Yves here. This post describes how efforts to tackle the bad loan problem at Eurozone banks have made a dent, but still leave banks in countries that had a high level of non-performing loans at considerable risk.
That matters because the EU implemented banking “reforms” which became effective in 2016 called the Bank Recovery and Resolution Directive. However, it was notably lacking in features that would prevent a future bank crisis. It was instead preoccupied with having investors take losses instead of having governments, as in Germany, on the hook. The wee problem is that approach is more likely to create bank runs and failures than the current regime. like having adequately-funded EU or Eurozone-wide deposit insurance and implementing measures to resolve sick banks (which really needs to include firing top managers and the board as a common course of action, as well as clawbacks). Thomas Fazi gave a high-level overview back then:
On 1 January 2016 the EU’s banking union – an EU-level banking supervision and resolution system – officially came into force….In its original intention, the banking union was supposed to ‘break the vicious circle between banks and sovereigns’ by mutualising the fiscal costs of bank resolution….
In the course of constructing the banking union, however, something remarkable happened: ‘the centralization of supervision was carried out decisively; but in the meantime its actual premise (that is, the centralization of the fiscal backstop for bank resolution) was all but abandoned’, Christos Hadjiemmanuil writes. Within a year, Germany and its allies had obtained:
- the exclusion from the banking union of any common deposit insurance scheme;
- the retention of an effective national veto over the use of common financial resources;
- the likely exclusion of so-called ‘legacy assets’ – that is, debts incurred prior to the effective establishment of the banking union – from any recapitalisation scheme, on the basis that this would amount to an ex post facto mutualisation of the costs from past national supervisory failures (though the issue remains open);
- critically, a very strict and inflexible burden-sharing hierarchy aimed at ensuring that (i) the use of public funds in bank resolution would be avoided under all but the most pressing circumstances, and even then kept to a minimum, through a strict bail-in approach; and that (ii) the primary fiscal responsibility for resolution would remain at the national level, with the mutualised fiscal backstop serving as an absolutely last resort.
Bailing In For Distressed Banks
In short, when a bank runs into trouble, existing stakeholders – shareholders, junior creditors and, depending on the circumstances, even senior creditors and depositors with deposits in excess of the guaranteed amount of €100,000 – are required to contribute to the absorption of losses and recapitalisation of the bank through a write-down of their equity and debt claims and/or the conversion of debt claims into equity.
Only then, if the contributions of private parties are not enough – and under very strict conditions – can the Single Resolution Mechanism’s (SRM) Single Resolution Fund (SRF) be called into action. Notwithstanding the banking union’s problematic burden-sharing cascade (see below), the SRF presents numerous problems in itself. The fund is based on, or augmented by, contributions from the financial sector itself, to be built up gradually over a period of eight years, starting from 1 January 2016. The target level for the SRF’s pre-funded financial means has been set at no less than 1 per cent of the deposit-guarantee-covered deposits of all banks authorised in the banking union, amounting to around €55 billion. Unless all unsecured, non-preferred liabilities have been written down in full – an extreme measure that would in itself have serious spillover effects – the SRF’s intervention will be capped at 5 per cent of total liabilities. This means that, in the event of a serious banking crisis, the SRF’s resources are unlikely to be sufficient (especially during the fund’s transitional period).
There’s even more along these lines, but you get the idea.
As you can infer from the post below, the powers that be in the Eurozone appear to have recognized that they need to Do Something given the weaknesses in the BRRD, particularly since the slow-moving Italian banking crisis has the potential to metastasize.
But the solution is to have governments guarantee the riskiest tranche of securitized pools of bad loans. I wish I could see more of how these structures worked. The reason is that for subprime mortgage securitization, the structurers similarly provided inducements to buy the riskiest tranche (the equity layer), which was securitized as “net income margin” or NIM bonds. They got the benefit of overcollateralization and excess spread (the fact that the interest on all the mortgages was higher than the total interest paid out on all the bonds in the securitization).
But the next riskiest tranche, the BBB or BBB- tranche, didn’t pay enough in interest to attract much in the way of buyers….which led them to be rolled into CDOs.
Investors are now so desperate for yield that I doubt that even the riskiest uninsured tranche is wanting for buyers. But it seems likely that they are unduly risky relative to the interest paid. So I wonder who is buying them.
