Euro Area Policies: Selected Issues

Euro Area Policies: Selected Issues

Abstract

Euro Area Policies: Selected Issues

Policy Options for Tackling Non-Performing Loans in the Euro Area1

A. Introduction

1. Euro area banks are increasingly challenged by high levels of impaired assets. The financial crisis and deep recession have left many euro area countries with high levels of nonperforming loans (NPLs) and corporate debt. For the euro area as a whole, NPLs stood at €932 billion (or 9.2 percent of GDP) at end-2014, more than double the level in 2009 (Figures 1 and 7). The ECB’s Comprehensive Assessment (CA) of the largest euro area banks in October 2014 revealed a much larger stock of impaired assets than expected, indicating that balance sheet repair is far from complete. The CA showed that the nonperforming exposures (NPEs)2 of the euro area’s largest banks exceeded 20 percent of aggregate credit exposures in several economies.3 With 40 banks in ten countries carrying NPEs of 20 percent or more, problem loans represent a risk to financial stability.

Figure 1.
Figure 1.

Euro Area: Comparative Analysis of Nonperforming Loans

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Sources: GFSR,; ECB; National central banks; IMF, Financial Soundness Indicators; and IMF staff calculations.Note: 1/ NPL = nonperforming loan; net NPL = gross NPL plus provisions; provision ratio = provisions as a percentage of gross NPL; write-off ratio = write-offs as a percentage of gross NPL.
Figure 2.
Figure 2.

Euro Area: The Implications of NPLs for Banking Activities

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Sources: Bloomberg L.P.; European Banking Authority; SNL Financial; Amadeus database; national central banks; Haver Analytics; Bankscope; and IMF staff calculations. Note: 1/ Left graph shows annual interest income to gross loans, for over 100 euro are banks, relative to the annual average for banks with the same nationality, calculated over the period 2009–13. The right graph shows annualized lending growth relative to average lending growth in the same country, using data from the European Banking Authority for a sample of more than 60 banks over the period 2010–13. Outliers have been excluded, based on extreme values for lending growth, nonperforming loans and interest margins. 2/ The funding cost for each bank was defined as: [interest expenses/(financial liabilities-retail deposits)]-German government bond yield (5-year rolling avg.).
Figure 3.

Euro Area: Potential Capital Relief and New Lending from NPL Disposal

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Sources: Bankscope; EBA; ECB; Haver Analytics; national central banks; and IMF staff calculations. Note: calculations based on bank-by-bank data from the EBA Transparency Exercise (2013), with NPLs reduced to historical average and capital adequacy ratio (CAR) of 13.0 percent. No capital relief for Germany since net NPLs are below their historical average. 1/ The results for Cyprus are not shown for formatting reasons. The whiskers indicate the results for capital relief and new lending capacity for a +/-5 percentage point deviation from the 5 percent haircut assumption. See Box 3 for more details on the underlying methodology.
Figure 4.
Figure 4.

Euro Area: Capitalization and Provisioning

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Figure 5.
Figure 5.

Euro Area: Impact of Insolvency and Enforcement Regimes on NPLs in the Banking Sector

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Sources: ECB, World Bank Doing Business Survey (2014), RBS Credit Strategy, and IMF staff calculations.Note: 1/ The z-score represents a normalized (within sample) index value, i.e., a negative value means that the strength of the insolvency procedures/effectiveness of enforcement is below the sample average. The effectiveness of enforcement in the left chart does not refer to the enforcement of secured debt but to the enforcement of ordinary contractual obligations (basedon the “enforcing contracts” indicator of the World Bank Doing Business Survey).
Figure 6.
Figure 6.

SAREB: The Role of an AMC in Starting a Market for Distressed Debt

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

Sources: PricewaterhouseCoopers; investment bank reports; and IMF staff estimates. Note: Shows nominal volumes of publicy announced portfolio sale transactions; does not include private transactions or salesto retail; percent of nonperforming loan stocks as of end of previous year.
Figure 7.
Figure 7.
Figure 7.
Figure 7.
Figure 7.

Euro Area: Asset Quality Developments1

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A003

2. The current low growth environment discourages banks from addressing their distressed assets problem. As documented in the April 2015 Global Financial Stability Report, write-off rates of euro area banks remain low by international standards (6.2 percent), and are less than a quarter of that in the United States, despite the euro area’s higher stock of distressed debt (Figures 1 and 7). Provisioning levels (slightly above 40 percent) are also much lower than in the United States (about 70 percent), where stricter supervision and accounting of NPLs support a more timely restructuring or liquidation of impaired assets. Limited capital buffers and low profitability constrain euro area banks’ capacity to clean up their balance sheets, especially in countries where the level of impaired assets is high and the debt servicing capacity of borrowers is low. Accounting rules also hinder timely loss recognition and inflate loan loss reserves, while the lack of a well-functioning market for distressed assets, as well as costly debt enforcement and lengthy foreclosure procedures, complicate the disposal of impaired assets.

3. Reducing NPLs expeditiously will be crucial to restore the health of the banking sector and support credit growth. Credit growth remains slow in countries where banks report a high level of impaired assets, insolvency procedures are weak, and the effectiveness of enforcement is low. Euro area banks with higher NPLs ratios in 2012–2013 have been lending less than banks with average asset quality operating in the same country under the same demand conditions. Staff calculations suggest that, given the current level of impaired assets, a timely resolution could release as much as €42 billion (or 0.5 percent of selected countries’ 2014 GDP) of additional capital, which could unlock new lending of more than 5 percent of GDP (see below).4 Because of the uneven distribution of high NPLs and their capital intensity, the potential impact on credit supply could be much higher in some countries.

4. Resolving impaired loans can also strengthen growth by encouraging corporate restructuring and enhancing monetary policy transmission. NPL resolution would allow the debt of viable firms to be restructured (including through equity conversions), while hastening the winding-down of unviable firms. When businesses undergo debt restructuring, they have more room to invest and are better able to reorient their resources to more productive uses. Finally, reducing NPLs increases the effectiveness of monetary policy: banks that are concerned about capital adequacy and rising loan loss provisions are likely to be less responsive to changes in the policy rate.

