ECB Gets Serious about Non-Performing Loans

US businesses traditional relied on bond and equity markets to raise capital.  When the crisis struck, the US acted early and quickly to re-open market functions before the banks were prepared to expand their lending.

The European and Japanese models of capital distribution are less market-oriented than the US and traditionally rely more on bank loans.  A bank’s decision is binary.  One gets the loan or not.  The markets have capital for anyone, even enterprises that are well below investment grade.  The markets dicker about the price of the capital not usually the availability.

As is well appreciated, the bank-centric distribution of capital lends itself to the souring of loans.  A bond of a company whose fortunes has deteriorated will see the bond price fal,l and the credit quality will become more suspect.  Loans are stickier.  And therein lies the problem.  European countries had different definitions of non-performing loans and different rules to address it.   Part of the effort in Europe toward a banking union has seen significant strides toward harmonization.

The ECB announced earlier today that as of the start of the New Year, EMU banks would have two years to cover 100% of the newly classified non-performing unsecured debt.  Bank will have seven years to cover all their secured non-performing debt.  Also, by the end of Q1 18, the ECB’s Banking Supervision will offer additional measures to address the existing stock of NPLs, including transitional arrangements.

Non-performing loans in Europe are estimated to be near one trillion euros.  Of course, there is great variance within Europe.  A study by Italian academics drawing on World Bank data produced the following chart that shows the non-performing loans as a percentage of all loans. 

Knowing the size of the non-performing loans is necessary, but too much
analysis stops with it. 
For investors,
this is not sufficient.  Banks are not simply sitting with the non-performing
loans.  With great variance across the region, banks have made provisions
through boosting capital holdings against the non-performing loans. 
Italy, for example, may count for nearly 40% of the region’s bad loans, while
the Italian banks may have made provisions for almost half of the stock of
NPLs, according to reports.  

While the Trump Administration appears committed to easing some of the
regulatory burdens for banks and how
leverage ratios are calculated, Europe
appears to be moving in the opposite direction of increasing the capital buffer
There is an alternative for European
banks.  Sell portfolios of NPLs to other investors. This can be done
by officials helping to facilitate a secondary market for NPLs.  Reports
suggest about 80 bln euros in NPLs were sold
in 2016.  

Reports suggest that there may be foreign interest in such distressed
assets as well. 
Several groups of foreign investors, including
AnaCap, Bain Capital, PIMCO, and Fortress have struck
deals to buy European NPLs.  A report suggests
that some $300 bln have been raised,
primarily from private equity and credit firms, as well as some large US banks.  Moreover, lending against NPL
portfolios provides some investors with indirect exposure at attractive nominal
yields typically said to be about 400 bp above benchmark rates.  Note that
Italy’s biggest bank, Unicredit, sold 17.7 bln euros of NPLs this year at an
average price of 13% of the gross notional value. 

Another measure that could help facilitate a solution is arguably the
creation of national bad banks that could warehouse, package and sell the
non-performing loans
.  Spain and Ireland went down this route. 
Those (distressed ) asset management companies bought the bad loans from the
banks at around 50% of the nominal value.  

To summarize,  the ECB announced measures aimed at (finally)
addressing the NPL problem which hangs over many financial institutions. 

US banks have long addressed similar issues.   To the extent that the NPLS
need to be covered fully will likely boost the capital needs of European
banks.  The exact amount of funds
needed is not immediately clear and depend on some
other issues, including how much provisions have already been made, and the willingness and ability to
sell-off the bad loans to other investors.   



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