where it barely exceeds 30 per cent.

Inadequate supervision requirements allowed the banks to cultivate impaired loans and maintain them in their balance sheets much longer than they should and much longer than American banks do. Meanwhile, in the past provision requirements in Europe were – as the IMF has calculated – one quarter the level of requirements in the USA.

The lower the charges to provisions for impaired loans, the less banks gain from restoring them. Hence, the supervision pressure for higher provision motivates the sale or restructuring of debt. The IMF has calculated that if the banks in Europe got rid of impaired loans at their book value, they would “free” EUR54bn of capital which would give a potential EUR553bn in new lending.

“We are stuck in a vicious circle. We need capital but we can’t obtain it, because we have bad debts. If the bank increases its capital to cope with bad debts, there will be losses but then the profitability will rise,” said Carlos da Silva Costa, Governor of Banco de Portugal, during the congress.

In June last year, the Single Supervisory Mechanism under the ECB established a team which is to develop common principles of supervision policy against impaired loans. Earlier, these principles were different in each country.

Reform of bankruptcy law

IMF analysts believe that in Europe there are two principle structural obstacles to getting rid of the overhang of bad debts. The first is the ineffective and inconsistent system of bankruptcy law. Secondly, it differs greatly in different countries.

“Bankruptcy law is a critical issue. The diversity of bankruptcy law does not allow the management of NPL on a European scale,” said Elke Koenig, head of the Single Resolution Board, which deals with orderly resolution of banks, at the congress.

Several countries of Europe in the last few years have decided to reform their bankruptcy law, regarding both the bankruptcy of companies and consumers. This is the case in Cyprus, Latvia and Romania. However, the governments were guided by different social or economic motivations. The law in France strongly protects debtors and probably causes banks to refrain from selling EUR120bn of impaired loans. Although the NPL ratio in France is not so high compared to Europe as a whole, and stands at 4.2 per cent, the nominal value is the second highest on the continent.

It cannot be ruled out that the new resolution law and the relaxation of the rules for consumer bankruptcy have led to a significant increase in the sale of impaired loans and a fall in their price.

In Ireland, the law also strongly protects people who are not able to repay consumer loans and mortgages. If the bank rejects the proposals for a restructuring settlement, the law imposes judicial supervision. At the beginning of 2016, the time for bankruptcy proceedings was shortened in Ireland to one year, while even in 2013 it lasted… 12 years, according to the analysis of the European Parliament. Despite this, the market for the sale of impaired loans is one of the biggest in Europe.

The reform of bankruptcy law in Spain in 2014 introduced new instruments, such as the possibility to cancel debt, extend the maturity date, or convert the debt into the company’s equity. Before the reform of bankruptcy proceedings, in almost 95 per cent of cases they ended with the liquidation of the debtor. Currently the company must reach an agreement with 60 per cent of the creditors in order to extend the maturity date or convert the debt to “participatory” credit, which is a hybrid instrument combining debt and equity financing.

Similar hybrid instruments have been introduced in Croatia, Germany, Latvia and Slovenia. In several countries, however, including in Poland, procedures for pre-court settlement with creditors have been enhanced. Despite this, the IMF argues that in over 60 per cent of the Eurozone countries there are no time limits in force for the conducting of bankruptcy proceedings, and in 30 per cent of the cases consumer bankruptcy does not exist.

The harmonization of the bankruptcy law in Europe has one more aspect. It is one of the conditions for the success of the capital markets union project (CMU). This is why the European Commission  appointed a group of experts in December 2015, and on the basis of their work, intends to present the minimal standards of the harmonization of the law by the end of the year.

Divergent price expectations

Another reason for the persistence of large overhangs it that the bad debt market in Europe does not function adequately. Limited supply does not meet the demand at the offered price. In many countries there is a lack of good information about the situation of borrowers and collateral. There is also a lack of regulation covering companies that purchase debt. In some countries only banks can do this, and thus the vicious circle closes.

The low value of recovered debt is often the result of protracted court proceedings. Finally, the collateral in the banks’ balance sheets is sometimes overstated, and the real estate markets are not liquid. The banks themselves examined by the IMF indicated that for these reasons there are discrepancies between the price expectations of sellers and buyers and often the negotiated transactions are not finally concluded.

One of the recommendations of the IMF is to create a public or private agency for the management of assets which would play a role in the launch and implementation of the bad debt market. In Poland, Professor Elżbieta Mączyńska proposed the creation of a Public Fund for Debt Restructuring. So far, such agencies have been established in Hungary, Latvia, Ireland, Slovenia and Spain.

“It is necessary to create a market, because  the price must be low. The question is, who will pay, because [burdening] the public sector is out of the question,” said Stefan Ingves.

According to the analysis of the IMF, a good example is the activity of the Spanish “bad bank” SAREB. It was established as one central institution to buy the bad assets of the remaining banks, forcing them to accept conservative valuations. When it began to sell these assets, the banks had to adjust their offers to its prices. The creation of SAREB led to an increase in the sales of bad assets from approx. EUR7bn in 2012 to approx. EUR20bn in 2014.

The problem of debt reduction in Europe does not just concern companies and households, but also governments. It cannot be ruled out that a debate will also begin on this issue. However, the background of this will be the same situation as before the crisis – the high balance sheet surpluses and high level of savings in the Northern countries and the borrowing needs of the South.

“After 2018 we will have a nominal haircut,” said Joschka Fischer, the former German vice-chancellor, during the congress.

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