5. The objective of this paper is to assess the NPL situation in the euro area and suggest a comprehensive approach to accelerate NPL resolution. The next section discusses the literature on the macro-financial implications of NPLs. Section C explores various impediments to NPL resolution in the euro area against the background of international experience. Section D recommends a comprehensive approach to addressing high levels of impaired assets in the euro area. To preview, the main elements of this approach are:

  • Enhanced supervision. In parallel with efforts to foster a more conservative application of provisioning and collateral valuation practices, capital surcharges on long-held NPLs and time limits on NPL disposal could provide incentives for timely write-offs.

  • Structural reforms to enhance debt enforcement and facilitate asset recovery. Impediments to debt restructuring (e.g., unfavorable tax treatment) should be tackled and reforms to debt enforcement and insolvency regimes (including out-of-court workouts) carried out to support market-led corporate debt restructuring.

  • Developing distressed debt markets. Improved credit reporting, NPL securitization, and the creation of private and in some cases, public asset management companies (AMCs), could facilitate the development of a market for distressed debt.

B. What are the Macro-Financial Implications of NPLs?

6. High NPLs undermine the capacity of banks to lend in the recovery (Figure 2). Growing NPLs require banks to raise provisioning levels, lowering net operating income. NPLs, net of provisions, also tie up substantial amounts of capital due to higher risk weights on impaired assets. Diawan and Rodrik (1992), Kashyap and others (1994), and Krosner and others (2007) find that high NPLs adversely affect banks’ capital positions and raise their cost of capital, thereby resulting in higher lending rates and lower credit growth.5 Bending and others (2014) find a significant negative relationship between NPLs and the growth rate of corporate and commercial loans in a sample of 42 banks across 16 euro area countries. Given the dominance of bank lending in corporate sector finance in Europe, high NPLs also impair monetary transmission, as credit supply remains heavily influenced by the lending behavior of banks.

7. Banks’ reduced lending capacity is likely to disproportionately affect SMEs that are more dependent on bank finance. Rajan and Zingales (1998) argue that firms that are dependent on external financing are particularly sensitive to financing constraints. Kannan (2010) stresses that smaller firms with fewer tangible assets producing fewer tradable goods are more at risk of being credit constrained. This is borne out by international experience: Inaba and others (2005) find that the deterioration of banks’ balance sheets after the bursting of the bubble in Japan in the early 1990s hindered investment by firms heavily reliant on bank borrowing. And Klein (2014) shows that tight financial conditions for European SMEs have been a drag on the recovery. In the euro area, countries with the largest NPL ratios tend to be those in which SMEs account for large shares of output and employment (Al-Eyd and others, 2015).

8. Persistently high NPLs can also reflect an unresolved corporate sector debt overhang, which depresses the demand for investment. Viable firms may be held back from investment due to deleveraging pressures. In the absence of debt restructuring, overextended companies have little incentive to invest because any return is used to service their debt. Based on aggregate firm-level data for 2000–2011, Goretti and Souto (2013) investigate the macroeconomic implications of high corporate debt and find a negative effect of the debt overhang on firm investment.

9. Accelerating NPL write-offs could free up considerable capacity for new lending (Figure 3). For a large sample of euro area banks supervised directly by the SSM, we calculate bank-by-bank the amount of capital that would be freed-up if NPLs were reduced to a level consistent with historical averages (between 3 and 4 percent for most banks). It is assumed that NPLs are sold either at the net (after provisioning) book value, or at a “haircut” of 5 to 10 percent. Up to €42 billion of capital could be released, amounting to 0.5 percent of the combined GDP of sample countries at end-2014 (or 0.2 percent of total assets of sample banks).6 The risk-weighting of performing loans is then compared, bank by bank, to the risk-weighting on NPLs. It is found that the freed-up capital could support new lending of up to €522 billion (5.6 percent of GDP), assuming that the aggregate capital adequacy ratio remains at 13 percent. Due to the uneven distribution of capital and NPLs, capital relief varies significantly across countries. Under the stylized assumptions above, Portugal, Italy, Spain, and Ireland would benefit the most. In reality, the haircut required on the book value of assets is likely to be influenced by several factors including the efficacy of the insolvency and debt enforcement regime (with larger haircuts required the longer the average time for collection) and the expected rate of return demanded by distressed debt investors. Annex 3 describes a country-specific methodology accounting for some of these factors.

C. Impediments to NPL Resolution: European and International Context

Structural Obstacles to NPL Resolution in Europe

10. The size of capital buffers and accounting standards and practices significantly influence banks’ incentives to resolve NPLs. Low profitability and thin capital buffers constrain banks’ ability to increase provisions and discourage timely loss recognition as banks approach minimum capital requirements. NPLs in excess of the total loss absorbing capacity, i.e., common equity plus reserves, could exacerbate this situation (Figure 4). Moreover, accounting standards provide insufficient incentives for NPL resolution in several ways. First, the incurred-loss approach to provisioning for loan losses under IFRS leaves substantial room for judgment, which may result in insufficient provisions (though this will be addressed when IFRS 9 becomes effective in 2018).7 Second, while IFRS explicitly permits loan write-downs for impairment losses, it does not provide details on write-off modalities, which are left to the supervisors. Third, IFRS allows for the accrual of interest income from NPLs, providing an incentive for banks to retain NPLs to inflate profitability and coverage ratios. Lastly, while collateral is taken into account in impairment loss recognition under IAS 39,8 neither accounting nor regulatory rules have detailed guidance on its measurement.

11. Tax regimes can also reduce incentives for NPL resolution. In some countries, charge-offs and/or losses as a result of higher provisions are not eligible (or are subject to a certain cap) as deductions for income tax purposes. For example, until recently the tax treatment in Italy penalized banks that wrote off problem loans more aggressively, allowing tax deductibility for write-offs only in the state of insolvency. Tax deductibility of loan loss provisions was limited to 0.3 percent of outstanding loans—a clear disincentive to provisioning. A 2013 reform allowed provisions and write-offs to be fully deducted in equal installments over five years, and with a higher tax rate; and in June 2015, this period was further shortened to a year. To take another example, Spain recently eliminated taxes on debt-to-equity swaps in a similar move to encourage banks to recognize losses from impaired assets. Both countries now compare favorably with others in the euro area, where longer time periods for tax deductibility discourage accelerated write-offs.

