It seems that Europe’s non-performing loan problems are diminishing just as European authorities are issuing long-overdue proposals to deal with them – so are they still relevant? Stefanie Linhardt investigates.

ECB flags

Ten years on from the onset of the financial crisis, authorities are still working on a response to the non-performing loan (NPL) problem in the EU. Better late than never, some say. But recently updated data on bad loans show a trend of falling volumes and NPL ratios.

At their peak at the end of 2014, NPLs reached €1120bn across EU banks, according to the European Banking Authority’s (EBA) Risk Dashboard, which started collecting NPL data that year. Since then, the figure has fallen to €813bn as of the end of 2017, or to 4% from 6.5%.

Asset quality is improving across Europe’s banking sectors but the recent reduction in the NPL ratio is also related to lower NPL creation, thanks to an improvement in the underlying economic situation. Gross domestic product growth in the eurozone was 2.5% in 2017. Indeed, the economy in every EU member state grew in 2017 and the International Monetary Fund expects this trend to continue in the medium term.

So are the responses from the European Central Bank (ECB) and the European Commission, plainly put, 10 years too late, as the severity of the issue seems to be lessening? Or are the measures key to resolving problem loans – especially bearing in mind the next downturn in the economy, which will inevitably come? And how are Europe’s banking sectors set up to deal with the NPL burden?

Establishing a strategy

The ECB took the first step in creating more urgency around NPLs with the publication of its March 2017 guidance on bad loans. Although the ECB is not a legislative body, the guidance aimed to flag up to significant eurozone financial institutions the criteria that the ECB’s Single Supervisory Mechanism would be looking for in its supervision.

According to Anne Froehling, the ECB’s coordinator of the NPL task force, the guidance follows a comparison of the different approaches to NPLs across eurozone banks and a stock take with the national supervisors. “And we found out there was a lot of good practice and also a lot of not so good practice,” which led the ECB to “put that into a guidance to make our lives easier”, she said at a conference on NPLs in Europe, organised by the Association for Financial Markets in Europe (AFME). The first draft of the guidance was published in September 2016.

“The regulatory response has definitely accelerated the momentum around NPLs,” says Tom McAleese, managing director at consulting firm Alvarez & Marsal. “The most important piece for me was the ECB NPL guidelines issued in September 2016.”

Indeed, data indicates that at significant institutions within the eurozone NPLs have reduced from a volume of €878bn and ratio of 6.2% at the end of 2016 to €721bn and 4.9% at the end of 2017, according to the ECB’s Financial Stability Review from May 2018.

A key point set out in the ECB guidance was to drive strategic and operational focus of bank management to the reduction of NPLs and it included a 5% threshold for determining a ‘high NPL bank’. This level has been picked up by the EBA in its guidelines on management of non-performing exposures (NPEs) and forborne exposures (which form part of the NPL action plan announced by the Council of the EU in July 2017) to distinguish between high and low NPL banks.

The consultation for this closed on June 8, during which several industry bodies criticised this classification. Still, the 118 significant institutions supervised by the ECB (as of January 2018) can already be subject to tighter supervision if they are classified as ‘high NPL banks’.

Even though the Greek banks have an agreed reduction plan, if I am able to accelerate it, I will do it

Christos Megalou

Back to the drawing board

The ECB’s NPL guidance brought surprises for some. After years of tackling bad loans and exposures, some Irish banks found themselves back in the spotlight.

“The ECB NPL guidelines categorised banks with an NPL rate above 5% as ‘high NPL banks’, which included the main Irish banks – including AIB and Permanent TSB, which have NPL rates of 15% (for the first quarter of 2018) and 25% (as of the end of 2017),” says Mr McAleese. “Each bank has had to prepare an NPL reduction plan including additional deleveraging and therefore the banks have come back to the market with significant loan sales in the first half of 2018.”

Data from the KPMG Debt Sales Monitor and ECB calculations show that since more than €10bn-worth of NPLs were sold at Irish banks in the third quarter of 2015, disposals have reduced. But according to an official at the Irish finance ministry, NPL portfolio sales at state-owned banks will increase significantly in 2018. The market, however, is well established and bidders are comfortable with the jurisdiction.

