Blog Post

A framework for thinking about bad loans

An important guiding principle in resolving non-performing loans (NPLs) should be to ensure that viable debt remains serviced, while non-viable debt gets resolved. We present here a framework to approach the issue.

By: Date: October 18, 2016 Finance & Financial Regulation Tags & Topics

The attempt to address the problem of non-performing loans in the EU should tackle both sides of credit creation at once.  On the demand side, new credit is not picking up as long as the problem of the debt overhang, namely the disincentive of undertaking new investments and consumption while old debts are prohibitively high, remains.  This, hinders the creation of new productive capacity, necessary to absorb factors formerly misallocated to sectors hit by the crisis. By implication, as long as private debts remain at high levels, economic activity will struggle to pick up. On the supply side of credit, progress has been slow in resolving impaired loans, which persist in banks’ balance sheets. This is problematic for both their overall health but also the creation of new credit.

Figure 1: Gross non-performing debt instruments, % of total gross debt instruments

Source: ECB, Note: peak year to 2016Q1

md-18-10-16

And while a number of countries (namely the Baltics) have managed to decisively resolve bad debts to the benefit of new credit creation, others have made less progress and some have even been unable to make any (Figure 1). The ECB recently issued draft guidelines in an attempt to pool resources and address the issue.

I argue here that an important guiding principle in resolving NPLs should be to ensure that viable debt remains serviced, while non-viable debt gets resolved. But this is not the same as resolving non-performing debt while holding on to performing debt. It helps therefore to categorise loans in two dimensions: viability and ability to service themselves.

Table 1 then provides four possible ways of classifying loans. Performing loans are those that are effectively being serviced and paid back. Viable loans are those for which the underlying assets generate sufficient value to cover funding costs.

Good loans are then, productive loans that are being serviced. This is the only category where debt has a productive role.

Bad loans by contrast are those that do not perform, but also those for which the activities they had financed do not generate enough value.  Aiming to resolve these loans in a swift and timely way should be encouraged, as the only way of identifying losses and reducing uncertainty for creditors but also releasing debtors from unproductive activities (second chance).

Unproductive loans are then those which may actually perform in the sense of servicing payments, but do not themselves generate value. Collateralised loans can provide indicative examples here.

Consider a household in the following situation: the value of its house is smaller than the loan that financed it (negative equity); it is liable by law for that remaining difference, as is the case in European countries (full recourse), and has very little possibility of walking away from such obligation by declaring bankruptcy (say through strict insolvency rules). If the household chooses (or needs) to sell that house, additional resources would be needed to repay the loan in full. Also, since the possibility of walking away from such a liability is effectively not available, the household is left locked into servicing a loan which is economically unattractive, as it is larger than the value of the house.

Protecting creditor rights is of course an important reason why insisting on servicing such debt may be a good idea. But when housing markets have gone through sharp corrections, followed typically by a downturn in the business cycle, such arguably unproductive loans may not be isolated cases, but rather wider spread. From a macroeconomic perspective, one ought to therefore at least consider whether the benefits of “creative destruction” outweigh the costs of violating creditors’ rights. The European Commission alludes to this in its last country report for the Netherlands.

Finally, there is also a category of temporarily distressed loans or strategic defaults. This includes either debts that are temporarily in distress but could return to being performing or loans that are non-performing by choice. The latter are the result of moral hazard where debtors choose not to pay back debt even when economically feasible. Evidence shows that strategic defaults increase as negative equity on mortgages increases, and especially when there is no full recourse. However, households’ likelihood to default strategically is shown to be also associated with perceptions of fairness, but also decreasing with the perceived risk of negative consequences of doing so (stigma, negative credit ratings etc). In this respect, indiscriminate protection of debtors or the less than perfect ability to collect collateral may lead to more strategic defaults.

Resolute action to remove non-performing loans from banks’ balance sheets should address both the supply and demand side of credit. Removing bad loans from bank’s balance sheet is important for their health and financial stability more generally. But removing them also from the debtors’ balance sheet is equally necessary if new credit is to be demanded.

Given the four categories presented above, understanding debtors’ true ability to pay back debts and restructure appropriately is crucial in this process. But aligning incentives between the different parties involved, creditors, debtors and relevant institutions (supervisors, regulators but also tax authorities and courts) is equally important.

The aim is to have as much debt fall in the “good” category. If loans are only temporarily distressed, they need to be identified as such and assisted in becoming productive again. Banks should be incentivized to deal with this in a timely manner.

Unproductive loans could be reduced if, for example, the possibility of walking away from debts through bankruptcy was not protracted and/or unforgiving. But here, while banks do not have an immediate incentive to either identify or deal with such loans, macroeconomic policy makers do, in particular when their size is systemic to the economy. Data on debtors failing to make other payments, like taxes or health insurance contributions, could serve as important indicators of financial distress. Such loans should then be assisted in becoming “bad”, which in turn should be treated swiftly to help redirect resources to productive activities. Enforcement and the rule of law are important in identifying “non-performance”; aligned incentives and bank involvement are important in determining “viability”.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event

Upcoming Event

Feb
3
09:30

Tackling Europe’s non-performing loans crisis: restructuring debt, reviving growth

How can we connect the different initiatives for NPL resolution and identify an agenda that is shared between EU, national authorities and the private sector.