12. In some countries, public creditors do not participate (or participate to a limited extent) in debt restructuring. Priority or super-priority of public creditor claims, such as for taxes, in insolvency and foreclosure processes raises the difficulty for banks to restructure/foreclose on a distressed debtor. In some countries the tax authorities are not required to participate in out-of-court debt restructuring or are effectively granted priority because they cannot be affected by a restructuring process. In Spain, tax authorities are not bound by out-of-court debt restructuring decisions. In Portugal, on the other hand, legal changes in 2011 require tax authorities to participate in out-of-court workouts (although they remain at liberty to forgo and need to provide their consent for debt restructuring).

13. Weak debt enforcement procedures and ineffective insolvency frameworks increase the cost of asset recovery and prevent the timely resolution of NPLs (Figure 5). The ability to enforce credit claims in a predictable, equitable, and transparent manner is essential to efficient debt workouts. Lengthy foreclosure and judicial processes raise the legal cost of debt restructuring and hamper banks’ ability to seize loan collateral, reducing the expected recovery rate on delinquent loans.

14. In some countries, national debt enforcement and insolvency regimes are slow and inefficient, and reforms remain uneven. This results in considerable variation in the speed and rate of asset recovery. The average length of foreclosure proceedings in Italy is almost five years compared to less than one year in Germany and Spain. Some recent steps have improved the prospects for harmonization, but there remains much ground to cover.9 In several countries, the large share of heterogeneous SMEs in NPLs, combined with inefficient and costly court procedures, complicates asset recovery (e.g., Greece and Italy).10

15. Banks are often poorly equipped in terms of expertise and available tools to undertake internal NPL resolution, and may face perverse incentives. Banks may lack the experience, resources and restructuring tools to provide sustainable loan restructurings.11 They may also lack specialized skills in real estate servicing and corporate turnarounds, which can be necessary to work out certain asset classes. And small banks typically do not enjoy the economies of scale to invest in internal management of nonperforming assets. Moreover, bank managers might be inclined to engage in loan forbearance in order to avoid loss recognition from NPLs in times of deteriorating credit conditions. They might also refrain from aggressive debt enforcement and recovery processes for reputational reasons or expend too many resources on loans with little prospect of recovery.

16. Finally, the market for distressed debt in Europe is small compared to that in the United States, which complicates the disposal of impaired assets. The market value of distressed debt transactions in Europe was only €64 billion compared to $469 billion in the United States at end-2013, despite a stock of NPLs several times higher (Altman, 2014). A market for NPL disposal reduces the collection burden on banks and can help boost loan recovery values by providing a more cost-efficient alternative to lengthy court procedures if assets are restructured or liquidated outside the originating bank. The distressed debt market in Europe is relatively under-developed, and focused mainly on commercial real estate and consumer loans. In part this is explained by the lack of a liquid secondary market for loans and credit information sharing. Reliable credit registers containing, for example, data on the total amount of debt owed by each distressed debtor—which are critical for effective debt restructuring—do not exist in many euro area countries.

International Experience with NPL Resolutions

17. International experience suggests that a comprehensive strategy is most effective in resolving NPLs (Hagan, 2003; Liu and Rosenberg, 2013). Such a strategy typically includes: (i) tightened prudential oversight, (ii) foreclosure and insolvency reforms, and (iii) the development of a market for distressed assets. Realistic loan loss provisioning standards and strengthened capital requirements give banks the proper incentives for loss recognition and debt restructuring. Promoting effective and orderly insolvency regimes facilitates both rehabilitating viable debtors and liquidating non-viable debtors. Developing a market for NPLs is crucial to provide an outlet for banks to sell and manage their bad assets regardless of whether the strategy is public or private-led. Governments have often been involved in removing key bottlenecks to debt restructuring, such as tax disincentives, or through supporting asset management companies (AMCs) to remove impaired assets (Woo, 2000).

18. In almost all successful cases, supervisors have pushed for swift loss recognition, enhanced supervision, and exit of nonviable borrowers to accelerate the resolution process. For example, in Sweden (1994), corporate firms with low interest coverage ratios and high leverage were identified for bankruptcy or liquidation. Similarly, in Korea (1998), the supervisor instructed banks to separate out nonviable firms, following specific forward-looking criteria and leverage levels. In Japan (2001), the FSA also required major banks to apply strict discounted cash flow analysis in their NPL assessments.12 Some supervisors (e.g., Cyprus, Ireland, and Spain) have enhanced supervisory reporting of NPL portfolios and issued guidance for addressing NPLs through time-bound write-off schedules. Cyprus and Ireland also introduced explicit operational targets for banks to engage borrowers in loan restructuring discussions.

19. Countries also attempted to strengthen their formal insolvency systems to facilitate reorganization and out-of court workouts (Indonesia (1999), Thailand (1999), Turkey (2002), Japan (1999, 2008), and Korea (1998, 2006)). Countries enhanced their insolvency laws to encourage rehabilitation while creating a credible threat of bankruptcy for recalcitrant debtors. This was important for setting the proper incentives and expected payouts for negotiating agreements out-of-court (IMF, 1999). Reforms typically aimed to enable the rapid liquidation of non-viable debtors, allow for ownership changes in debt restructuring agreements, and introduce pre-pack procedures for quick court approval of debt restructuring plans negotiated out-of-court. Insolvency reforms were complemented by other reforms such as specialized courts (Indonesia, Thailand), reform of insolvency administrators (Indonesia), and the removal of tax and other regulatory impediments (Korea, Thailand).

20. In many cases, out-of-court workouts proved to be more efficient and less costly than court-led procedures.13 These schemes varied from purely voluntary schemes to enhanced/hybrid schemes with more formal government involvement (Garrido, 2012). The former followed closely the example of the London Approach (UK) which was administered under the leadership of the Bank of England and targeted at large corporates. Crisis countries have also used temporary, formal, enhanced (such as creditor committees, and arbitration/mediation), and hybrid (such as majority voting and limited judicial intervention) frameworks with government involvement (Korea (1997 and 2004), Indonesia (1997), Thailand (1998), Malaysia (1998) and Turkey (2002)).

