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Tackling Non-Performing Loans Seriously. The Case for an EU Bad Bank (di Matteo Arrigoni)

In the aftermath of the Covid-19 pandemic, European banks will likely face an increase in non-performing loans. Due to the high costs involved, the management of non-performing loans is complicated, if not completely impractical. Therefore, public intervention is necessary to avoid further damage to the real economy and instability in the financial system. Nonetheless, national solutions are hampered by the EU regime related to banks’ crisis management. Several proposals aim at rethinking this regime by introducing greater flexibility. These, however, involve numerous political obstacles. A “way out” to overcome this impasse could be the establishment of an EU bad bank.

Keywords: Non-Performing-Loans; AMC; Bad Bank; Bail-in; State Aid

Spunti per un’adeguata gestione dei crediti deteriorati. Le ragioni per una bad bank europea

All’indomani della pandemia da Covid-19, le banche europee si troveranno ad affrontare un aumento dei crediti deteriorati. Per gli elevati costi, la gestione dei crediti deteriorati secondo un meccanismo di mercato risulta complicata, se non impraticabile. Un intervento pubblico è, quindi, necessario per evitare ulteriori danni all’economia reale e una possibile instabilità del sistema finanziario. Il regime europeo di gestione delle crisi bancarie ostacola, tuttavia, la proposizione di soluzioni su base nazionale. Di qui, le proposte di un ripensamento della disciplina europea, così da introdurre maggiore flessibilità che tuttavia presentano rilevanti costi politici. La costituzione di una bad bank europea potrebbe essere la “via d’uscita” per superare l’impasse.

Parole chiave: Crediti deteriorati; Società di gestione degli attivi; Bad Bank; Bail in; Aiuti di Stato


1. The dangerous increase expected in non-performing loans on European bank balance sheets. - 2. The “private” management of NPLs. - 3. The negative externalities of NPLs and the need for public intervention. - 4. A national AMC and compliance with the EU regime applicable to banks’ crisis management. - 5. Political obstacles to greater flexibility and possible palliation provided by the Temporary Framework for State aid measures. - 6. The “way out” involving an EU bad bank. - 7. A possible objection to the proposed solution. - 8. Looking at the future. - NOTE

1. The dangerous increase expected in non-performing loans on European bank balance sheets.

The measures taken to address the Covid-19 pandemic (including lockdowns) have had the undesirable effect of creating significant economic turmoil. Geopolitical imbalances, together with the rising cost of raw materials and energy, further complicate the situation. As a result, and notwithstanding the strong recovery that took place in 2021, the non-performing loans (NPLs) bound to occur on European bank balance sheets will increase. At the EU level, despite comforting data coming from 2020 [1], it is considered “vital to closely monitor the situation and possible risks to financial stability as well as ensure that banks can continue to play a constructive role in the recovery following the economic downturn. Further structural measures could be needed to prevent the accumulation of NPLs on banks’ balance sheets over the medium term” in order to “increase the financial system’s preparedness, thereby supporting financial stability and the economic recovery” [2]. Furthermore, it has recently been noted that “we do expect a rise in non-performing exposures, particularly once public support measures, such as payment moratoria, expire” [3]. Similar considerations also apply to the individual Member States. For example, in Italy, the increase in NPLs is considered to be the most significant risk facing Italian banks today [4]. This, together with the rigid application of prudential measures [5], may entail the need for capital strengthening, often through significant capital injections, that can be difficult to find.

2. The “private” management of NPLs.

The contractual default by the debtor and the management of NPLs are part of the business risk of the banks, which are therefore responsible for the related management. However, the solutions banks can practice are affected by possible problems. First, if there is a liquid secondary market, direct sales of NPLs can be the quickest option for banks needing to deal with them [6]. However, secondary markets for NPLs have not been very active in Europe [7], and therefore this may not be a viable option. The sale of NPLs in the secondary market provides immediate income, but it is often lower than that which can be obtained through debt collection [8], since in illiquid markets the buyer can exploit the seller’s needs. Thus, in this situation NPLs are sold at disadvantageous prices for the benefit of private buyers who are able to exploit the emergency in the banking sector. If it occurs at excessively discounted prices, the sale of NPLs on the secondary market can therefore lead to an excessively consolidated loss and, above all, can have a significant impact on the valuation of the NPLs still in the bank’s balance sheet, with significant consequences on the balance sheet. Alternatively, NPLs can be managed internally. However, this solution may have a duration incompatible with the bank’s available capital and liquidity. Indeed, if the value of NPLs exceeds banks’ liquidity and capital buffers, this option may be infeasible. Furthermore, effective internal management of NPLs requires efficient systems of justice and well-designed insolvency resolution frameworks, both of which are at present gaps that need to be filled [9].

