Divide and conquer

Many Eurozone banks to this day carry large volumes of non-performing loans (“NPLs”) from the various episodes of the Eurozone debt crisis during the last decade. Due to the C-19 crisis the volume of NPLs in the Eurozone will soon increase. A policy debate has ensued on how to address the rising volume of NPLs.

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Andrea Enria, head of the European Central Bank’s Single Supervisory Mechanism and highest ranking Eurozone bank supervisor, re-introduced his proposal to establish a single Eurozone bad bank (or a number of national bad banks) that would hold a good part of the NPLs of the currency block. When he first introduced the idea in 2017, it did not gain much traction. What to make of the renaissance of this proposal?   

The basic premise of a bad bank is to allow banks to take NPLs off their balance sheets and transfer them to a special purpose vehicle (a so-called “bad bank”) where they would be parked until they can be sold to specialized investors at a price higher than their current market value. 

The two most important reasons to remove NPLs from a bank’s balance sheet are capital cost and scarcity of balance sheet space. Holding NPLs is expensive for a bank. Bank capital rules (Basel III, implemented in the European Union with the CRD IV package as amended) mandate that bank capital requirements are set corresponding to expected and unexpected losses. This means the more NPLs a bank holds, the more regulatory capital it will be required to hold, and the more interest investors will charge. 

During the C-19 crisis, the balance sheet space of banks should be used on a priority basis to hold the kind of debt that keeps the financial system afloat and the state capable of acting, i.e.  government debt. NPLs should take up as little space as possible on a bank’s balance sheet. Banks are in the unique position to receive reserves (i.e. central bank money) in exchange for government debt, which increases the overall amount of money available in the financial system and (hopefully also) lending to the real economy. 

Yes, it is correct that the ECB buys government debt. Yet, the ECB’s asset purchases are limited in scope and it may run out of capacity, especially when it comes to certain Eurozone member states. Hence, it may be advisable to not only rely on the ECB purchasing government debt but also to free up space on banks’ balance sheets so that they can buy more and use more government debt to receive reserves from their respective national central banks. The space on the balance sheet of a bank is finite. Basel III requires that any asset a bank holds, including government debt, is risk-weighted and considered in the calculation of its capital (and liquidity) requirements. Thus banks’ balance sheets are much less elastic than they used to be before the Global Financial Crisis.

Transferring NPLs to a bad bank is, of course, not the only way to provide relief to banks. For example, the European Securities and Markets Authority published guidance loosening the definition of what is considered an NPL so that loans that are currently not being serviced due to the C-19 crisis will under certain circumstances not be considered non-performing and consequently will not trigger higher capital requirements. Similarly, the ECB has allowed banks to use capital and liquidity buffers and announced a temporary reduction in capital requirements. Most recently, the EC introduced a legislative proposal that would in essence lower capital requirements through a series of modifications to the Capital Requirements Regulation. 

Amending accounting and prudential requirements to provide relief to banks is an important step to adjust the banking system to the “new normal” of the C-19 world. Yet, it decreases overall loss absorption capacity and, by conflating accounting and prudential categories, decreases the visibility of what type of assets a bank actually holds. Thus this approach may lead to a credibility issue for the entire banking sector in certain Eurozone member states.

If NPLs were transferred to a bad bank, how would it work from a mechanical perspective? Pursuant to Enria’s original proposal, the bad bank would receive a government guarantee before it raised money in the capital market. The money raised would be used to buy NPLs from banks. The purchase price of the NPLs would be neither their book value nor their current market value but a “fictional” price, the so-called “real economic value” (“REV”), which would be the assumed future market value of the NPLs. The REV would be set on the basis of a valuation at the time of sale and the assumption that the market value of the NPLs would appreciate in the future given that inefficiencies, such as for example, lengthy enforcement and insolvency proceedings and the unavailability of reliable data on the NPLs, would be addressed while the NPLs are parked in the bad bank. At the time of the sale of the NPLs, a bank’s shareholders and possibly also its junior creditors would have to absorb losses in the amount of the difference between the REV and the book value of the NPL portfolio. The statues of the bad bank would prescribe that the NPLs would have to be sold into the private market within a certain timeframe. If the market value of the NPLs appreciated to the REV within that timeframe, no additional losses would have to be borne by the investors. If the market value did not appreciate to the REV or the NPLs remained unsold, the bad bank would accumulate losses. To cover these losses, the investors in the bad bank would call on the government guarantee and the government would take recourse to the bank that originally sold the NPLs and its shareholders and creditors (the legal mechanism allowing such recourse could be equity warrants).

While the Eurozone bad bank is not per se an (illegal) debt mutualization mechanism among Eurozone member states—private creditors would bear the losses of the NPLs and a guarantee  of the government of the member state in which the bank that originally sold the NPL is based will back the bad bank, the legality of a single Eurozone or multiple national bad banks is far from clear cut. 

Let’s consider the elephants in the room. First, for the proposal to be implemented, the EC would have to approve the government guarantee, which constitutes state aid under Art. 107 of the Treaty of the Functioning of the European Union. The government guarantee is a key component of the proposal because it provides tangible evidence for the government’s commitment to address the legal issues underlying the Eurozone NPL problem. 

Second, the success of any bad bank hinges on whether investors consider the valuation of the NPLs credible. This is very doubtful given widespread (market) uncertainty in the near and medium term.

Third, it is debatable whether the shareholders and junior creditors of the banks will be able to bear the losses imposed on them. In some Eurozone member states, retail investors are heavily invested in the banking sector, and these retail investors will likely already be struggling due to the outfall of the C-19 crisis and may not be able to bear further losses (without politically destabilizing outcry and/or upheaval). Art. 27 (7) of the Single Resolution Mechanism Regulation requires that private creditors bear losses at a minimum in the amount of 8% of the total liabilities of a bank before the Single Resolution Fund could absorb losses (capped at the amount of 5% of total liabilities of the bank). 

Returning to the bigger picture, it is clear that all approaches to the Eurozone NPL issue—be it amending accounting and prudential requirements or establishing (a) bad bank(s)—are highly technical in nature. They depart from the assumption that there is or shortly will be a large volume of private sector debt that can no longer be serviced and aim to minimize the systemic impact of the debt burden on the banking sector, which is paramount for the entire Eurozone economy. 

What distinguishes Enria’s bad bank proposal is that it prominently exposes the Eurozone debt mountain through an off-balance sheet vehicle, and thereby inevitably heightens political pressure and implicitly calls for a new European political project. This political project is in principal open-ended and would not necessarily have to lead to debt mutualization, fiscal centralization, or less sovereignty for all member states (all of which are dreaded by numerous stakeholders in many member states and not political consensus).

In essence Enria’s bad bank proposal is an attempt to adopt a “divide and conquer” approach to the challenges facing the Eurozone. The proposal is an example for how the many challenges facing the Eurozone can be disentangled, broken into “digestible” pieces, isolated, and staged prominently to further a debate, educate the public and allow consensus building across party lines and member states.

Any “divide and conquer” approach has always required vision and courage. It is remarkable that an unelected technocrat, a bank supervisor, shows us that this route remains open during times of unprecedented crisis. 

Maria C. Schweinberger

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