21. Asset management companies (AMCs) have also been used to facilitate NPL disposal and corporate restructuring (Sweden, Indonesia, Malaysia, Korea, and Thailand).14 The rationale for AMCs is to separate bad from good assets allowing the ceding bank and the AMC to focus on their respective objectives—financial intermediation and asset recovery. Centralized AMCs have typically been public, though recent examples in Europe have included majority privately-owned AMCs (e.g., SAREB). These ventures were particularly effective in Asia, where they were instrumental in bridging the gap between the price at which banks are willing to sell and investors are willing to buy (“pricing gap”). More recently, the creation of SAREB in 2012 appears to have kick-started private transactions in NPLs in Spain (Figure 6 below).15

D. A Comprehensive NPL Resolution Strategy for Europe

30. This section proposes a multi-faceted strategy for NPL resolution in Europe, combining regulatory/supervisory approaches and insolvency reforms with measures to develop markets for distressed debt. The suggested policy measures are informed by the international experience in addressing previous episodes of high NPLs.

Supervisory Policies

22. Pursue a conservative application of accounting standards. The SSM and EBA should take steps to foster more robust provisioning, write-off, and income recognition. Specific guidance on loan loss provisions (following the approaches taken in Ireland and Cyprus) should focus on appropriate impairment triggers, provisioning methodologies for collectively assessed loans, and management judgment and assumptions.16 This should be accompanied by extensive dialogue between the SSM and the auditing standard-setters, including on approaches to reinforce implementation of IAS 39. Unreasonable accounting assessments should be referred to ESMA, the market authority, for follow-up. The SSM and EBA should also clarify supervision regarding write-offs and foster consistent practices across banks.17 In particular, a supervisory policy should be introduced underscoring the importance of timely write-off of uncollectible loans before having exhausted all legal means to collect the debt. Time-bound write-off requirements for uncollectible loans could also be considered where the domestic legal framework allows it. With regard to interest accrual practices, the adoption, for prudential purposes, of a nonaccrual principle for loans past a set delinquency threshold would be critical.

23. Ensure that banks apply a conservative approach to collateral valuation. While it is reasonable to take account of collateral in provisioning, a conservative approach should be adopted, reflecting various constraints in valuing and disposing of collateral. In particular, the value of collateral should reflect changes in market conditions, the costs of sale, and delays in realizing proceeds. Furthermore, collateral should be periodically valued by reliable and independent third parties and subject to enhanced supervisory scrutiny. In the case of real estate, banks should obtain sound appraisals of the current fair value of the collateral from qualified professionals. Real assets accumulating on the balance sheet as a result of workout activities should be valued appropriately and not be held for excessively long periods.

24. Strengthen capital requirements to encourage asset disposal. Conservative application of accounting standards could be supplemented by micro- and macro-prudential measures, such as time-bound targets for disposing delinquent assets and raising risk weights on impaired assets of a certain vintage (above the current 150 percent, for instance, for banks reporting under the “standardized approach”).18 If applied on a system-wide basis, such measures would generally fall under the category of Pillar II requirements of CRR, and thus would be initiated by NCAs. But the SSM could play a coordinating role among NCAs by encouraging the use of these instruments.

25. Enhance prudential oversight. The SSM has already followed a supervisory review approach to foster more active resolution of NPLs by placing banks with high NPLs under enhanced monitoring and setting objective targets for these banks to restructure or write off problem loans. The SSM should ensure that NCAs follow a similar approach for smaller banks. Banks with NPLs above a set threshold (e.g., 10 percent) should be subject to a more intrusive oversight regime to ensure that they conservatively recognize and proactively address asset quality problems. Prudential reporting requirements for NPL portfolios should be significantly enhanced through detailed submissions (on a quarterly or more frequent basis).19 Banks should also be required to include in their regular reports the interest income from NPLs, including restructured loans and those from accrued, non-cash earnings. For banks with high SME NPLs, the SSM could set targets for NPL resolution and introduce standardized criteria for identifying nonviable firms for quick liquidation and viable ones for restructuring (the “triage approach”).20

26. Require banks to develop internal NPL management capabilities. Banks should be encouraged to develop a comprehensive NPL management plan, which determines rules and work practices for NPL resolution, such as: (i) removing impaired loans from regular loan servicing and adopting specific tools for early arrears, (ii) risk scoring to set case prioritization, and (iii) developing a customer charter to cater for hardship and sensitive cases, subject to clearly defined implementation targets. A series of voluntary and mandatory codes should be introduced to promote minimum standards in NPL workout activities. A code of conduct should be introduced to set minimum standards of customer engagement for target portfolios as has been adopted in Cyprus (all retail and SME loans), Greece (all retail and commercial loans), and Ireland (mortgages).

27. Enhance disclosure. Extended Pillar III reporting of NPLs and granular disclosure by supervisory authorities of NPL portfolios and NPL management performance would increase market transparency and discipline. Disclosures could usefully include the accrual treatment for NPLs, including the increase in NPLs due to loan deterioration (i.e., deterioration in loan principal), and from the accrual of interest income; and separate disclosure of fully provisioned unrecoverable loans from the general NPL pool.

28. Strengthen the regulatory sanctions toolkit. A review of the scope of supervisory enforcement powers should accompany the implementation of stricter supervisory policies. While the toolkit for regulatory sanctions is typically well-developed for capital and market abuse, it is often under-developed for NPL oversight. NCAs should review their sanctioning powers in this regard.

Insolvency Reforms to Facilitate Debt Restructuring

29. Strengthen incentives for viable but distressed debtors and creditors to participate in meaningful restructuring. The legal framework should consist of both legal systems designed to facilitate speedy in- and out-of-court solutions and an adequate institutional framework (including courts) to support the consistent and predictable implementation of these laws. Enforcement and foreclosure regimes are essential in enabling creditors to enforce/foreclose on their collateral, and, thus, should be swift and cost-effective. Many euro-area countries have reformed their insolvency regimes with pre-insolvency features, strengthened protection of post-commencement financing, or broadened restructuring toolkits (e.g., debt-to-equity swaps, see Bergthaler and others, 2015). The institutional framework, i.e., the regulations governing judges, insolvency practitioners and enforcement agents/bailiffs also should be strengthened, specialization increased, the supervision of such professionals enhanced, and the fee structure should incentivize value maximization. More specifically, the authorities should:

  • Enable the rapid exit of non-viable firms and the rehabilitation of viable firms. A number of features could enhance insolvency laws: (i) expedient in-court approval of settlements negotiated out of court (“pre-packs”),21 (ii) post-commencement financing recognizing creditor priority to enable financing for the firm during restructuring, (iii) inclusive restructuring involving all creditors (including secured and public creditors) (Annex 2); (iv) pre-insolvency processes that enable restructuring before reaching non-viability, (v) majority voting in classes (including cram downs), and (vi) the facilitation of various restructuring tools, such as debt-equity swaps (e.g., through suspending the requirement for shareholders to approve corporate changes).

