Blog Post

Will better insolvency standards help Europe’s debt deleveraging?

Insolvency regimes in the euro area are on the whole costly, lengthy, and recover little value. A new directive proposed by the Commission sensibly aims to strengthen preventive restructuring and to give once-failed entrepreneurs a second chance. But to assist banks in their NPL workout judicial capacity will need to be built up, and regimes better tailored to SMEs will be necessary.

By: Date: January 23, 2017 Topic: Finance & Financial Regulation

The ECB’s new guidelines on the management of non-performing loans (NPLs) will shine a spotlight on the way banks deal with NPLs. Both supervisors and market analysts will be scrutinising banks’ efforts to work out loan delinquency in enterprises and households. The need to address financial distress early will be further reinforced in 2018 when the EU’s new accounting standard (the IFRS 9) will force banks to recognise loan impairments on the basis of expected, rather than actual, credit losses.

Banks’ workout efforts, their attempts to restructure, divest or write off their portfolios of NPLs, will be shaped by the quality of national regimes for insolvency and restructuring. As is well known from the World Bank’s Doing Business indicators, insolvency procedures in several euro area countries are costly, lengthy and result in inadequate value recovery. There have been a number of notable reforms but on the whole regimes are still biased towards liquidation, rather than restructuring.

Early financial restructuring of borrowers in debt distress ahead of a formal insolvency proceeding and liquidation will result in higher value recovery for lenders. It also raises the chance of preserving the business as a going concern. However, debt restructuring occurs “in the shadow of the law”: in anticipation of a court-led process that unfolds unless borrower and lenders come to a timely private agreement. Where legal proceedings are unclear or costly, the borrower’s incentive to seek an early restructuring remains quite weak, and further value loss ensues.

Several EU countries lack a framework for early private debt restructuring (whether entirely ‘out-of-court’ or with light court supervision). However, such provisions can play a crucial role. They can enable coordination between lenders, provide temporary protection from enforcement, secure the ongoing operation of the distressed business, and protect new credit provided on the basis of restructured finances and a new business plan.

Against this backdrop, the Commission in November released its proposal for a Directive on preventive restructuring frameworks and debt discharge. This is somewhat of a milestone in a long process. The Commission had already released a non-binding recommendation two years ago, calling on member states to reform their insolvency frameworks, but this had only mixed success. This directive could now lead to some sensible pan-European practices, such as:

  • the availability of a rescue procedure ahead of insolvency;
  • a limited stay on enforcement;
  • securing the ongoing operation of distressed businesses that are in the process of restructuring through continuity of management (“debtor in possession”);
  • rules for majority decisions that bind all lenders (“cram-down”);
  • protection of new financing which would be senior to existing funding;
  • clarity on the court involvement that will sanction these arrangements, without imposing inordinate delays or costs.

This feeds into at least three of the EU’s current objectives:

  • The Commission’s single market strategy underlines the importance of promoting entrepreneurship. According to this policy, there is a need to reduce the stigma of debt and the lengthy discharge periods during which lenders may pursue entrepreneurs – often including their personal estate – which discourages former and would-be entrepreneurs from taking the risk of launching a new firm or start-up.
  • Providing some standard in insolvency regimes was a key element in the Commission’s capital market union plan. This is vital, given the related risk premia in loans and bond issuance, and because about one in four insolvency cases have a cross-border dimension.
  • This seems doubly relevant within the euro area, where levelling out some of the risks lenders bear in individual banking markets should result in deeper financial integration and uniform transmission of a common monetary policy within the currency bloc. The Council’s roadmap to complete the Banking Union last year indeed pointed out insolvency reform as essential to prevent the re-emergence of NPLs.

But will this legislation support the swift workout of NPLs in the euro area? Discussion at a Bruegel seminar on 18 January underlined many benefits in the directive although there were doubts that this could be a quick fix for banks’ NPL overhang:

  • The treatment of business insolvency is rooted in cultural and legal norms that may be difficult to change. Implementation of the directive will be lengthy, and there is likely to be resistance to common norms in areas such as preventive restructuring outside court proceedings, or a speedy discharge from debt for previously insolvent entrepreneurs;
  • The wide ranging endorsement of a moratorium on enforcement in the directive could be seen as compromising creditors’ rights further in those legal environments which investors already consider weak; this could accentuate, rather than close, risk premia in such markets;
  • Decisions imposed on all classes of creditors by qualified majority (the so-called cross-class cram down) will be problematic. Valuation of the debtor’s estate would need to be credible (in the US this would be done by specific experts).

Finally, panelists at the Bruegel seminar agreed that there need to be solutions that are tailored to the situation of SMEs where NPL ratios are highest. A 2015 IMF study underlined that this group of companies is particularly affected by complex insolvency regimes. Entrepreneurs who default are typically hit by severe penalties (given that personal and business assets are conflated). Moreover, limited equity coverage requires that non-financial claims, such as public sector liabilities or suppliers’ credit, are part of the restructuring process. Banks normally have poor capacity to deal with a large number of restructuring cases in small enterprises, and debt-equity swaps will not be attractive as the existing owners need to remain involved. In this area the Commission’s directive still falls behind international best practice for simple and cost effective tailored instruments.

