EBA’s Enria says Europe-wide bad bank is essential to avoid Japan-style stagnation

Given that it has been stress-testing the region’s banks since 2009, the European Banking Authority (EBA) should have a pretty good idea about the challenges that the banks under its watch face.

Andrea Enria, chairperson of the EBA, has little doubt about what the most urgent of those challenges is: dealing with non-performing loans (NPLs).

“This problem is so big that it is a problem for the European Union as a whole,” he says. “It risks reigniting the bank/sovereign link crisis from 2012.”

His solution is a Europe-wide bad bank, or asset management company.

“You can put pressure on banks to dispose of NPLs, but the problem is that there isn’t an efficient market to do so,” Enria points out. “We need to develop a pull effect as well as a push effect. The AMCs [asset management companies] are a very important tool to provide that pull effect.” 

Enria, formerly head of bank supervision at the Bank of Italy, outlined his thinking at a meeting in Luxembourg on Monday.

“The average coverage ratio in Europe is 44%, or 60c on euro book value,” he says. “The market price is around 20c. It is this steep bid-ask divide that is blocking the secondary market for NPLs in Europe. If there was an efficient secondary market for NPLs their real economic value would move to 40c.

“You need the public sector to bridge the gap between the inefficient secondary market today and an efficient secondary market tomorrow.”

Enria argues that the establishment of a pan-regional AMC to purchase loans from the banks at their real economic value would kick-start an acceleration in the disposal of bad loans books in Europe.

“If we maintain this pace of NPL recognition, it might take Europe longer than Japan to get back to pre-crisis levels of NPLs,” he warns.

Under Enria’s plan, banks would transfer bad loans to the AMC, which would subsequently dispose of them in the secondary market. Banks would transfer the loans at their net book value: if the net book value is higher than the transfer price to the AMC, existing bank shareholders would suffer an immediate loss. If the eventual sale price is lower than the transfer price, shareholders are diluted and a clawback clause is activated whereby the bank is recapitalized by its member state – there is no burden sharing.

“The clawback is on the bank,” Enria emphasizes. “If the bank doesn’t have the resources, the member state will recapitalize the bank. It won’t affect the capital base of the AMC.

“The real economic value would be reflected in state aid practices. This is the form of intervention that an AMC could take. It would push banks to transfer their NPLs to the AMC at their real economic value. The AMC would then face a timeline to dispose of the assets in the secondary market.”

Enria’s idea has been given cautious support by Klaus Regling, managing director at the European Stability Mechanism (ESM).

“There are many issues that need to be sorted out: corporate governance, funding and the role of governments,” he points out. “The AMC will have to issue billions of euros of debt. That is no simple task – I speak from experience, because it is what we do at the ESM. Some role for the public sector is probably needed.

“Another complication will be the sheer complexity and size of the newly established entity. The target is to move €200 billion to €250 billion of NPLs to the AMC. This means you would have to transfer millions of loans. In Greece alone, there are more than half a million corporate and SME NPLs.”

Perhaps the most surprising thing about the idea of a pan-European AMC is that it has taken so long to be suggested. Ireland’s National Asset Management Agency (Nama) was set up at the end of 2009, and Spain, Slovenia and Hungary have all followed suit in one form or another.

The €1,061 billion NPLs sitting on the books of Europe’s banks – 5.4% of total gross lending – have not turned bad overnight.

Any move to speed up the process of dealing with them should, therefore, be applauded.

“I don’t think that you can deal with NPLs in a speedy way without the public sector,” says Enria. “The policy objective is to speed up the process.”

He argues that a common blueprint is necessary to do this.

“We do already have AMC in several countries, but we have a lot of differences and there is no clear understanding of how investors are safeguarded,” says Enria. “It wouldn’t require much to distil these experiences into good practice and to have a common framework.

“I want to go to the full scope of having a European AMC. The positive is that we could achieve volume from pooling at a European level. The clout you would have in having a single approach would give the sell side a bit more of a voice.”

The fundamental premise behind Enria’s AMC plan is that those €1,061 billion bad loans are everybody’s problem.

However, a closer look reveals that they are fairly tightly clustered in a small number of countries. 

Italy alone accounts for 26% of the total, but nearly 80% of all European bad debt is held in six countries: Italy, France, Spain, Greece, the UK and Germany. Enthusiasm for bearing the costs of funding a pan-European bad bank might, therefore, be understandably thin on the ground elsewhere.

"The AMC solution could involve either one Europe-wide institution or a series of mutually consistent national solutions,” Regling tells Euromoney. “The latter would be easier to implement but, as the ESM demonstrates, sometimes opting for a Europe-wide solution is worth it.”