  • Augment out-of court frameworks with hybrid features. International practice suggests that out-of-court debt restructuring generates more rapid and cost effective results, especially if the restructuring occurs against the backdrop of strong insolvency procedures. Out-of-court frameworks that use hybrid and enhanced features, such as a stay on creditor actions, majority voting, mediation/arbitration, or a coordinating committee achieve the best results. Several euro area countries have recently introduced such out-of-court frameworks.

30. Encourage outcome-based (or “functional”) convergence of insolvency and debt enforcement regimes across euro area countries to facilitate asset recovery. The European Commission (EC) could issue further Recommendations (beyond the current guidance on pre-insolvency regimes and out-of-court restructuring (EC 2014a and 2014b)) to establish principles based on international best practices which Member States are assessed against (preferably by an independent agency other than the EC) or need to regularly report on. Functional convergence of insolvency regimes across EU countries would greatly facilitate the move towards an EU Capital Markets Union (EC, 2015). In the area of debt enforcement / foreclosure, the EU has adopted Directives to harmonize the legal regime for EU members, such as the late payment directive, cross-border garnishments, and the European payment order. Data collection on insolvency and enforcement processes should be unified and enhanced within the EU to enable adequate comparisons and proper assessments.

31. Improve access to debtor information to enhance the effectiveness of NPL workouts. Credit bureaus should include full details of borrowers’ debts, including loans above a specific threshold and arrears to utility companies or tax authorities. Asset registers that record real estate, vehicle, machinery and equipment ownership should contain sufficiently granular information to facilitate reliable assessments of wealth. Authorities should also ensure that such repositories are centralized, electronic and economical. Improved links between asset registers and credit registers across national borders is needed in some regions to fully capture wealth and debt abroad.22

External NPL Management and Distressed Debt Markets

32. Support the development of markets for distressed assets to facilitate the disposal of NPLs. In several countries the absence of a market for distressed assets limits the prospects for effective NPL disposal. A liquid secondary market for impaired assets (or foreclosed collateral) provides banks with a crucial instrument to manage the credit risk of NPLs (Jassaud and Kang, 2015). It allows banks to clean up their balance sheets, boost asset recovery and allocate capital to solvent lending. If the disposal of NPLs entails the restructuring or cancellation of debt, it also ameliorates the debt service capacity of debtors and frees up space for investment. Over time, a distressed debt market can facilitate corporate restructuring and a reallocation of resources to more productive investments. As the market increases in size and efficiency, it can also attract a wider range of institutional investors and instruments, promoting further development of capital markets.

33. The market for distressed debt can only proceed as far as the market infrastructure allows. Access to timely financial information on distressed borrowers, collateral valuations, and recent NPL sales are critical for the development of an active market for NPL restructuring. Facilitating the licensing of nonbanks for restructuring, as opposed to entities with a banking license, would lower the cost of entry into this market and allow for greater specialization. Promotion of NPL servicing and loan collection agencies and more efficient collateral auctions would help raise recovery values.

34. Structured finance techniques can also facilitate the removal of impaired assets from bank balance sheets (Aiyar and others, 2015 and 2014; Barkbu and others, 2013). European institutions, such as the EIB/EIF, could play a role in fostering markets for distressed debt, for example through investing in senior tranches and/or providing guarantees on mezzanine tranches of NPL securitization transactions. This involvement may also foster transparency and homogeneity, setting the stage for a truly pan-European market. The securitization of NPLs has proven to be a successful resolution technique in many jurisdictions.

35. In some countries, AMCs or other special purpose vehicles could help kick-start a market for distressed debt. First, they bring economies of scale, which may help smaller banks in particular resolve problem loans. For example, centralizing impaired assets from several banks into an AMC may help reduce the fixed cost of asset resolution, increase the efficiency of asset recovery, allow for a more efficient packaging of assets for sale, and attract outside investors. Second, and relatedly, AMCs are likely to enjoy greater bargaining power due to their size, especially when credits are scattered within the system, collateral is pledged to multiple creditors, and the size of debtors is large relative to that of banks. Third, they encourage specialization by enabling banks to focus on new lending while allowing the AMC to concentrate on the recovery of impaired assets. This division of labor becomes increasingly important if NPLs are at systemically high levels and for smaller banks which lack workout expertise and resources. Fourth, (and related to the previous point), increased specialization can facilitate better valuation and credit discipline. The transfer of NPLs entails a separation of the loan administration away from their credit officers, which could foster a more objective assessment of credit quality. Breaking-up unhealthy ties between banks and corporate borrowers may also improve the collection on delinquent loans and facilitate a correct assessment of the ceding bank’s external value by market participants. Finally, all these points together suggest that AMCs could be crucial to price discovery.23 Economies of scale, central bargaining power and better valuation are likely to be key ingredients in bridging the pricing gap in situations where no market exists, or the market is extremely illiquid.24

36. AMCs could be private or public. Larger banks may be in a better position to establish their own private AMCs. However, for smaller banks or in cases of market failure due to significant structural constraints or where NPLs have reached systemically high levels, consideration could be given to a national-level AMC with public participation. But any AMC should be: (i) complementary to other NPL resolution strategies (such as loan workouts in separate bank unit or bank-specific AMCs); and (ii) combined with strict supervisory policies, robust insolvency frameworks, and the removal of impediments to NPL resolution as described in the previous sections.

