Growing number of possible bankruptcies and credit defaults expected in the coming months is a critical issue, which could undermine the recovery path of the European economy in the delicate phase following the lockdown measures,
ECB’s more conservative estimates predict growth of up to 1400 billion for the stock of new impaired loans, while a survey carried out by the consultancy firm PWC quantifies the volumes expected for Italy in the next 12-18 months at up to 100 billion.
The phenomenon is worrying for two main reasons: on the one hand, the reduction in Gross Domestic Product due lower value added by bankrupted firms and the decrease in tax revenues due to the decline in income and profits, on the other hand, financial institutions are likely to reduce the amount of funds they can make available to the economic system in the very moment in which when there is a high need for liquidity, because they are forced by strict regulations to allocate significant amounts of capital to cover expected credit losses.
In particular, credit institutions find themselves in an uncomfortable position, which is also a dilemma for supervisory authorities and national governments:
– focusing on stability and risk management , implies a potential reduction in the supply of credit to the entire economic system and in particular to those firms who may need it most
– using less restrictive criteria in lending to corporations struggling to survive and, broadly, to support the economic recovery, entails the risk of excessive deterioration in credit quality which may disrupt banks’ balance sheets
How to get out of this deadlock?
During a round table held last September 25th, Valdis Dombrovskis, Executive Vice-President of the European Commission stressed the need to intervene in a timely manner:
If we fail to act in time, we could see the consequences of the last financial crisis repeating themselves and NPLs would rise on banks’ balance sheets would rise for years afterwards.
That would undermine our financial stability and the entire economic recovery.Speech by Executive Vice-President Valdis Dombrovskis at the roundtable on tackling non-performing loans
So far, solutions demanded by lobbyists and bankers, and discussed within the institutions range from the “Bad Bank” hypothesis, in the centralized version at European level or declined through a series of national operators (in Italy there is already AMCO company owned by the Ministry of Treasury born in 1997 as SGA to clean up the Banco di Napoli) to changes in current regulations considered too strict: few weeks ago Alberto Nagel, CEO of Mediobanca, said that calendar provisioning is like “an atomic bomb in the balance sheet of banks” .
In the first case, the idea is that banks offload bad debts onto some public institution that will also bear (probably at taxpayers’ expense) the additional losses associated with this burden.
In the second case, it is a matter of allowing larger flexibility on default definition (when a credit is qualified as non performing) and expected loss forecast ( how much banks are going to recover on non performing loans): this would mean to undo the remarkable progresses made by by regulators and supervisory authorities in recent years.
So far, there has been a negative feedback from authorities on the hypothesis of softening the rules because of a clear risk of undermining the solidity of financial intermediaries by triggering a dangerous “domino effect” that starts from the corporate debtors, is transmitted to the banks and could risk involving national governments, and this would frustrate the past efforts to make the system more transparent and stable after the last sovereign debt crisis in Europe.
There seems to be greater openness towards solutions that, at least on a theoretical level, can replicate market mechanisms by requiring that the loans divested by banks are assessed as independently as possible so as not to transfer undue losses to taxpayers.
In particular, in the Dombrovskis speech we read two suggestions to address the problem:
Overall, I believe that the strategy should focus on two areas:
Firstly, to develop secondary markets for distressed assets.
Here, I would urge the European Parliament to reach agreement on the proposal for a directive on credit services and credit purchasers. This should be a top priority.
Secondly, to further reform the insolvency and debt recovery frameworks. Here, we should build on the results of the ongoing benchmarking exercise to discuss targeted national measures.
These will play a key part in tackling NPLs over the longer term, combined with a rapid agreement on the proposal for a directive on accelerated extra-judicial collateral enforcement.Speech by Executive Vice-President Valdis Dombrovskis at the roundtable on tackling non-performing loans
The dilemma therefore concerns a profile that we have already discussed on this blog:
- banks play a key role within the economic system (credit supply and transmission of monetary policy) and this is the reason why they are subject to specific rules especially regarding resolution and insolvency frameworks in order to defend whole system stability.
- Defending banks involves transferring a series of burdens to other parties, from consumers to taxpayers, and when this is not strictly justified by concrete risks to the stability of the system, it could grant an unfair advantage for banks and their shareholders.
- The way to deal with this difficult situation, maintaining as far as possible a balance of different interests and avoiding abuse and distortions, necessarily passes through a careful mix of transparency, accountability of financial intermediaries and modulation of public intervention
In terms of transparency, the regulatory effort in recent years has been directed towards ensuring that, especially with reference to banks in Mediterranean countries, there were no longer doubts and uncertainties regarding the quality of their loans (how much is truly Performing, how much is simply Unlikely to Pay, and above all how much is really Non Performing ) and the adequacy of the capital.
This should avoid new cases like Monte dei Paschi di Siena and the Popolari Venete.
It is not the case to go back on this point, not even for the Pandemic, because a fair representation of credit quality is a mandatory requisite in order to to determine the extent of the losses actually expected and the capital required to compensate them.
As far as accountability is concerned, it cannot be an accounting rule or an extraordinary intervention by the state to assess whether or not a company is able to recover and meet its obligations. It is up to the banks to decide to whom they grant and withdraw credit and to bear the consequences of this choice. In difficult circumstances such as those we will be going through in the coming months, it is essential that this role is not lost and that it does not degenerate into the extreme excess of avoiding any risk by interrupting the granting of credit, nor the opposite extreme of artificially keeping insolvent counterparties alive.
State intervention should be concentrated on offsetting the negative effects of the exogenous shock, without fuelling unfounded expectations, but rather actively supporting the transformation and reconversion of business activities that are no longer appropriate to the new context.
Before the spread of the pandemic, financial intermediaries were going through a delicate transition phase, in order to survive in a world characterized by low interest rates, strong competition from innovative operators and the need to deploy new energy, resources and technologies to correctly measure risk.
Health emergency has accelerated this process and enlarged problems for less innovative financial institutions: the best way to overcome this critical moment need to pass through the search for solutions adapted to the new environment and any attempt to hide behind emergency legislation or state subsidies will enlarge the cost of adjustment and postpone the time of resolution.
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GLG – Gerson Lehrman Group – Council Member