Mario Draghi entering an informal Eurogroup meeting, September 2017.

Mario Draghi entering a Eurogroup meeting, September 2017.

The days when the Italian financial system was on the brink of collapse are not long gone. Not a year has passed since Monte dei Paschi di Siena, the world’s oldest surviving bank and once Italy’s third-largest lender, failed to recapitalize itself in the private market, and had to be bailed in by the Italian government. Perhaps the main reason for the bank’s woes was its level of exposure to non-performing loans, one of the Eurozone’s most pressing concerns when it comes to financial stability.

Europe may seem to have bright skies on its economic horizon, but the continent’s exposure to non-performing loans remains high. These NPLs have implications that affect the whole Eurozone economy. Further, different NPL levels across countries within the Eurozone pose challenges to completing the formation of a European banking union.

When it comes to solving the NPL problem, few foresee a uniform European solution financed collectively by all Eurozone countries. Differences arise when it comes to whether mechanisms for dealing with NPLs should be established on a purely national basis, and what role European regulators and the European Central Bank should play in attempting to curb the problem.

What Got Us Here (Won’t Get Us There)

In Europe, bad debt tends to pile up in countries where economic performance is poor and where the financial system relies heavily on traditional retail banking. The reason for this is simple: the more financial systems rely on specific instruments––in this case, traditional borrowing and lending––the more exposed they are if that sector experiences pressing problems.

The data corroborates this framework. Statistics gathered by the European Parliament suggest the problem is most serious in economically challenged countries such as Italy, Portugal, and Greece, all with NPL ratios over 15 percent. Overall, the E.U. average of 5.1 percent is still well above that of comparable economies: the United States and Japan have NPL ratios of 1.3 percent and 1.5 percent, respectively.

This is due to both the slower response by European policymakers to the financial crash of 2008, and the effects of the subsequent European debt crisis. According to Eduardo Stock da Cunha, the head of corporate development at Lloyds Banking Group, a more decisive response to the crash in countries like the United States helped mitigate its repercussions. “Even though the macroeconomic situation was largely the same, success in effectively responding to the crises was different,” he told the HPR.

European monetary policies have further complicated the resolution of NPL levels. Low interest rates have reduced banks’ profit margins substantially, thereby delaying much-needed balance sheet repairs. The pressure on profits encourages banks to overvalue NPLs, discouraging banks from selling their bad loans. The European Central Bank’s ever-stricter capital requirements have also shrunk banks’ profit margins. However, low rates help invigorate the economy during downturns, which can contribute to resolving NPLs. “Monetary policy has undoubtedly had a role in promoting economic recovery,” Nuno Amado, president of Banco Comercial Portugues, told the HPR, “and to that extent it has helped to mitigate the NPL issue.”

A further complication is that countries affected with high NPL ratios often have inefficient legal mechanisms in place to deal with bad debt resolution. “In countries with high NPL exposure, there are serious legal inefficiencies that prevent a sound resolution of the problem,” said Stock da Cunha.

The secondary market for selling NPLs also suffers from problems of its own, information asymmetry being chief among them. Potential buyers struggle to adequately price NPLs, as they have less knowledge than banks about the quality of the debt being sold. Further, some countries have markets for NPLs that are dominated by a handful of buyers, which widens the gap between their prices, the prices banks are willing to sell at, and socially optimal solutions.

In Portugal, the secondary market for NPLs has a “few buyers who dominate the market and can make it function like an oligopoly,” according to Amado. Enrico Risso, a McKinsey partner in Milan, told the HPR of a different situation in Italy: “at the moment there is quite a lot of interest in secondary markets for NPLs.”

These problems can have broad implications. European economies depend on credit to finance growth. High levels of NPLs on banks’ balance sheets perpetuate inefficiencies and hinder potential economic growth, which itself risks further exacerbating the problem.

Getting Things Moving

There are many potential methods for dealing with NPLs, each of which attempts to tackle the different dimensions of the problem.

Although a unified European approach is tempting, an optimal solution would be tailored on a country-to-country basis, since NPL resolution varies widely in different legal frameworks. This means a one-size-fits-all approach, such as the creation of a European “bad bank,” would likely be unfeasible or ineffective. Nor does a unified approach address the significant differences in NPL exposure levels across the Eurozone. “I am skeptical of initiatives that can be done at a European level, basically because the nature of the issue is so different in different countries,” said Risso. Amado, in turn, questioned the strategy’s feasibility: “this is not an approach that we deem likely to draw the necessary political support.”

Indeed, these disparities reflect a more general problem facing a European banking union: asymmetrical national banking structures make proposals for deep financial integration difficult to put into practice. While further integrating financial systems would likely alleviate some of the union’s more worrisome financial troubles, the fact that these troubles are much more prevalent in some countries than in others makes those in better financial conditions hesitant to sponsor solutions to problems that are not their own.

Despite these difficulties, there is broad consensus that reforming the legal frameworks for debt resolution is a critical next step governments can make. Besides lifting the cloud over banks with a large number of long-term NPLs, it also helps the secondary market for NPLs to become more competitive. Especially in smaller countries, few risk-tolerant buyers are currently in the market to buy NPLs from banks. If the certainty and efficiency of NPL-related regulation improves, then the risk to buyers is lowered and more can enter the market. Amado called such efforts the “critical missing element” of current solutions to the problem.

Other policy instruments can be used to incentivize banks to deal with NPL losses sooner rather than later. A recent European Central Bank report advises countries to review their tax policies toward NPL write-offs to find ways to make declaring NPL losses more attractive to banks. The same principle, the report argues, could be used to incentivize NPL trading on the demand side. “State guarantees … could help open the secondary market for NPLs by generating more interest,” said Risso.

Furthermore, the European Central Bank has recently reinforced NPL guidance rules, requiring that banks provide full coverage for them within a set period. Banks with high levels of NPLs are also required to present NPL strategies and reduction targets to European regulators.

The issue of non-performing loans in Europe is at once regionally-specific, difficult to resolve, and a pressing concern for the economic performance of the Eurozone. Although a rising economic tide is helping reduce NPL ratios, there are many structural problems that remain to be addressed, and the issue brings to light the many obstacles facing a European banking union. As of yet, whether or not European policymakers will be able to rise to the challenge remains to be seen.


Image credit: Flikr/EU2017EE Estonian Presidency

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