One of the reasons for a renewed need for NPL reductions came from a reclassification of Ireland-specific exposures, so-called ‘split mortgages’. These housing loans are the result of a restructuring in which the loan is rewritten to a level the borrower can pay, while the remaining part is frozen. This has allowed Irish banks to keep one portion of the mortgage alive and classed as ‘performing’. However, the ECB classes the entire loan as non-performing under its criteria.

Overall, the average NPL ratio of Irish banks had reduced from 14.6% as of the second quarter of 2016 to 11.2% in the third quarter in 2017, according to ECB data.

A Greek odyssey

The ECB classes about 30% of the banks it directly supervises as “high NPL” institutions, according to Ms Froehling, and is focusing on these banks’ NPL strategies and targets.

On paper, Greek and Cypriot banks still had by far the highest NPL ratios at the end of the third quarter of 2017 – on aggregate 46.7% and 32.1%, respectively (versus 47.2% and 37.6% as of the second quarter of 2016) – according to ECB data, followed by Portuguese banks in third place (14.6% in the first quarter of 2017 versus 17.6% as of the second quarter of 2016).

According to The Banker’s Top 1000 World Banks ranking for 2018, Cyprus’s Hellenic Bank and Bank of Cyprus have the highest ratios of disclosed NPLs to total loans in Europe (see pages 178 and 179) followed by Greece’s Alpha Bank, Piraeus Bank, Eurobank and National Bank of Greece, as well as Portugal’s Novo Banco – at all of which the ratio was above 30% as of year-end 2017 data.

Greek banks have pledged to lower their NPLs from €72.8bn in June 2017 to €38.6bn by the end of 2019. Christos Megalou, chief executive of Greece’s largest bank by assets, Piraeus Bank, says his bank’s strategy is to “do whatever it takes” to reduce NPLs and NPEs. “This year the target is to reduce NPEs by €5.5bn,” he adds. According to Piraeus Bank’s first-quarter results for 2018, the bank seeks to reduce its NPEs from €30.8bn as of March 2018 to €20.3bn by the end of 2019.

“Even though the Greek banks have an agreed reduction plan, if I am able to accelerate it, I will do it,” says Mr Megalou. “The problem is such that you cannot address it if you don’t also consider radical solutions,” he adds, stressing that sales of portfolios in the second quarter of 2018 have reduced exposures by about another €2bn.

Greece was slower to develop its secondary market than fellow crisis countries such as Ireland, Spain or Italy, but with its Project Amoeba disposal of real estate NPEs to Bain Capital in May 2018, bidders have, after the first unsecured sales in the second quarter of 2017, purchased the first secured Greek portfolio.

“On the back of that, more deals are going to follow from us and other banks,” says Mr Megalou, who adds that apart from Bain, the portfolio sale got another three international players interested in the Greek NPL market. “One of the reasons why transactions were not happening was because we did not have servicers in the market,” he says. “Now we [do].”

Secondary thoughts

An established servicing market is a key component for a working secondary market, agrees Mr McAleese, who notes that especially in certain countries such as Spain, banks carved out their work-out units in order to sell their loan servicing units together with NPL portfolios to investors while the servicing market matured.

In the past two years, Spanish lenders, alongside Italians, have been selling the largest volumes of NPLs; in 2017 alone, Spanish banks disposed of €66.7bn of NPLs, according to the KPMG Loan Transaction Tracker. The bulk came from Santander’s €30bn sale to Blackstone and BBVA’s €13bn transaction with Cerberus. According to The Banker data, NPL ratios at the country’s two largest banks, Santander and BBVA, were below the ECB’s 5% cut off at the end of 2017, at 4.8% and 4.4%, respectively.

On an aggregate basis, Spanish banks have reduced their bad loans by 1.2 percentage points between the second quarter of 2016 and the third quarter of 2017, to 4.7%.