Speakers: Corso Bavagnoli, Iker Beraza, Arne Berggren, John Berrigan, Marco Buti, Vítor Constâncio, John Davison, Maria Demertzis, Sharon Donnery, Vítor Escária, Giorgio Gobbi, Piers Haben, Boštjan Jazbec, Gert-Jan Koopman, Alexander Lehmann, TJ Lim, Brendan McDonagh, Reza Moghadam, Emanuele Rosetti Zannoni, Dirk Schoenmaker, Carola Schuler, Julien Wallen, Thomas Wieser and Guntram B. Wolff Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Opinion

Nicolas Véron

ECB finally addressing Italian bank woes

Italy’s banking problem has been left unaddressed for too long. Similar to Japan in the 1990s, it is best understood as a combination of structural and cyclical factors.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: January 4, 2017
Read article More on this topic

Opinion

MariaDemertzis1 bw
Guntram B. Wolff

Eurozone QE and bank profitability: Why it is too early to taper

In the eyes of the critics, the quantitative easing programs have been of little help to growth and inflation and have instead been an attack on savers, undermining the profitability of banks and insurances. Do these arguments stand scrutiny?

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: December 8, 2016
Read article Download PDF More by this author

Policy Contribution

pc-23-12European Parliament

The impact of the legal and operational structures of euro-area banks on their resolvability

Following the financial crisis, the question of how to handle a big bank’s collapse has come to the fore. This Policy Contribution evaluates the obstacles to resolvability that the legal and operational structures of the large euro-area banks could pose to the European Union’s new resolution regime.

By: Dirk Schoenmaker Topic: European Parliament, Finance & Financial Regulation, Parliamentary Testimonies Date: December 6, 2016
Read article Download PDF More on this topic More by this author

External Publication

cover-ep

The impact of the legal and operational structures of euro-area banks on their resolvability

This paper evaluates the obstacles to resolvability that the legal and operational structures of the large euro-area banks could present, assuming that it is possible to liquidate smaller and medium-sized banks through a transfer of the relevant activities to other banks.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: December 6, 2016
Read article Download PDF

Policy Contribution

pc-20-16_page_01European Parliament

What impact does the ECB’s quantitative easing policy have on bank profitability?

This Policy Contribution shows that the effect of the ECB’s QE programme on bank profitability has not yet had a dramatically negative effect on bank operations.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance, European Parliament, Parliamentary Testimonies Date: November 30, 2016
Read article More on this topic More by this author

Blog Post

sd-12177-_0028bea2-web

Can public support help Europe build distressed asset markets?

Distressed asset investors can relieve banks of their NPL overhang and offer valuable restructuring expertise, although banks will need to realise a further valuation loss. Regulators could do a lot to support the growth of this market.

By: Alexander Lehmann Topic: Finance & Financial Regulation Date: November 29, 2016
Read article More on this topic More by this author

Blog Post

sd-12177-_0028bea2-web

Credit recovery in Spain: NPL resolution was essential, but success depended on broader sector reform

Growth in Spain again exceeded expectations this year, and bank deleveraging appears to have reached an end. Addressing non-performing loans was a precondition for recovery, and it required comprehensive financial sector reform.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: November 21, 2016
Read article More on this topic More by this author

Blog Post

Schoenmaker pic

Stealing London’s financial crown would bring both benefits and responsibilities

After Brexit, several major cities across the EU27 are looking to take over London's financial activity. While there are plenty of benefits in hosting a major financial centre, it also comes with significant risks and responsibilities.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: November 17, 2016
Read article Download PDF More on this topic More by this author

External Publication

claeys-ref-2016

What role for the financial markets in Europe?

The European European financial system is too strongly bank-based. How can it be rebalanced to become favourable to growth and employment again? (This paper is only available in French).

By: Grégory Claeys Topic: Finance & Financial Regulation Date: November 16, 2016
Read article More on this topic More by this author

Opinion

Silvia Merler

An Italian take on banking crisis

The year 2016 has not been good to Italian banks. While resilient to the first wave of financial crisis in 2008, due to their low exposure to US sub-prime products and to the fact that Italy did not have a pre-crisis housing bubble, they have been suffering much from the euro sovereign crisis and the ensuing deteriorating economic conditions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: October 27, 2016
Read article More on this topic More by this author

Opinion

Nicolas Véron

Breaking the vicious circle

Nicolas Véron argues that EU banking union can only be complete if the vast amounts of domestic sovereign debt held by many banks are reduced

By: Nicolas Véron Topic: Finance & Financial Regulation Date: October 21, 2016
Load more posts