- Why the Eurozone is stepping up efforts to tackle non-performing loans
- What we learned from recent bank resolutions
- What are the implications for investors in Europe's banking sector
A rise in bad debt is common in times of financial distress. However, two factors differentiate the Eurozone’s non-performing loans (NPLs) problem. First is its size; the chart shows how total NPLs ballooned after the onset of the global financial crisis, reaching €1.2 trillion in 2014 or 6.8% of total loans (known as the NPL ratio). Second is its persistence; while the absolute level of NPLs and the NPL ratio have declined to €948 billion (bn) and 5.0% respectively, the reduction has been slow and unevenly spread. NPL ratios are still above 10% in some peripheral countries.
Chart: the build-up of non-performing loans
The European Central Bank (ECB) has identified the NPL issue as a contributing factor behind weak economic growth and financial instability. NPLs are also a factor in the relatively weak transmission of the accommodative monetary policies pursued by the central bank; high levels of NPLs can impact a bank’s ability or willingness to supply credit or new loans.
Solutions for resolutions
Until recently, the strategies used to tackle the NPL issue in Europe have been largely idiosyncratic and not consistently applied, contrary to the aim of a full banking union. However, the last 12-18 months have seen more work towards a common definition of an NPL and specific guidance to banks on tackling NPLs. Discussions on market-based solutions to the NPL problem have also been wide-ranging. The outcome when a private sector solution can be reached is relatively clear cut for stakeholders and usually only involves some dilution or losses for shareholders. A private sector solution also leaves the requirement for state aid out of the equation.
This issue becomes more complicated when the NPL problem is too large to deal with without the use of public funds. The Bank Recovery and Resolution Directive (BRRD) is designed to act as a rulebook on how to deal with troubled banks. It gives the regulator a range of tools should remedial action be required, including a sale of business tool and a ‘bail-in’ tool. However, the process of implementing the rules is never straightforward. A key sticking point in the legislation is the concept that no creditor should be worse-off than in liquidation. Where liquidation is avoided, proving that this principle has been upheld is almost impossible.
In recent months, the BRRD has been used to resolve problems at Banca Monte dei Paschi, Veneto Banca and Banca Popolare di Vicenza in Italy, and Banco Popular in Spain. The process highlighted the generous flexibility included in the European rulebook, with public funds used in the cases of Monte, Veneto and Vicenza. Only with Popular were no public funds used. There were common features to the restructurings; losses were shared across all shareholders, bondholders and bank capital instruments; and recovery rates should be negligible. Only senior bondholders were made whole, although retail investors in subordinated bonds will likely receive some compensation to avoid any political backlash.
Looking ahead, it is unclear whether the regulator will be as generous towards senior bondholders. The focus is turning to ensuring banks have sufficient capital to absorb losses on a day-to-day basis, and to recapitalise a bank when other resources are utilised. This will require banks to issue a specific amount of loss-absorbing debt instruments, giving rise to the development of the holding company/non-preferred senior asset class. These instruments rank as senior unsecured liabilities but are subordinated to other preferred senior liabilities in the event of default. None of the banks that failed recently had issued this type of security; however, if they had, it would have been realistic to expect these senior liabilities to face losses.
Risk on the rise
For investors, it is clear that where NPL resolution results in bank failure, subordinated debt will be wiped out. For banks perceived to have asset quality problems, this will likely result in a clear negative impact on the valuation of their securities. With the development of the senior subordinated asset class and the willingness of the authorities to use the bail-in tool under BRRD, the risks of losses in the bank senior market have clearly increased. How much you might lose will depend on the quantity of subordinated instruments sitting above you in the creditor hierarchy, as well as the volume of debt with the same ranking.
The risks of investing in bank debt have risen but understanding a bank’s risk profile and capital structure brings opportunities to take advantage of mis-pricing of securities in the European banking sector.