IMF estimates that non-performing loans in the Eurozone banks amount to €800 billion
The latest IMF Global Financial Stability Report contains a substantial item on distressed bank loans in the Euro Area.
It comes to the conclusion that “without significant policy efforts to address the burden of nonperforming loans, some economies may find that they remain stuck in the mire of low profitability, low credit, and low growth”. Isn’t there some phrase invoking the name of Sherlock Holmes that’s appropriate for revelations like that?
But still, the IMF attempts to quantify the scale of the problem – it thinks non-performing loans in the Eurozone banks now amount to €800 billion (getting on for five times Irish GDP). The vast bulk of this distressed debt is corporate, not household mortgages. And it is concentrated in the banks’ home markets.
The IMF has defined the “weak tail” of corporate exposures as those firms whose earnings before interest and taxes are less than their interest expenses. Such firms account for 20-30% of corporate debt in Italy, and 30-40% of corporate debt in Spain and Portugal (2012 average figures).
Despite additional provisioning efforts, the stock of impaired assets is still high relative to overall loss absorbing buffers, and has acted as a drag on bank profitability in stressed Euro area countries (defined by the IMF as Cyprus, Greece, Ireland, Italy, Portugal, Spain and Slovenia).
The IMF says there has been very little progress in restructuring corporate debt in the Euro Area, and this has left highly indebted companies unwilling to demand credit. At the same time, banks have raised the interest rate charged on loans, further dampening demand for new loans and leading to fragmentation in bank lending rates.
Cuts in bank credit supply, and the low level of demand, have resulted in a fall in the stock of loans in the stressed Euro Area. This has been a key element in the balance sheet deleveraging of the banks in these countries, according to the IMF. It is also been a way of plumping up bank balance sheets in recent months, to make them look good ahead of the ECB stress tests.
Restoring bank balance sheets to strength and resolving the burden of non-performing loans are, says the IMF, key to restarting the flow of credit in the Euro area economies.
Obvious. So what’s holding them back? The IMF lists four factors, starting with limitations in banks’ financial capacity- that is they don’t have enough provisioning buffers and capital (or shareholders funds). This means they can’t take the hit if they sell on distressed loan portfolios at the kind of discounts need to shift them in the market.
Second, problems with legal capacity have slowed down the resolution of bad loans. It lists difficulties in enforcing creditor rights, impediments to the sale of collateral, and long delays in processes. It also says investors buying distressed loans demand a discount to compensate for these difficulties, driving down the prices of impaired assets.
Third, banks have operational capacity constraints in their efforts to resolve non-performing loans. In other words, they just don’t have enough people with the required skills to deal with this many bad loans.
Fourth it points to “the immaturity of frameworks for out of court debt restructuring in some countries”, as well as a lack of mechanisms to foster creditor co-ordination. It points to something called the “London Approach”, a framework defined and disseminated by the Bank of England in the mid 1980s to bring debtors and their banks together and broker restructured or amended lending arrangements. Although the approach doesn’t guarantee a solution, it does allow for an efficient and timebound process for voluntary resolutions, away from the courts.
The IMF makes a number of recommendations for asset cleanup and resolution, including urging bank supervisors to increase the incentives for bank provisioning and write offs. They should also ensure that banks with big capital buffers actually use them to crystallise losses. “Institutions that are overcapitalised for precautionary reasons should use their capital buffers to help clean up balance sheets”.
Legal frameworks should be reformed and adequately resourced for timely resolution. Although several countries (including Ireland) have overhauled their insolvency and bankruptcy regimes, they are being held back by “sluggish creditor co-ordination, a lack of new financing for companies undergoing restructuring, and an overburdened judicial system that is ill equipped to deal with large volumes of distressed debt”.
Doing these things will lead to the promotion of a secondary market in distressed debt, because they should help reduce the current gap between what banks think their non-performing loan portfolios are worth, and what the market is willing to pay for them.
Using specialised capacity for handling the stock of non-performing loans may also help, such as external management companies which would allow banks to pool operational resources for debt workouts, and enable more effective co-ordination of the resolution of companies with multiple creditors.
But non-financial corporates are not the only companies being crushed by debt. Some banks are non-viable as well. While European governments have used rescue mergers and eventual resolution for some banks, there has been marked reluctance to pull banking licenses. Hence the IMF’s advice that any strategy to deal with the debt overhang in Europe also needs to include the resolution of non-viable banks.
Of course another way around the credit famine in Europe is to develop the non-bank financial sector (something John Moran at the Department of Finance is heavily involved in). The IMF lists three suggestions for this.
Firstly, existing regulatory constraints on non-bank lenders acting as direct lenders to hard-to service borrowers (notably SMEs) need to be reviewed. In some countries only banks are allowed to provide credit, while in others intermediaries with the capacity to hold long duration loans directly (such as life insurance and pension funds) have been excluded from doing so.
Second, market regulators should facilitate the listing of high-yield bonds by smaller firms. It notes that Italy and Spain have both recently launched mini-bond markets for SMEs. To help such markets, governments need to review restrictions on insurance and pension funds investing in such instruments. The IMF even takes the Irish approach to solving all known problems – it proposes tax incentives (temporary mind you) “to help incubate the market”.
Finally it says impediments to the securitisation of loans need to be reconsidered. This is particularly relevant for the insurance industry, where the incoming Solvency II directive makes the holding of securitised assets more capital intensive than holding the underlying loans directly. It says restarting the asset-backed securities market on a sound basis should enable banks to release assets and capital to support lending elsewhere.
What it doesn’t mention is that asset backed securities – properly rated, priced and tradable through a market – are one of the asset classes the ECB is looking for as a means of launching a QE programme. No wonder Michael Noonan said ““The mechanism would seem to be that the ECB would buy certain financial instruments in the banks – we had wanted to make sure we have the financial instruments in place if they are going to go in that direction”.
On the other hand, we have seen how Mario Draghi responds to “generous advice” from the IMF…..