Blog post

ECB bank supervision cannot tackle debt restructuring single-handedly

The European Central Bank has begun to tackle a key symptom of banking sector fragility with its proposed guidelines on banks’ management of non-perfo

Publishing date
13 October 2016

In mid-September the ECB’s supervision arm issued draft guidelines on banks’ management of NPL portfolios. In principle, by next year the most significant Eurozone banks may have to:

  • Comply with targets for NPL reduction in individual asset classes, which will be set for different time horizons;
  • Establish strategies and operational plans for NPL resolution, through better staffing of workout units and their integration in management structures, and IT systems that facilitate loan quality monitoring and portfolio sales;
  • Account annually to the ECB supervisors on progress in NPL reduction.

NPL resolution will now figure prominently in the ECB’s regular discussions with the 129 significant banks that it directly supervises. Ultimately, similar standards may be implemented for smaller banks where direct supervision lies with national authorities. In the near future this guidance will only inform discussions with systemic banks that have a persistent and excessive NPL stock. But binding ECB supervision might follow for those banks that fail to comply.

This is a welcome further step in the long-running attempt to cleanse balance sheets from the legacy of the financial crisis. To date, euro-area banks have made no more than a small dent in the NPLs which stood at over € 1 trillion in 2015, according to the latest IMF assessment.

As the ECB has again pointed out in their latest Financial Stability Review, high levels of NPLs remain a key obstacle to a recovery in lending. This traps capital in loss-making enterprises and as credit supply is stifled, investment suffers across all sectors, aggravating debt distress further.

The NPL overhang is particularly serious in the euro area countries that have undergone sharp financial contractions (see the table below). In Spain and Ireland NPLs are now falling, but this process remains in the early stages in Italy, Portugal and Slovenia, and Greece.

Given cross-border linkages between banking sectors, NPLs will complicate lending relationships throughout the single capital market, and also undermine the effectiveness of the ECB’s more aggressive monetary easing (a recent paper by V. Acharya and co-authors underlines the scale of credit misallocation). So a consistent effort in cleansing distressed loans from bank balance sheets, and preventing their re-emergence, will be essential for confidence in the banking union.

New standards on loan quality were adopted by the European Banking Authority (EBA) in 2013. In the 2014 comprehensive review these enabled a first glimpse of true asset quality based on a common standard. Forbearance – the modification of loan terms in the expectation of the recovery of the borrower’s capacity to repay – was clearly defined and inadequate restructuring, in the spirit of ‘extend and pretend’, has become more difficult since then.

The ECB guidelines seem a significant extension of the scope of supervision, beyond ensuring compliance with prudential norms and addressing the deeper causes of weak capital coverage that lie in business models and organisational structures. Some may see this as a regime change for banks that are already confronted with a significant compliance burden. Nevertheless, the ECB’s mandate clearly allows examination of banks’ internal organisational structures, and this mandate has already been used to constrain banks’ risk management practices.

Banks that work through an excessive backlog of distressed loans will need to acquire additional skills and reform internal capacity and management structures. ECB supervision has now established transparent benchmarks, and will in future encourage convergence to best practices. The workout of distressed loans is rarely a glamourous business line within a financial organisation. Senior management will need to provide more resources for this effort and offer appropriate incentives to their workout teams. Ultimately, this should reassure investors and depositors.

IMF analysis suggests that only very few European countries successfully reduced NPLs,  either where they benefitted from a pickup in external demand or where there was a concerted effort to clean up bank balance sheets in parallel with corporate debt restructuring. The banks under ECB supervision will account for the best part of banking system assets. In other words, setting NPL targets for individual banks will in effect amount to system-wide deleveraging. To be successful, ECB supervision therefore need to be flanked by a number of supporting policies:

  • In an initial step the ECB will need to determine how much restructuring and sales of distressed portfolios the system as a whole can, or should, manage. Under-provisioning, capital coverage and slow replenishment from earnings will of course constrain this process. Responsibility for systemic or macro-prudential supervision is shared between the ECB and national central banks, which should spell out this path clearly.
  • This judgement on aggregate deleveraging capacity should then guide NPL reduction targets for individual large banks. Such targets would need to be carefully defined and communicated. There is a risk they could give rise to poor restructuring practices, to moral hazard among borrowers, and could be mis-perceived by the public and investors. A comparable experience comes from Ireland in 2013. In that instance the national central bank was closely involved in setting targets, which related to two specific asset classes (residential mortgages and SME loans). These targets were made public, and where there was a clear definition of what amounted to sustainable restructuring solutions.
  • There should be a clearer encouragement of market-based restructuring solutions. At present, the ECB guidance seems indifferent about alternative options. In reality, banks’ internal workout units are not normally sufficiently empowered to oversee a costly restructuring of large enterprises. Restructuring is a cyclical activity, and skills are rarely in sufficient supply. By contrast, investors in distressed assets or specialist restructuring firms are more likely to recover value in viable enterprises, though will also extract a price given the risks in the legal environment and in loan servicing provisions.
  • Where banks remain in the lead, coordination with other creditors will need to define restructuring solutions that maximize value recovery in large enterprises. The enforcement of collective restructuring principles is a task for a national central bank or government.
  • The ECB last month also published an assessment of national restructuring frameworks in eight countries that spells out many shortcomings. This analysis underlines how governments need to raise standards in insolvency frameworks, build capacity and provide conditions for the entry by investors within appropriate regulation.

Tackling legacy assets and pre-empting the reflow or re-emergence of new debt distress should be a core element of bank supervision and the ECB has rightly broadened the scope of its policies. But this effort needs to be framed within a realistic deleveraging path for each banking system. For now, this work is aimed at key bank groups in the euro-area but should of course be coordinated with the supervisors of other EU countries where these institutions control significant subsidiaries, all with their own NPL problems.

In the euro area’s multiple NPL crises this process will need to be supported by national central banks and governments. There have been some reforms in national insolvency regimes, such as in Italy. But legal reforms will take time, and will only be effective if adequate capacity is built up, within the courts and among restructuring professionals more broadly.

About the authors

  • Alexander Lehmann

    Alexander Lehmann joined Bruegel in 2016 and was a non-resident fellow until 2023. His work at Bruegel focused on EU banking and capital markets, private and sovereign debt issues and sustainable finance.

    Alex also heads a graduate programme at the Frankfurt School of Finance and serves as a member of the consultative group on sustainable finance at the European Securities and Markets Authority (ESMA) in Paris.

    In numerous past and ongoing advisory roles Alex has worked with EU and emerging market policy makers on capital market development, financial stability and crisis recovery. Until 2016, he was the Lead Economist at the European Bank for Reconstruction and Development (EBRD) where he led the strategy and economics unit for central Europe and Baltic countries. Previously, Alex was on the staff of the International Monetary Fund and held positions as Adjunct Professor at the Hertie School of Governance (Berlin) and as Affiliate Fellow at the Royal Institute of International Affairs (Chatham House). He holds graduate degrees from the London School of Economics and the College of Europe, and a D.Phil. in Economics from Oxford University.

    His academic, policy and market-related work has generated extensive publications on international finance and regulation. This is regularly presented in teaching, media commentary and industry conferences.

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