For months, European authorities have been mulling over a crucial issue for the health of the financial sector: reducing the stock of non-performing assets that have been piling up in banks’ balance sheets during the years of financial crisis.  The creation of a bad European bank is one of the alternatives that are being considered to solve the problem.

Last week, the idea of creating a European ‘bad bank’ was again under the spotlight, following statements by the Chairperson of the European Banking Authority (EBA).  As reported in Voz Pópuli, she proposed creating a European Union (EU) taxpayer-backed fund to buy billions of euros in toxic assets from troubled institutions at “fair value.” Expansión pointed out that this measure would result in the dual benefit of increasing transparency about the actual value of toxic loans in banks’ balance sheets, while nurturing the nascent market for such assets.

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La banca en la sombra

However, BBVA Research noted that the baseline situation of European institutions varies greatly, as some countries have already created their own bad banks and in some banking systems default rates have remained contained.  Such is the case in Spain, where “much progress has been made in improving the credit quality of financial institutions through provisions, renegotiations, disposal of unproductive assets and the creation of a bad national bank (Sareb),” said Ana Rubio, lead economist of financial systems at BBVA Research. Therefore, she pointed out, “this effort should be taken into consideration, regardless of the mechanism that Europe chooses.”

An alternative to the bad bank could be the creation of a European clearing house where information on non-performing assets is shared, but without transferring risks. According to BBVA Research, this would be a positive solution, as the clearing house would offer standardized information on assets for sale at a one-stop European shop, in which the data are guaranteed by authorities.  “This would allow investors to perform analyses at a lower cost and build portfolios by pooling assets from different banks,” said Rubio.  In any case, Ana Rubio noted that “the information should be detailed enough to guarantee that asset valuations are correct, including for example data on loan collaterals.”

Last July, the EU announced an action plan to expedite the reduction of non-performing loans (NPLs), including a number of proposals, such as the publication by the European Commission of a guide to help member states create their own national bad banks.

Also, the European Community launched in July a public consultation process aimed at all stakeholders involved. The purpose of the consultation was to gather feedback about the possible actions aimed at improving the functioning of secondary markets for non-performing loans. This would allow banks to off-load legacy assets from their balance sheet and boost their lending capabilities. Another aspect that the consultation aimed to assess is the role of third parties taking over the non-performance risk from the originating creditor (Special Purpose Vehicles).

Data show that the situation is quite different in each country. At the end of last year, NPL ratios in Greece and Cyprus stood at 46% and 45%, respectively, according to European Central Bank (ECB) statistics. ECB vice-president Vítor Constâncio recently pointed out that euro area banks hold almost one trillion euros in non-performing loans on their balance sheets. While the average euro area NPL ratio has declined gradually from a peak of 8% in 2013, it still remains at 6% and differences across countries are marked.

On the other hand, in order to improve the credit market for SMEs, the European Community also requested feedback about a new instrument, dubbedaccelerated loan security. The purpose of this new instrument is to increase protection of secured creditors against from borrower’s defaults. Upon expiration of the consultation period (which ends October 20), the European Community could launch a regulatory proposal to regulate its functioning.

Why is bad debt a problem for banks and the economy?

According to the Banking Outlook report issued a few months ago by BBVA Research, there are several reasons why non-performing assets are a problem for banks and economies:

  • Maintaining them is costly:  costs of recovery of loans, asset maintenance, taxes, appraisals, marketing expenses, registry of transactions and legal expenses.
  • They require an allocation of capital that could be better spent on new credit operations to sustain the economy.
  • They may exacerbate the vicious bank-sovereign circle, since the European regulation says that after the bank has exhausted its resources in the first instance, the national government must recapitalize them.
  • They hinder the granting of new credit and thus impede the transmission of European monetary policy.

Contact: Communications