If backed by improved capacity in national judiciaries, which often do not have specialist insolvency judges, the directive could usher in a more conducive restructuring environment. Banks will also need to build up skills and resources in their workout teams. As the principal beneficiaries of a more restructuring friendly legal regime that cuts across the entire EU market they should be the principal advocate for a speedy implementation.


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 More by this author

Blog Post

The challenge of fostering financial inclusion of refugees

Creation of a European identification for refugees and a pan-European registry would encourage better financial inclusion, along with clear guidelines about financial regulation and public-private partnerships

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: December 13, 2017
Read about event

Past Event

Past Event

Zombie firms and weak productivity: what role for policy?

At this event, we will have the chance to discuss the final findings of OECD's project on Exit Policies and Productivity Growth, which started at the end of 2015.

Speakers: Carlo Altomonte, Dan Andrews, Giuseppe Nicoletti and Reinhilde Veugelers Topic: Finance & Financial Regulation, Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 6, 2017
Read article More on this topic More by this author

Blog Post

Accounting for true worth: the economics of IFRS9

The introduction in 2018 of forward-looking provisioning for credit losses in EU banks delivers on a key objective in the post-crisis regulatory agenda. This was intended to dampen future lending cycles. For now, banks will be sheltered from the impact on regulatory capital requirements, as the implications for financial stability are far from clear. In any case, the new standards should encourage the disposal of banks’ distressed assets, underpinning the ongoing agenda on NPLs.

By: Alexander Lehmann Topic: Finance & Financial Regulation Date: November 13, 2017
Read article More by this author

Blog Post

Bailout, bail-in and incentives

Ever since the outbreak of the global financial crisis, more and more rules have been developed to reduce the public cost of banking crises and increase the private sector’s share of the cost. We review some of the recent academic literature on bailout, bail-in and incentives.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 23, 2017
Read article More on this topic More by this author

Blog Post

Catalonia and the Spanish banking system

As tensions rise around Catalonia's independence movement, there are worries about the impact on the Spanish banking sector. Banks based in Catalonia account for around 14% of total assets. Some major institutions are already moving their headquarters to other parts of Spain. However, most Spanish banks have significant exposure to the Catalan market, and all could be caught up in the turmoil.

By: Yana Myachenkova Topic: European Macroeconomics & Governance Date: October 6, 2017
Read article Download PDF More on this topic

Policy Contribution

A European perspective on overindebtedness

The sequence of crisis and policy responses after mid-2007 was a gradual recognition of the unsustainability of the euro-area policy framework. The bank-sovereign vicious circle was first observed in 2009 and became widely acknowledged in the course of 2011 and early 2012. The most impactful initiative has been the initiation of a banking union in mid-2012, but this remains incomplete and needs strengthening.

By: Nicolas Véron and Jeromin Zettelmeyer Topic: European Macroeconomics & Governance Date: September 28, 2017
Read article More on this topic More by this author

Blog Post

Chinese banks: An endless cat and mouse game benefitting large players

As deleveraging moves up in the scale of objectives of the Chinese leadership, banks now face more restrictions from regulators. As a result, banks have been very creative in playing the cat and mouse game in front of evolving regulations.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 26, 2017
Read about event

Past Event

Past Event

Is there a way out of non-performing loans in Europe?

At this event we looked at the issue of non-performing loans in Europe. The event also saw the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 6, 2017
Read article More on this topic More by this author

Blog Post

A tangled tale of bank liquidation in Venice

What can we learn about the Italian banking sector from the decision to liquidate Veneto Banca and Banca Popolare di Vicenza? Silvia Merler sees a tendency for Italy to let politics outweigh economics.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 26, 2017
Read article Download PDF More on this topic

External Publication

A New Liquidity Risk Measure for the Chilean Banking Sector

This paper introduces a new metric for central banks – and in particular for the Central Bank of Chile – to measure liquidity risk in their banking sector using the bidding behavior of commercial banks in their open market operations.

By: Grégory Claeys, Sebastián Becerra and Juan Francisco Martínez Topic: Finance & Financial Regulation Date: June 7, 2017
Read article Download PDF More by this author

Policy Contribution

The governance and ownership of significant euro-area banks

This Policy Contribution shows that listed banks with dispersed ownership are the exception rather than the rule among the euro area’s significant banks, especially beyond the very largest banking groups. The bulk of these significant banks are government-owned or cooperatives, or influenced by large shareholders, or prone to direct political influence.

By: Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 30, 2017
Read article Download PDF More on this topic More by this author

External Publication

Les banques européennes se retirent-elles de la scène internationale?

Dirk Schoenmaker conducts a comparative analysis of global systemically important banks (G-SIBs) and examines their evolution (Note: this paper is available only in French).

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: May 23, 2017
Load more posts