Blog Post

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: Date: November 29, 2016 Finance & Financial Regulation Tags & Topics

Over the coming months the European financial sector will need to digest a whole spate of bank restructurings. The sale of distressed loans will be a key element in recovery plans, such as we see in the recently-approved sale of a portfolio of EUR 27 billion book value by Italian bank Monte dei Paschi.

But relying on the secondary market only will be a sensible strategy if that market is liquid. Third parties need to be able to apply workout methods in debt resolution that recover value more efficiently than banks’ in-house processes.

As the latest ECB Financial Stability Review makes clear, Europe has not succeeded in building a vibrant market for distressed debt. Private sector advisory firms estimate the stock of non-performing loans and other ‘non-core’ assets at about EUR 2 trillion, of which only about EUR 100 billion transact per year.

Some euro area countries with systemic NPL crises, such as Greece, have seen no transactions at all in recent years. In the US this market is both more liquid (with an annual investment about seven times that in the EU in 2013), and also assigns investors a more prominent role in workout efforts.

Market failure?

Transferring the ownership in a credit exposure from the originating bank to an external investor encounters a basic market failure. While the bank has built up a long-standing relationship with the client, the investor cannot know the true quality of the underlying business, and the chances of its recovery.

As with the sale of used cars, imperfect information on the buyer’s side will prevent the market from clearing fully. This is the principal reason behind the significant spreads between the price at which the bank is prepared to offer an asset, given its provisioning so far, and what a potential investor is prepared to bid.

These problems are of course more pronounced for complex and heterogeneous loans to SMEs and larger enterprises, where the workout scenario and value that could be realised from collateral are hardest to predict. And it is indeed these corporate NPLs to medium and larger corporates where the secondary NPL market has been near absent.

For these reasons successful NPL transactions generally happen where the bank has successfully bridged the information gap, in particular by providing investors with a comprehensive data picture and legal documentation. Typically, a two-stage bidding process ensues during which potential investors will undertake extensive – and costly – due diligence.

The selling bank will need to support a lengthy bidding process over many months with staff and management from various departments, and signal clear commitment to the ultimate success of the transaction (see these overviews from IFC and EBRD).

Public support

Many European banks are still ill-prepared to engage with potential investors in this demanding market. The new ECB guidelines will give a much needed impetus to an upgrade of internal capacity. Supervisors will now monitor whether dedicated workout units are set up, that portfolios are managed and tailored for the relevant workout strategies, and that the IT infrastructure supports a sale process.

But the distressed loan market may not grow organically. One option for public support was Italy’s scheme of early 2016 under which banks securitise their bad loans, and then a government guarantee protects investors in senior tranches of such portfolios. While there would now be a protection for investors who come early in the hierarchy of value recovered, such a scheme does not deal with the underlying uncertainty about the workout process.

Another idea that was recently proposed by EU Commission officials is to create NPL clearing houses at either national or EU level. Such institutions could be either private or public and would register all portfolios for sale. The key role would be to act as a single counterpart for all potential bidders, and ensure all sales are backed by consistent data quality. Unlike in the case of a ‘bad bank’, ownership of the assets would remain with the originating bank, thereby avoiding problems in determining market value.

What only asset management companies can offer

The Commission proposal would essentially concentrate within a single institution the ‘match-making’ between bidders and banks that restructure their balance sheets. This role is currently taken on by advisory firms, who charge significant fees.

The assumption seems to be that this should be a public or public-private function because the success or failure of individual transactions can have important effects on the market as a whole. Also, a single institution may be more effective in championing reforms that support the involvement of investors in the workout process.

However, it is unlikely that a central conduit would simplify the sales process. Bidders for portfolios will no doubt seek direct contact with originating banks, which will retain ownership of the underlying exposures.

Experience in Ireland and Spain has demonstrated that central asset management companies can play an important role in facilitating the emergence of a liquid NPL market. Only direct ownership of the loan portfolios supports the function of ‘market maker’ – ie pooling and phasing sales in order to provide liquidity and predictable pricing.

Complex corporate exposures, as in the NPL stocks in Italy or Portugal, call for transparent valuation techniques, the pooling of exposures, and centralising expertise in restructuring. At present, the discussion on the establishment of new national asset management companies remains on hold as the EU bank resolution directive raises the risk that state aid triggers a bail-in of investors.

Recognising the loss in value

The EU can support the emergence of secondary NPL markets. One option could be to simplify the licensing of non-bank investors and loan servicers who acquire and restructure assets. The EU’s capital markets union programme could clarify when banking-type licenses are required. Another option could be to support the engagement by the EIB and EIF in managing securitised NPL portfolios.

As more portfolios are offered in the EU distressed debt market, more realistic valuations will emerge for some types of assets. Many banks will need to face up to the reality that their portfolios are still under-provisioned, and that specialist investors will demand risk premia and rewards for their workout efforts.


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 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

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
Read article More on this topic More by this author

Blog Post

MariaDemertzis1 bw

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: Maria Demertzis Topic: Finance & Financial Regulation Date: October 18, 2016
Read article More on this topic More by this author

Blog Post

sd-12177-_0028bea2-web

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: Alexander Lehmann Topic: Finance & Financial Regulation Date: October 13, 2016
Read article More by this author

Blog Post

Silvia Merler

The Deutsche Bank Frenzy and what it says about European banks

What’s at stake: The IMF recently published its Fall Global Financial Stability Report, which points to a decrease in short-term risk but building of medium-term ones. At the same time, European market has been nervous last week on the news that Deutsche Bank (Germany’s biggest bank) has been demanded USD14bn by the US Department of Justice to settle allegations that the bank mis-sold mortgage-backed securities before the financial crisis. While reports point to a possible USD5.4bn settlement, this turmoil raises a question of whether the European financial system is still weak, eight years since the crisis. We try to summarize the reactions in the blogosphere.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 10, 2016
Read article Download PDF More on this topic

Policy Contribution

pc-17-16

Fiscal capacity to support large banks

This Policy Contribution outlines a fiscal cost scenario for the recapitalisation of large banks during a severe systemic crisis.

By: Pia Hüttl and Dirk Schoenmaker Topic: Finance & Financial Regulation Date: October 3, 2016
Load more posts