3. The negative externalities of NPLs and the need for public intervention.

A significant increase in banks’ NPLs has consequences that extend outside the bank. First, the impact of NPLs on bank’s balance sheet can compromise its solvency, causing a crisis of confidence capable of affecting the financial system’s stability (so-called systemic risk). Furthermore, the higher capital requirements required by a significant increase in NPLs reduce the credit capacity and, therefore, support the real economy (so-called credit crunch) [10]. Such negative externalities, therefore, make public intervention reasonable. Public intervention can indeed lead to morally hazardous behaviour by banks that should be avoided [11] and can distort competition. However, as demonstrated by the case of the ‘four banks’ of central Italy, the importance of negative externalities largely exceeds the risk of moral hazard associated with public support for banks in difficulty and competition is not an absolute value. In other words, the objective of protecting financial stability is hierarchically superior to that of preventing moral hazards and of protecting competition in the internal market of the European Union [12]. It should also be noted that, in the current climate, the increase in the number of NPLs is not generally attributable to incompetent management of banks but rather to the consequences of Covid [13]; moreover, in this case, public intervention is aimed at addressing a market failure [14] (i.e., the depreciation of the value of NPLs due to a market that is not yet efficient).

4. A national AMC and compliance with the EU regime applicable to banks’ crisis management.

Thus, because traditional tools are not entirely effective in solving the current NPL problem, the risk of NPL management should be borne by a public entity that assumes the risk of negative externalities. In this perspective, numerous proposals have been made [15] – in addition to the securitization mechanism [16] and the possibility of providing public guarantees [17] – including the establishment of an asset management company (AMC) [18]. Well-designed and professionally managed AMCs can help speed up the credit recovery process while preventing unnecessary losses; they have the potential to overcome the temporary problem of selling off in depressed markets; and finally, they may prevent premature insolvencies and provide the ability to restructure the pool within a single institution [19]. Although the four AMCs in operation in the eurozone “have had a good track record of loan restructuring and value recovery” [20], for AMCs to be more effective, public aid would be appropriate to avoid excessive losses that would discourage participation by the banks [21]. However, imposing NPL risk on a national AMC to assist banks involves assessing whether it complies with the European regime relating to the management of banking crises and state aid. Moreover, the opposite choice, namely to intervene at “market conditions” involves the problem of identifying the correct value of the loans: especially in a context such as the current one, in which it is necessary to act quickly to avoid the risk of a new systemic crisis, this problem does not seem ridiculous [22]. From this perspective, an “impaired asset aid granted in the context of a transfer of NPLs from a bank to a publicly-supported AMC constitutes extraordinary public financial support” [23]. In turn, a bank receiving “extraordinary public financial support” shall be deemed to be “failing or likely to fail” [FOLF: art. 32, para. 1, let. a, and para. 4, let. d, Directive 2014/59/EU, Bank Recovery and Resolution Directive (BRRD); a similar discipline is provided by the Regulation (EU) No 806/2014, Single Resolution Mechanism Regulation (SRMR) within the Banking Union. Throughout this paper, references to the BRRD include those to the SRMR]. The FOLF determination involves either the beginning of a resolution procedure if “a resolution action is necessary in the public interest” [...]

5. Political obstacles to greater flexibility and possible palliation provided by the Temporary Framework for State aid measures.

Since the solution identified to cope with the increase in NPLs is apparently prevented by the rigid application of the regime relating to banking crises, there are numerous suggestions to alter the rules to introduce greater flexibility [36]. Such attempts, however, face substantial political obstacles: the cases in which a revision of this magnitude is undertaken are few and far between. Nonetheless, albeit temporarily [37], the European Commission has specified that, first, aid granted by the Member States to banks under art. 107(2)(b) TFEU (i.e., “aid to make good the damage caused by natural disasters or exceptional occurrences”) “to compensate for direct damage suffered as a result of the COVID-19 outbreak does not have the objective to preserve or restore the viability, liquidity or solvency of an institution or entity. As a result, such aid would not be qualified as extraordinary public financial support” under the BRRD, so the bank receiving the aid need not be deemed FOLF (art. 32, para. 1, let. a, and para. 4, let. d, BRRD) [38] and a resolution or liquidation of the entity need not have been initiated. Moreover, “to the extent such measures address problems linked to the COVID-19 outbreak, they would be deemed to fall under point 45 of the 2013 Banking Communication [39], which sets out an exception to the requirement of burden-sharing by shareholders and subordinated creditors” [40]. Therefore, even though there is room for public intervention, such a regime is subject to stringent conditions [41] that are not always reconcilable with the needs of banks. Furthermore, this regime is temporary and therefore cannot offer a structural answer to the problem. Even in the event of renewal of the suspension (i.e., at the end of the transitional period, they decide to renew the “Temporary Framework” for a further period of time) [42], the use of the state aid regime as a trigger – which does or does not allow public intervention from time to time – entails political risks that have repercussions in the internal market: the long period of time needed for the decision and the impossibility of proceeding after the veto of some Member States would generate uncertainty in the market which would penalize the possible aid beneficiary. Due to incompatibility with the foreseen conditions and alterations to the Commission’s temporary position, the problem of [...]