37. To allow banks to sell NPLs without facing penalties, AMCs should comply with EU State aid rules. Thus, they should either (i) involve no transfer of public resources or (ii) receive only such public sector support as is compatible with the EU treaty. The EC (DG Competition) has the exclusive mandate and power to ensure that granted State aid is compatible with the EU Treaty, and that any State aid provision is accepted in exchange for strict conditionality.25 There are two general steps to the assessment process—the assessment of the existence of State aid (with a notification obligation of the granting Member State to the EC) and the assessment of the compatibility of State aid. If assets are transferred to the AMC “above market value” this would involve State aid. Such public support would trigger the bail-in of junior creditors and hybrid instruments holders under the BRRD, and the implementation of a far-reaching restructuring plan for the beneficiary bank in order to ensure its return to long-term viability.26 In exceptional circumstances, exemptions to the restructuring and bail-in requirements could be granted, for example on the grounds that the public support addresses a market failure or serves a well-defined social objective such as the preservation of financial stability.27

38. A possible model for national AMCs without transfer of public resources would involve a limited lifespan, minority public ownership, and asset transfers at market prices. The government should receive adequate remuneration (realistic pricing, equity warrants) for national AMCs to minimize fiscal costs. The following characteristics should be satisfied:

  • Semi-private ownership. Public sector participation in equity and funding would demonstrate political commitment and attract private sector funding through shared ownership. But public ownership should be limited to a minority stake. AMC liabilities would be treated as only as contingent liabilities for the state, helping overcome potential fiscal constraints.

  • Transfer at market price. Assets should be transferred from banks to the AMC at market prices. If there is no market, or if the market is undermined by severe illiquidity, prices should be determined using a model-based approach agreed with EC’s DG Competition (typically a robust pricing model would factor in risk premia in line with valuations of similar assets classes elsewhere).

  • Voluntary participation by banks. Banks should have the option to work out loans internally or through their own AMCs, or sell them directly to the market.

  • Governance. To avoid risks of moral hazard and warehousing of bad assets national AMCs should have a clear mandate to acquire assets within a limited time period and to maximize recovery value over a fixed life span. Clawbacks could be used to protect public investment in the event of losses.

  • Strengthening the recovery value of NPLs. Special powers, such as time-bound fast track restructuring, might be needed to overcome structural deficiencies (inefficient enforcement processes, deficient insolvency laws, and clogged judicial systems).28 Any such powers and would be granted to all market participants, including banks that are resolving NPLs internally, in order to ensure a level playing field.

39. Clarity is needed on the conditions under which a transfer of public resources to support NPL disposal would be permissible without triggering bank restructuring. While the national AMC proposal above should avoid State aid (by virtue of market price asset transfers), there may be circumstances in which State aid would be needed to address risks to financial stability or market failures arising for example from costly enforcement and lengthy foreclosure procedures. Here, the EC should issue guidance clarifying ex ante the permissible design/implementation of AMCs involving public support to address a market failure or systemic risk, which would not result in a requirement to restructure the benefitting banks. In the current context, this guidance should take into account that NPLs have assumed systemic proportions in several euro area economies, hindering credit supply and impairing the monetary transmission mechanism. Greater flexibility under these conditions would allow earlier and more proactive steps to address potential risks to financial stability.29

E. Conclusion

40. Reducing the level of impaired assets is an important policy priority to restore the health of the banking sector and support credit growth in Europe. High NPLs hold back credit supply by locking up capital that could be used to support fresh lending. They also reflect a large corporate and household debt overhang, which acts as a drag on credit demand. A comprehensive strategy is needed to address the NPL problem. This paper suggests three main elements to such a strategy: (i) enhanced supervision; (ii) insolvency reforms; and (iii) the development of a distressed debt market.

Table 1.

Comparative Analysis of Selected European and International AMC Initiatives

article image
Sources: Bloomberg L.P., Consensus Economics, European Commission Annual Macro-Economic Database, U.S. Federal Reserve, Haver, IMF (FSI, GFSR, WEO), company information, and broker reports.Note:

narrow=financial objective only, broad=additional elements, such as contribution to economic recovery or employment;

NPL ratio and sovereign indebtedness at end of previous year (t-1), realized real GDP growth (t), one-year ahead real GDP growth expectation in the month after set-up of AMC (t+1), n/a = not available, n/r = not relevant or suitable for comparison;

GDP, banking assets and NPL volumes as of transaction date (or end-2014);

broker reports.

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Annex I. The Regulatory Treatment of NPLs in the United States—Early Loss Recognition1

There are significant differences in the approach to recognizing loan losses through provisions between IFRS (as applied in Europe), and GAAP (as practiced in the United States). Both apply the incurred loss approach (FSF, 2009), but although the accounting standards are comparable, a key difference is the regulatory requirement that overlays the accounting standard. This overlay limits the discretion that bank managers have in applying GAAP. This results in a more conservative U.S. GAAP treatment of NPLs for banks than is the case under IFRS.

There are two key regulatory requirements that are imposed in the US. Banks must (i) suspend and reverse interest income on NPLs once the loan is 90 days past due on any payment or is deemed uncollectible in whole or in part (i.e., the non-accrual principle);2 and (ii) promptly charge off/write down the loan balance on the bank’s accounting statements to the recoverable collateral value after six months – applies particularly to retail credit.

For a charge-off, any loan balance that exceeds the recoverable value (less the cost to sell) should be charged against the loan loss reserve. In determining the collateral value, it should be today’s “spot price” with no adjustment for forecasted increase in collateral values. The act of charging-off the loan should not be confused with the forgiveness of the borrower’s debt. The bank must still be judged on its ability to collect defaulted loans – including through loan sales.

A nonaccrual loan may be returned to accrual status after the borrower has made a series of contractual payments. This improvement in the borrowers’ condition may arise from a modification of lending terms. However, given the concern that liberal modification leads to misstatement of loan portfolio condition, modification practices are subject to close regulatory scrutiny. There must be sound internal control processes governing any modification, and management information systems must monitor and verify that the modifications are working.

The effect of this treatment is that banks will recognize credit losses sooner in a weakening credit cycle. This aids earlier recovery (or failure if capital is insufficient), as evident in the recent crisis—though severe, system NPLs peaked at 5 percent of loans in 2009, and have since declined to less than 2 percent. The charge-off requirement with strong prompting by supervisors removes the disincentives to bank sales of NPLs, contributing to earlier price discovery for NPLs and underlying collateral. This leads to a quicker rebounding of asset markets.

Annex II. Treatment of Public Creditors’ Claims in Corporate Debt Restructuring and Insolvency1

In generally, the participation of all creditors, including public creditors (such as tax and social security authorities) makes corporate debt restructuring more effective. The treatment of public creditors range from granting them super-priorities in some countries to detailed guidance on how public creditors may take part in out-of-court debt restructuring or outright prohibition of participation in debt restructurings in other countries.

