Resolving Europe’s NPL burden: challenges and benefits

I am grateful for this opportunity to speak on the important issue of NPLs in European banks at the invitation of Bruegel, a think-tank doing such significant work in shaping economic thinking in Europe. My remarks today will be on the euro area non-performing loan (NPL) problem and on the policy response that would be needed from a macroprudential perspective. I will first outline the size and scope of the NPL problem. I will then put the NPL problem into a microeconomic and structural context, focusing on the reasons why it has developed this way and what the impediments are to an exclusively market-based solution to the problem. With this in mind, I will move on to the range of necessary and feasible solutions, underlying in particular the role of securitization schemes and the creation of Asset Management Companies (AMC) to achieve an orderly and fast resolution of NPLs. The NPL problem is one of the main reasons behind the low aggregate profitability of European banks. Let me recall here that the return on equity of euro area banks has hovered around 5%, which does not cover the estimated cost of equity. It is important to keep in mind that the issue is not about the robustness of balance sheets as capital and provisions have significantly increased since 2012. Indeed, whereas CET1 ratio was 7% in 2007, it reached 9% in 2012 and is now 14%. Including provisions and collateral, the NPL coverage ratio stands at 82% on average, both for the group of six countries with higher NPLs and for the euro area as a whole. Asset quality issues have been brought to the fore by the global financial crisis. In the euro area, NPL ratios stood at low or manageable levels prior to the crisis. At the same time, the NPL problem has deep structural reasons that were further amplified with the start of the financial and economic crisis. In fact, the surge in NPLs further revealed the limited ability of large parts of the euro area banking system to deal with distressed debt. Chart 1 In the euro area, the average NPL ratio peaked at 8% in 2013 (see Chart 1).[1] As the economic recovery took hold, GDP growth resumed and unemployment started to decline, this ratio started to fall. The reduction in NPLs has, however, been slow and heterogeneous. The ratio of NPLs is still at two digit level in six i euro area countries - Cyprus, Greece, Italy, Ireland, Portugal and Slovenia. Banks directly supervised by the ECB, still held €921 billion of such troubled loans at the end of September 2016, representing 6.4% of total loans and equivalent to nearly 9% of the euro area GDP.[2] The NPL outlook is also very diverse across the euro area. In two countries, Cyprus and Greece, about one-half of total loans are not performing, accounting for about one-third of total bank assets. Four countries report NPL ratios of close to 20%. On the other end of the spectrum, many countries maintain NPL ratios of less than 3%. Despite this heterogeneity, NPLs are a problem with a clear European dimension, as even those countries where banks do not struggle with asset quality, are likely to be affected by spillovers, both financial and real. The NPL problem has no comparable dimension in the U.S. for a number of reasons ranging from structural, to regulatory- and tax-related motives. In the U.S., Government Sponsored Entities (GSEs), and not the banks, account for the majority of mortgages in their balance sheets. Differently to Europe, regulatory requirements overlay accounting standards imposing the write-down of loans to their recoverable collateral value already after six months past-due, for example. The IAS 39 accounting standard (under the incurred loss approach) and the absence of guidance on write-off requirements tend to lengthen NPL write-offs in Europe. The distribution of non-performing exposures by sectors is also quite mixed across countries. Taken together, about 60% of currently distressed loans were extended to non-financial companies, of which about a third is related to lending backed by commercial property. But lending to households also constitutes a significant part of troubled debt exposures, accounting for more than a half of the NPLs in some countries. The distribution of non-performing exposures of high-NPL countries (with NPL ratios in excess of 10%) broadly follows this pattern (see Chart 2). Chart 2 Clearly, a sizeable part of the NPL stock is no longer a risk to bank balance sheets. Provisions, made under applicable accounting standards, amount to about 46% of the stock of NPLs. The remaining value of NPLs is supported by expected future recoveries. Collateral may be a major source of value in NPLs, covering a further 36% of the total exposure, bringing total coverage to 82% on average, for the euro area, broadly in line with the figures for the high-NPL countries (see Chart 3). However, it is very important to bear in mind that access to that collateral is often lengthy and costly, eroding its net present value.