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-performing loans (NPLs). But detailed targets for the reduction of NPLs and prescriptions for the internal governance and management of distressed assets also represent a new style of more intrusive supervision. For the ECB to succeed in bank rehabilitation, a macroeconomic scenario should guide the deleveraging process, capacity needs to be built, and governments will need to support a more holistic restructuring effort.

By: Date: October 13, 2016 Topic: Finance & Financial Regulation

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.


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 article More on this topic

Blog Post

European bank mergers: domestic or cross-border?

As the European economy recovers from the global financial crisis, bank mergers are back on the agenda. While cross-border mergers have been predicted before, most European bank mergers have been domestic until now. What are the odds of cross-border mergers in the upcoming bank-consolidation wave?

By: Patty Duijm and Dirk Schoenmaker Topic: Finance & Financial Regulation Date: June 21, 2018
Read article More on this topic

Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 8, 2018
Read article Download PDF

External Publication

The changing fortunes of central banking

What are the major challenges of central banks today? This book discusses the developing role of central banks and the policies they pursue in seeking monetary and financial stabilisation, while also giving suggestions for model strategies.

By: Philipp Hartmann, Haizhou Huang and Dirk Schoenmaker Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 29, 2018
Read article More on this topic More by this author

Blog Post

Are SBBS really the safe asset the euro area is looking for?

The European Commission is pushing to create a synthetic euro-area-wide safe asset in the form of sovereign bond-backed securities (SBBS). However, SBBS do not fully fulfil their original promises. If introduced on a massive scale, they might increase the supply of safe assets in good times and loosen the link between sovereigns and banks. But they will not give governments a means to maintain market access during crises, they might change incentives for governments to default, and they could pose a problem to individual bonds not included in SBBS if, in the end, they are put at a regulatory advantage vis-à-vis individual bonds.

By: Grégory Claeys Topic: Finance & Financial Regulation Date: May 28, 2018
Read article Download PDF

External Publication

Central banking in turbulent times

Central banks came out of the Great Recession with increased power and responsibilities. Indeed, central banks are often now seen as 'the only game in town', and a place to put innumerable problems vastly exceeding their traditional remit. These new powers do not fit well, however, with the independence of central banks, remote from the democratic control of government.

By: Francesco Papadia and Tuomas Valimaki Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 22, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Post-crisis prognosis for macroeconomics

The global financial crisis prompted the field of macroeconomics to rethink its methods. In this Director's Cut of 'The Sound of Economics', Bruegel deputy director Maria Demertzis addresses the changes made and the problems still unresolved, in conversation with Nicola Viegi, South African Reserve Bank professor of monetary economics at the University of Pretoria, and Frank Smets, director general of economics at the European Central Bank.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: May 15, 2018
Read article More on this topic More by this author

Opinion

The upheaval Italy needs

While Italy remains without a new government, it would be foolish to believe that a country where anti-system parties won 55% of the popular vote will continue to behave as if nothing had happened. But political upheavals sometime provide a unique opportunity for addressing seemingly intractable problems. After its political upheaval, Italy now needs an economic one.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: April 30, 2018
Read article More on this topic More by this author

Blog Post

Latvia’s money laundering scandal

Latvia’s third largest bank ABLV sought emergency liquidity from the ECB and eventually voted to start a process of voluntary liquidation, after being accused by US authorities of large-scale money laundering and having failed to produce a survival plan. What does it mean for the ECB?

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 9, 2018
Read article More on this topic More by this author

Opinion

The Lesser Evil for the Eurozone

For three decades, the consensus within the European Commission and the European Central Bank on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries and outlast procrastination in large ones. Today, however, the Eurozone playing field has become a battleground.

By: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 4, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Developing deposit insurance in Europe

In this week’s Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff talks with Nicolas Véron, senior fellow at Bruegel, about the implementation of a European Deposit Insurance Scheme (EDIS), one of the three pillars needed for the completion of banking union.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: April 3, 2018
Read article Download PDF More by this author

External Publication

European Parliament

Cash outflows in crisis scenarios: do liquidity requirements and reporting obligations give the SRB sufficient time to react?

Bank failures have multiple causes though they are typically precipitated by a rapidly unfolding funding crisis. The European Union’s new prudential liquidity requirements offer some safeguards against risky funding models, but will not prevent such scenarios. The speed of events seen in the 2017 resolution of a Spanish bank offers a number of lessons for the further strengthening of the resolution framework within the euro area, in particular in terms of inter-agency coordination, the use of payments moratoria and funding of the resolution process.

By: Alexander Lehmann Topic: European Parliament, Finance & Financial Regulation, Testimonies Date: March 28, 2018
Read article More on this topic

Blog Post

The (economic) ties that bind: The western Balkans and the EU

The western Balkan economies are already closely integrated with the EU; the EU is their largest trade partner, their largest source of incoming foreign investment and other financial flows, and the main destination for outward migration. Monetary and financial systems in the region are strongly dependent on the euro. Progress in EU accession can further strengthen economic ties between six western Balkan countries and the EU, with benefits for both sides.  

By: Marek Dabrowski and Yana Myachenkova Topic: European Macroeconomics & Governance Date: March 14, 2018
Load more posts