Despite the lack of absence of clear guidance from international best practice, there a several principles that would need to be considered. The UNCITRAL Legislative Guide recommends that priorities be “minimized”, especially, “priorities over secured claims”. The World Bank Principles for Effective Creditor Rights and Insolvency Systems state that “public interests generally should not be given precedence over private rights.” The IMF’s Orderly and Effective Insolvency Procedures state that “the privilege [related to tax claims] has been justified on the grounds that giving the government priority with respect to tax claims can be beneficial to the rehabilitation process in that it gives the tax authorities an incentive to delay the collection of taxes from a troubled company.

  • Ranking. Since super-priorities (i.e., ranking ahead of secured creditors) may impact negatively on secured credit and access to finance. Specifically, (i) they should be limited to the tax claims in terms of period of time (e.g., last 12 or 24 months), (ii) interest and penalties should be treated as unsecured (or be subordinated) claim, and only principal should enjoy preferential treatment, or (iii) VAT and employee withholding taxes may be ranked preferentially (e.g., ahead of unsecured creditors).

  • Restructuring. Subject to clear and predictable criteria, the best solution would be to allow public creditors’ claims (including principal) to be restructured like any private sector claim. It should be considered whether and how this can be affected within the constitutional and legal framework in those countries which need an explicit legal basis for the tax administration to engage in debt restructuring. Information sharing between private and public creditors should be enhanced (e.g., credit register).

  • Guidance. Clear and predictable guidance to the tax administration should be issued on how and under what conditions tax officials can participate in debt restructuring and insolvency to create a safe harbor for good faith application (which should shield staff from personal liability) subject to safeguards against fraud. Task forces of specialists (within the tax administration) could be established to deal with distressed business with tax liabilities. To the extent such guidelines are not advisable, due to the inexperience or lack of capacity of the tax administration, a certain degree of automaticity in debt restructuring could be envisaged.

Annex III. Capital Relief and New Lending Capacity from NPL Disposal1

The market price of NPLs will typically reflect several factors, such as the efficacy of the insolvency regime and the rate of return demanded by investors. In this box we assume that banks reduce the current stock of NPLs (end-2014) by selling their distressed loans to external investors. This reduces the regulatory capital charge of their loan book in proportion to the share of NPLs (and their applicable credit risk weight). The selling price reflects the expected time to recover or liquidate NPLs (being lower where foreclosure times are extended and debt enforcement regimes weak) and would need to offer a sufficiently high return on investment consistent with general profit expectations in distressed debt markets. The sale results in a loss (gain) on disposal and reduces (increases) the benefit of capital relief if the selling price lies below (above) the net book value (i.e., the gross value of NPLs after deducting the current level of loan loss reserves). A selling price below the net book value is commonly referred to as the “pricing gap” (which can also be expressed as a “haircut” on the net book value). The selling price is calculated as the net present value of the loan, assuming an accumulated depreciation of the secured portion of each loan at the average lending rate and the usual servicing and management costs (of 10 and 2 percent, respectively). As opposed to the application of a uniform “pricing gap” across sample countries in the main text (see Figure 3), this approach is more granular and generates country-specific valuation haircuts that account for the uneven distribution and capital intensities of NPLs in the euro area.

Timely disposals of NPLs—combined with structural reforms—can free up a large volume of regulatory capital and generate significant capacity for new lending. For a large sample of euro area banks covering almost 90 percent of all institutions supervised directly by the SSM, we calculate bank-by-bank the amount of capital that would be released by removing NPLs from bank balance sheets. We assume that banks reduce their NPLs to a level consistent with historical averages (between 3 and 4 percent of gross loan book for most banks); meet a target capital adequacy ratio of 13 percent; and offer a 10 percent rate of return on investment. Importantly, for countries with elevated expected foreclosure times (Ireland, Greece, Italy and Cyprus), we reduce the expected foreclosure time to assess the potential impact of insolvency reforms on the pricing gap. Under these assumptions, the aggregate capital relief would amount to €22 billion (or 0.1 percent of total assets of sample banks at end-2014). This in turn could unlock new lending of over €358 billion (or almost 4 percent of GDP), provided that there is corresponding demand for the new loans. Portugal, Italy, Spain, and Ireland would benefit the most. Since the impact on capital varies significantly across countries, the additional lending capacity would range from some 2 percent of GDP in Italy to 31 percent of GDP in Ireland. In addition, reducing investors’ return expectations from 10 percent to 7.5 percent has a powerful impact: for example, in the case of Italy, this would result in additional capital relief of almost €7 billion and about €80 billion in new lending.2

Without enhanced insolvency frameworks in some countries, selling NPLs would result in much lower capital relief. In some countries, structural reforms and/or lower investment returns of distress debt investors are essential for external NPL resolution to have a net positive effect. Applying observed foreclosure times and imposing a minimum investment return of 10 percent would imply a large haircut relative to book value in some countries, such as Italy (-26 percent) and Cyprus (-66 percent), reducing the aggregate capital relief from NPL disposal to a mere €6 billion (or 0.1 percent of GDP of selected countries at end-2014).

1

Authors: Shekhar Aiyar, Andreas (Andy) Jobst, and Kenneth Kang (all EUR); Dermot Monaghan, Marina Moretti, and Jean Portier (all MCM); Wolfgang Bergthaler, Jose M. Garrido, and Yan Liu (all LEG); with contributions from other staff in MCM, LEG and EUR. Research assistance was provided by Yingyuan Chen and Luca Sanfilippo (both MCM), as well as Jesse Siminitz (EUR). We thank staff from the ECB and the European Commission for their helpful comments and feedback.

2

NPE refers to the notional amount of impaired on- and off-balance sheet exposures, weighted by risk, and without considering the loss mitigating impact of collateral.

3

One-third of banks that were subject to the CA (still) have very weak balances sheets. Half of these vulnerable banks are in Italy and Spain, with 16 banks in eight countries reporting NPEs of 30 percent or higher.