6. The “way out” involving an EU bad bank.

A “way out” to overcome the impasse could be the establishment of an EU bad bank (or AMC) that would manage NPLs in full compliance with the banking crisis management regime. In addition to the creation of a pan-European holding company to participate in the capital of national AMCs in collaboration with domestic banks that want to transfer NPLs to AMCs (the proposal suggests that the losses and profits of each AMC be offset at the national level to overcome any criticism that this initiative would cause the mutualisation of losses between Member States) [43], the creation of a European AMC (or a network of national AMCs) has also been proposed [44], with the possible use of national guarantees to avoid the mutualisation of losses. Despite cautionary words on this point [45], the European regime on banking crisis management – certainly applicable to a national AMC or for the provision of public guarantees within an NPL securitization system – is not relevant to the creation of a European AMC, since the latter would not fall within the notion of State aid [46] as set forth by the European Commission [47]. Indeed, the measure “is not imputable to a Member State if the Member State is under an obligation to implement it under Union law without any discretion” [48]; moreover, “if such resources are awarded directly by the Union … with no discretion on the part of the national authorities, they do not constitute State resources” [49]. Consequently, it cannot even be considered as “extraordinary public financial support” (cf. art. 2, para. 1, no. 28, BRRD), which is the condition for triggering the discipline of the BRRD. In addition to addressing the obstacles related to the State aid issue and the bank crisis management regime (BRRD), the creation of an EU bad bank would, from a microeconomic perspective, also allow the tackling of the problem of NPLs more effectively, with additional benefits beyond those of national projects [50]. From a macroeconomic perspective, this would make it possible to avoid the risk that substantial constraints (i.e., the high ratio between public debt and GDP) will de facto prevent some States from applying this solution [51] (although individual States could theoretically act on their own, each must consider their structural situation; for example, a State with a high ratio of public debt to GDP will have less room [...]

7. A possible objection to the proposed solution.

The proposal for an EU bad bank is part of a new “economic orthodoxy” that sees the change from a system of rigid fiscal consolidation to more significant public intervention in the economy to protect financial stability as beneficial [55]. Even this proposal is not without political obstacles, as it may involve the mutualisation of losses [56]. However, the impediment does not seem to be decisive. A common solution must be found if the problem is shared – whether directly or indirectly [57]. Indeed, as has recently been argued, “whether this form of solidarity is feasible remains to be seen. But one thing is certain: the problem that the share of non-performing loans on European bank balance sheets is likely to rise again due to the coronavirus crisis will not disappear by doing nothing” [58]. Furthermore, by offering an effective solution to the NPL problem, the proposal could allow testing the framework for the management of banking crises, not yet implemented due to the risks deriving from the excessive presence of NPLs [59]. As the Eurogroup has pointed out [60], the banking crisis arising out of the pandemic may, prove to be an opportunity to support a greater integration of the European banking sector. The solution could also allow the achievement of other purposes. The European bad bank could, in fact, operate on the basis of certain conditions, including compliance with debtors’ rights and protection. Adopting of such a solution clearly requires making decisions regarding the governance of the European bad bank and the criteria on which it buys NPLs. In this regard, leaving the details to further study, it is appropriate to consider entrusting the management of the European bad bank to the European Commission, whose discretion may be limited by compliance with certain quantitative parameters in order to avoid resources being distributed excessively to one State to the detriment of others, as well as by compliance with some criteria identified by the EBA after a thorough screening of European NPLs.

8. Looking at the future.

The problems raised by the management of NPLs can, in any case, contribute to the debate on the relevance of the discipline on State aid. In fact, it is unreasonable for the issue to continue to be governed by the 2013 Banking Communication, which was temporarily introduced in an economic and regulatory context that is radically different from the current one [61]. The recent public consultation on the State aid rules for banks in difficulty  [62] promoted by the European Commission is the right occasion for a change of perspective.