Italian banks sold some €55.6bn of NPLs in 2017, after an already busy 2016 (which saw €49.6bn divested), and 2018 has also started strongly. The country’s second largest bank, Intesa Sanpaolo, teamed up with Intrum to create an NPL servicer with a 10-year contract to service Intesa’s bad loans. Monte dei Paschi di Siena’s securitisation of €24bn of NPLs with Italian government guarantees in May was an example of another option open to Italy’s banks until the scheme runs out in September 2018 – even if, in the so-called GACS securitisation structures, the banks keep the unsecured tranches on their books.

“Looking forward, based on our estimates, the NPL ratio [in Italy] is expected to continue to decline, to less than 10% in 2019 and less than 8% by the end of 2020,” says Giovanni Sabatini, general manager of the Italian Banking Association. “These trends confirm that banking risk reduction proceeds quickly – in Italy faster than in the rest of Europe. As a consequence, regulatory measures aimed at reducing risks are much less necessary and urgent than some time ago.”

Concerns for investors

Still, the time taken to recover a bad loan remains an issue in the Italian legal system – and lately the country’s political environment has been causing additional concerns among potential investors. While the country’s  NPL ratio, according to the ECB, has come down from 16.1% in the second quarter of 2016 to 12.1% in the third quarter of 2017, the issue lies with the Italian banking sector’s high legacy NPL problem (volumes in the second half of 2017 were at €199.6bn, according to data from rating agency Fitch’s report on asset quality trends in EU banks, compared with €261bn in 2014). European leaders would like to see it reduced before further integrating the eurozone’s banking union and setting up a European Deposit Insurance Scheme.

So, it was with the eurozone’s future in mind that the leaders of the EU28 called upon the European Commission in July 2017 to work on an action plan to tackle NPLs in Europe.

The list of issues that the Council of the EU has asked the European Commission to tackle is long and involves the EBA, the European Systemic Risk Board and the ECB’s banking supervision as well as national competent authorities.

These range from calling on member states to enable swifter collateral enforcements to make settling NPLs more efficient, to establishing a blueprint for national asset management companies and templates for NPLs, to developing better functioning secondary markets for NPLs and implementing statutory prudential backstops in the form of amendments to the existing capital requirements regulation.

Anger at the ECB

But the ECB has also been preparing additional provisioning requirements. Following the release of its NPL guidance, in October 2017 the supervisor proposed measures in an addendum, which sparked furious reactions from some market participants. Pier Carlo Padoan, at that point the Italian finance minister, saw the suggestions as a potential risk to the recovery of the Italian banking sector, while the European Parliament questioned whether the ECB was overstepping its remit.

In a letter to Roberto Gualtieri, an MEP and chair of the committee on economic and monetary affairs, in December 2017, the chair of the ECB supervisory board, Danièle Nouy, tried to reconcile: “The addendum… was never intended for any automaticity in the application of measures,” she wrote.

The final addendum applies to any loans at significant institutions under ECB supervision that become non-performing from April 2018 but will not be enforced until 2021. Any new unsecured NPLs must be fully provisioned within two years, while provisioning requirements for secured NPLs increase incrementally and must be fully provided for no longer than seven years after turning non-performing.

By implementing this, supervisors are aiming to achieve more urgency in dealing with the NPL burdens at significant institutions, especially through more portfolio sales.

It is very difficult to deal with a commission and a supervisor that have different approaches to the same problem

Carlo Messina

The final version of the addendum was published one day after a European Commission proposal to require incremental provisioning for loans originated after March 14, 2018 that become non-performing. The commission’s provisioning requirements for secured NPLs start with the first year but do not reach 100% until year eight while – as with in the ECB addendum – unsecured NPLs would need to be fully provisioned at two years.

Under this ‘prudential backstop’, banks would deduct any shortfall between their provisions that are less than those envisaged by the regulation from its core equity Tier 1 capital with no implications for the bank’s net income or International Financial Reporting Standards equity.