4

This assumes sales at net book value and that there is sufficient demand for credit at attractive interest margins for banks (Section II). If country-specific, market-implied haircuts are applied to asset sales (Box 3), the aggregate capital relief (for a capital adequacy ratio of 13 percent) is about €23 billion. The haircut is meant to account for the “pricing gap”—the difference between the price for which the ceding banks are prepared to sell their NPLs and the price at which distressed debt investors are prepared to buy them.

5

In opposition to this view, Krugman (1998) argues that banks may “gamble for resurrection” when their balance sheets are damaged, engaging in excessive lending in the absence of a bank run as was the case with the U.S. thrifts and banks in Japan.

6

This corresponds to NPL sales at net book value.

7

On July 24, 2014, the International Accounting Standards Board (IASB) published its guidelines for IFRS 9, a new principles-based approach for the valuation of financial assets and liabilities, including a single, forward-looking ‘expected loss’ impairment model that departs materially from the current ‘incurred loss’ model (see http://www.ifrs.org/Alerts/PressRelease/Pages/IASB-completes-reform-of-financial-instruments-accounting-July-2014.aspx).

8

The accounting standard IAS 39 sets out the principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.

9

The current European Insolvency Regulation acknowledges differences of national insolvency regimes within the EU but creates mechanisms for the mutual recognition of insolvency processes and cooperation among courts and insolvency representatives in different Member States (“functional convergence”). The European Commission has recently taken a step toward establishing common general principles for EU countries through a non-binding Recommendation for a narrow area of insolvency law, namely, pre-insolvency regimes and out-of-court restructuring to support timely rehabilitation of distressed debtors (European Commission, 2014a and 2014b). Several euro area countries have already reformed their insolvency laws (Austria, Cyprus, France, Germany, Ireland, Italy, France, Latvia, Portugal, Slovenia, and Spain). Some countries have established out-of-court frameworks ranging from purely voluntary to hybrid/enhanced mechanisms.

10

Many SMEs draw on letters of credit or other ancillary facilities that may be secured by the same asset, which complicates collateral access in cases of bankruptcy, especially in cases of multiple creditors.

11

Some national supervisory authorities (e.g., Greece, Cyprus, and Ireland) hired independent workout specialists to assess banks’ NPL management capacity and found that banks were unable to properly assess affordability and were also hindered by poor interbank collaboration in the case of ordinary borrowers.

12

Accounting standards have changed over time so that some strategies used in the past are no longer viable, but the general principle of encouraging rapid write-downs remains valid.

14

Other examples of AMCs include the Resolution Trust Corporation (RTC) in the United States (now part of the Federal Deposit Insurance Corporation (FDIC)), the Malaysian Danaharta, the Indonesian Bank Restructuring Agency (IBRA), and more recently, NAMA in Ireland, the SAREB in Spain, and BAMC in Slovenia (Table).

15

For a broader discussion of AMCs and prerequisites for their success, see Ingves and others (2005).

16

Detailed guidance to banks should include reference to the principles put forth by the Basel Committee (2006 and 2015).

17

In June 2015, the SSM created a joint task force with several NCAs to establish consistent and common supervisory practice for NPL resolution.

18

The application of these measures should be considered after a comprehensive assessment based on enhanced reporting for banks with elevated NPLs.

19

As adopted in Greece and Ireland, such reporting should include granular details on portfolio segmentation (i.e., distribution of days past due for various NPL categories), key performance statistics (i.e., cash recoveries, forbearance metrics, and collateral data), legal workout activity statistics, and loan modifications flow data.

21

“Pre-packs” refer to procedures under which the court expeditiously approves a debt restructuring plan negotiated between the debtor and its creditors in a consensual manner before the initiation of an insolvency proceeding. This technique draws on a significant advantage of court-approved restructuring plans—the ability to make the plan binding on dissenting creditors—while leveraging a speedy out-of-court negotiation process.

22

Some EU countries have recently taken steps to deal with identified shortcomings. Ireland has provided for and is introducing a new public credit register, a new real estate transaction register, and has made improvements to other national repositories.

23

The case of SAREB (Spain, 2009) is instructive. The announcement of the initiative was a trigger for other banks—fearing massive upcoming asset sales—to adjust their asset values and start selling their NPLs. With the market kicking in, investors bought servicing platforms and turned from opportunistic to recurring buyers (Figure 6).

24

In some cases, banks may choose to maintain NPL-AMCs on their balance sheets. On-balance sheet structures can help overcome structural constraints (mandatory licensing, tax implications, and insufficient data quality) and boost expected returns. Here, banks can continue servicing loans while the AMC focuses on providing management services for the restructuring and/or liquidation of impaired assets.

25

During the financial crisis, Member States providing state aid have been required to implement compensatory measures required by DG Competition. These measures included divestments, penalty interest rates, management removals, dividend suspensions and contributions from shareholders and subordinated debtors through dilution, conversion or write-down.

26

Such measures were implemented in Spain and Slovenia, where NPLs were transferred to public AMCs, and banks submitted restructuring plans.

27

Art. 107(3b) TFEU (Exception to Incompatibility): “The following may be considered to be compatible with the internal market: […] (b) aid to promote the execution of an important project of common European interest or to remedy a serious disturbance in the economy of a Member State.”

28

Danaharta (Malaysia, 1998) offers an example of a public AMC in which special powers were an essential feature of the AMC program (Table).

29

In several countries, uncertainty about EU State aid rules have delayed the resolution of NPLs, such as in the case of Slovenia, or hampered the return of banks to financial health (Portugal and Spain).

1

This Box was written by Michael Moore and Nolvia Saca Saca (both MCM).

2

The exception to the non-accrual treatment applies if the loan is secured and in the process of collection, i.e., legal or other action is proceeding that will result in recovery or restoration to a current status.

1

This Box was written by Wolfgang Bergthaler and Jose M. Garrido (both LEG).

1

This Box was written by Andreas (Andy) Jobst (EUR), Jean Portier, and Luca Sanfilippo (both MCM).

2

Note that the importance of the selling price depends on the relative scale of the NPL problem. If NPL disposals are substantial, a high haircut may jeopardize the capital adequacy of the ceding bank. Also, in certain countries, the anticipation of a greater supervisory push for NPL resolution might decrease the market price of collateral, imposing additional losses on disposal that are not captured by this calculation.

Euro Area Policies: Selected Issues
Author: International Monetary Fund. European Dept.