The bad-debt problem at banks in the Eurozone, an ongoing legacy of cascading loan defaults during the last financial crisis, may have grown smaller overall in recent years but it’s still a major cause for concern. That was the basic thrust of a speech delivered by Andrea Enria, Chair of the Supervisory Board of the ECB, on Friday. And these bad loans remain dangerously to catastrophically high in several countries, including Italy, Greece, Portugal, and Cyprus.
Over the past five years the total stock of non-performing loans (NPLs) on the balance sheets of Eurozone banks has fallen from just over €1 trillion to €580 billion. During the same period, the ratio of gross NPLs in the region has fallen from 8% to 3.8% — the result not just of a shrinking NPL stock but also growth in banks’ total loan balances. Nonetheless, the ratio remains well above pre-crisis levels and is far higher than in other major advanced economies. For example, in the United States and Japan the ratio is 1.6% and 1.1% respectively.
In the Euro Zone there’s also a huge disparity between national NPL ratios, with countries like Germany, Luxembourg, Belgium, Finland, the Netherlands and the Czech Republic clocking in at or around 2%, while Italy’s NPL ratio is 9.5% and three Eurozone countries still have ratios above 10%:
- Greece: 43% (down from 50% since 2016)
- Cyprus: 22% (down from 49% in 2016)
- Portugal: 11% (down from 19% in 2016)
“The problem of NPLs is not solving itself – and it has not yet been resolved,” Enria said. “While it is true that the amount of NPLs has fallen significantly – by almost 50% since 2014 – the stock of NPLs is still very high. It is also very old… For those banks with the highest levels of NPLs, more than half of their NPLs are older than two years and more than a quarter are older than five years.”
To compound matters, Eurozone banks appear to be piling up new bad loans on top of the old ones.
“It seems that inflows of new NPLs are still on the high side – not least when you consider where we are in the business cycle,” Enria said. “It also seems that some banks with high NPLs are still reporting increasing default rates. We find this somewhat worrying, and we urge banks to stem this inflow by rethinking their underwriting standards and engaging with distressed debtors.”
In recent years, EU authorities have launched a raft of policy initiatives aimed at tackling the NPL problem, including rules on minimum loss coverage for NPLs, new provisioning guidelines for NPL stocks and measures to facilitate debt recovery, which is particularly important in countries like Italy where it can take years to recover unpaid debt. As we reported last year, many of the policy proposals were watered down at the last minute, following furious lobbying from bank lobbies and some national governments, including Italy.
Another key game changer was the launch, in 2016, of the “GACS” scheme, which provides banks with a state guarantee on the least risky tranche in bad-loan securitization sales. This means they can price their bad loans higher than their market value would have been, based on the underlying risks — and if that tranche becomes affected by losses, Europe’s unsuspecting taxpayers will get to eat them, rather than bank investors.
As intended, the scheme helped fuel a surge in both the supply and demand of NPL securitizations. “In 2018 alone, banks from across the euro area sold or securitised around €150 billion of NPLs,” Enria said. “For significant institutions with high levels of NPLs, sales and securitisations amounted to around one-third of NPL outflows in 2018.”
Few countries have benefited as much from the scheme as Italy, where an estimated €37 billion of NPLs were sold by banks in 2016, followed by a further €47 billion’s worth in 2017, according to Deloitte. The buyers are often specialist American hedge funds like Cerberus Capital Management or Fortress Investment. Thanks to their voracious appetite for government-guaranteed bad debt, Italy’s banking system was able to almost halve its NPL ratio since late 2015 and late-2018, from 16.8% to 9.5%.
But that’s still dangerously high, even though it pales in comparison with the 43% and 22% NPL ratios that Greece and Cyprus respectively boast. With the amount of bad debt in the Eurozone still too high for comfort despite the prevailing low rate environment and other relatively benign economic indicators, what could happen if underlying economic conditions deteriorate?
This is a question Enria himself is asking, with a certain sense of urgency. “We have to get a handle on this problem. We have to solve the issue of NPLs while the economy is still resilient,” he said in his closing remarks. “If banks have to sail into the next storm with too many NPLs on their balance sheets, they will be less able to weather it and come out safely on the other side.”
The benefit of NIRP: There’s hell to pay – even the ECB admits it. Read… Inspired by Deutsche Bank’s Death Spiral, European Banks Sink to Dec 24, 2018 Level – First Seen in 1995