Commission rules prevail

Ultimately, the European Commission’s rules and schedules prevail over the ECB guidance. Once enforced, they apply to all banks in the EU and form part of the Pillar 1 regulatory framework. However, should the ECB consider the commission’s framework on a case-by-case basis as inappropriate for a specific bank under a Pillar 2 approach, the supervisor will expect the institution to increase provisions in line with the addendum.

“The pressure for quick but likely capital-destructive solutions with unrealistic goals, together with the adoption of a ‘one size fits all’ approach that does not take into account national and system specificities, risks doing more harm than good and may not be commensurate with the overall objective of preserving financial stability and supporting growth,” the Portuguese Banking Association told The Banker.

“We decided to work with this tough approach and have already increased coverage levels and we are working to decrease NPLs,” says Carlo Messina, chief executive at Intesa Sanpaolo, who adds that the collaboration with Intrum further supports this. “But it is very difficult to deal with a commission and a supervisor that have different approaches to the same problem. That is really something that [should be coordinated] between the ECB and European Commission,” he says.

Sebastijan Hrovatin, deputy head of Unit D1 – bank regulation and supervision, DG Fisma at the European Commission, points out that there are reasons for some differences between Pillar 1 and Pillar 2 requirements.

“That is the whole point,” he said at the AFME NPL Conference, suggesting that if both were “completely identical” there would be no need for Pillar 2. “Pillar 2 is there to, when necessary, go above and beyond what Pillar 1 says, because the situation of a particular bank actually warrants going above and beyond,” he added.

A wider reach

As part of the NPL action plan, the European Council also asked the ECB to extend the scope of its NPL guidance to less significant financial institutions by the end of 2018, “with targeted adaptations where appropriate”, in an attempt to not be too lenient.

“We consider it is very important that the introduction of any regulatory requirements does not penalise the recovery of both the banks and the economy,” says Mr Sabatini. “In this light, regulatory requirements should be gradual and should take into account the principle of proportionality by bank size and business and in terms of costs [and] benefits.”

Sam Theodore, head of financial institutions ratings at Scope Ratings, notes that not only NPL ratios but also coverage ratios have improved and that therefore the legacy asset burden should no longer be at the top of supervisors’ concerns. “Using the European Commission’s own numbers, EU-supervised banks have raised €234bn of additional capital since 2014,” he said in the Scope Debate on bad loans in Europe, adding that Tier 1 capital ratios at eurozone banks increased from 14.6% as of the third quarter of 2016 to 15.3% a year later. “It’s a legacy issue which is decreasing by the quarter,” he added.

Banks are concerned that authorities could potentially extend proposed and implemented measures to the NPL stock, placing the sector under even more stress.

The Portuguese Banking Association says: “It is important to separate between measures that will help to tackle the NPL legacy from those measures that are meant to avoid the reoccurrence of the problem in a future crisis, which if applied to the NPL stock would have a harmful impact on the financial stability and on the banks’ capacity to finance the economy.”

A consolidated hope

But even with the current set up, the increased provisioning requirements are likely going to push institutions to sell soon or face higher provisioning charges, which will likely see some banks weaken.

“In implementing the ECB NPL guidelines, some lenders may not have enough capital on their books, or will be weakened to such an extent that they may need to be merged, need repair or might eventually fail – but that’s part of the overall cleansing process,” says Mr McAleese.

Indeed, Peter Grasmann, acting director, DG Fisma and head of unit at the European Commission, calls it a “favourable scenario” should the measures turn into a catalyst for industry consolidation.

This could either mean improved asset quality or increased incentives for consolidation, especially across borders. Rumours about Italy’s largest bank, UniCredit, considering merging with Société Générale of France could underline the theory – should the merger happen.

Another way of facilitating consolidation would be related to banks “realising that certain business models… based on substandard loan underwriting and excessive forbearance… will be less tolerated by markets and supervisors [than] in the past,” said Mr Grasmann at the AFME NPL event. He added that this would drive banks to leave the market if they are unable to raise further capital.

“This is not the typical European way… but it could slowly also emerge as an additional [path] to industry consolidation across Europe… which, I think we all agree, is needed,” he says. 

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