However, if the object of the exercise is to speed up the disposal process, then the eye-watering logistics of setting up a European bad bank at this stage surely leave the proposal fatally holed below the waterline.

One NPL specialist who was involved in the early stages of Nama points out that “setting up an AMC takes a year to 18 months even in an emergency and things have changed since we did Nama that will make it even harder”.

Foremost among those are the changes to accounting treatment of NPLs and the changes to state aid rules under the Bank Recovery and Resolution Directive (BRRD).

“Those countries with high NPLs – there is unlikely to be further appetite to take more risk by the sovereign,” points out the specialist. “This proposal makes sense for the banks but not the sovereigns.”

The accounting change comes from the introduction of IFRS 9, an international financial reporting standard, which will require banks to recognise present impairment values from projected credit losses.

Enria expects this to ease the NPL disposal process, as the banks will be better provisioned for any losses.

“In the US, the accounting framework helps as loans are booked at market value after six months,” he says. “In Europe, the move to IFRS 9 will repair this.

“We are now finalizing our action of repair for use of internal models [under Basel IV]. Banks will be asked to calculate their risk parameters, taking into account selling of assets in a crisis so the hit to the banks [from selling bad loans] should disappear.” 

Enria suggests that transitional provisions could address this until the new rules are in place.

The BRRD initiative, the shortcomings of which have been covered by Euromoney in some depth, is designed to force holders of bail-inable debt to take any losses before state support is available.

The application of the year-old directive has been controversial, engendering legal gymnastics in, among others, Portugal and Italy as governments scramble to avoid investor losses.

“Wherever you have state intervention, BRRD and state aid rules should apply,” says Enria. “In particular, the concept of precautionary recapitalization.”

This is the injection of own funds into a solvent bank by the state when this is necessary to remedy a serious disturbance in the economy and preserve financial stability. It could, therefore, be used to justify the recapitalization of a bank under the clawback provision if AMC-held assets are sold below their net book value.

At the root of Europe’s bad debt problem is the disparity between its insolvency regimes.

“The EC has been very ambitious in the capital markets union (CMU) initiative to harmonize insolvency procedures,” says Enria. “But it will take time. It is important to push national legislators to take action when there is high inefficiency in national procedures, as happened in Spain.”

Certainly, the insolvency procedures in certain jurisdictions have acted as a serious brake to the development of a secondary market in bad debt.

“There are low incentives for banks to dispose of NPLs at a loss,” says Enria. “These are even lower if the process is so lengthy and uncertain that loss is higher than it otherwise would have been.”

Indeed, it could be argued that harmonizing insolvency procedures across the region would sort out its bad debt problem by default. When Euromoney puts this suggestion to Regling, he shrugs in agreement.

“The difference in insolvency regimes within Europe is clearly a problem and is deep-rooted in legal systems that are centuries old,” he tells us. “Differences in, for example, the Netherlands and Greece or Italy and Germany are extreme.

“While harmonizing insolvency regimes is part of the CMU initiative, it will still take time and the proposal for a Europe-wide AMC is a shortcut to address the problem."

If setting up a pan-European institution is a shortcut, it gives you some idea how intractable the insolvency regime problem in Europe is, and thus how long Europe’s NPL problem could take to be resolved.

“A bad bank should also function as a work-out bank, which resolves the over-indebtedness of borrowers,” says Regling. “It should not just be a vehicle to clean up the balance sheets of banks, so as not to simply shift the problem between the public and private sector.”

He suggests other measures that could be taken in parallel while the complexities of an AMC are worked through.

“The ECB has already started a programme assigning targets to banks to reduce NPLs,” says Regling. “And a platform with high-quality and consistent data or an EU servicing regime would be major steps forward that could be relatively straightforward to implement.”

Enria is quick to emphasize that his proposal is not a final one and there are many questions about it that remain unanswered.

“My role here is simply to throw a stone in the pond,” he says. “I am triggering a debate not selling a fully fledged proposal.”

However, he firmly believes that without a European AMC the lending function of the region’s banks will be impaired for a longer period of time than it would otherwise be.

“This is not being proposed to help banks – it is being proposed to help banks to support the economy,” he says. “I am still looking for examples of countries with NPLs in the high double digits which have been able to solve the problem without state aid. Some sort of state intervention is useful to kick-start the process and do the heavy lifting. This involves deploying public resources and trying to crowd in other funds.

“This is all about creating a framework for the market to buy the assets.”