20 July 2017

Financial Times: Hazardous non-performing loans obstruct Europe’s banking union

These problems risk spoiling the party when interest rates normalise. Restoring bank balance sheets to good health would enormously reduce downside risks. Positive steps have already been taken. They should be complemented by a debtor-focused approach that could be used beyond Italy.

Italy has the second-largest public debt burden in the eurozone and one of the lowest growth rates. Despite one of the largest primary fiscal surpluses of the group and record-low interest rates thanks to the European Central Bank’s massive sovereign bond purchases, this debt burden has only just stabilised.

The only way to prevent debt from becoming unsustainable when interest rates eventually rise is for Italy to grow faster. There are many reasons why Italy’s growth performance has lagged behind, but a key one is having a banking sector clogged up with bad loans: non-performing loans exceed 15 per cent of loans and 20 per cent of gross domestic product.

The good news is that finally the biggest trouble spots are being dealt with: an agreement was found at the beginning of June between the Italian government and the European Commission on the recapitalisation and restructuring of Monte dei Paschi di Siena. This was followed by the winding down of two smaller Veneto banks, all three with NPL ratios above 30 per cent.

In addition, the Single Supervisory Mechanism has heightened pressure on the banks it supervises to come up with a strategy to deal with NPLs. This has resulted in efforts to develop action plans and establish the basics of an approach that could eventually attract institutional investor interest into this space.

But this alone is unlikely to be a game-changer, because the banks have underinvested for years in their loan servicing departments and typically lack the capacity to actively manage these loans. This leaves disposal as the fastest option but the current market price exposes banks to significant losses. An approach focusing on raising the disposal price of NPLs would help them further. It would also reduce taxpayers’ exposure to loans guaranteed by the state during the Veneto wind-down. The insolvency reforms and guarantee schemes Italy adopted last year should eventually help. But their effectiveness will be hampered without further reform of court procedures. And the insolvency rules do not apply retroactively.

A more powerful approach would be to provide an incentive and, where strictly needed, financial support, to NPL debtors so that they resume servicing their loans, with adequate safeguards to limit moral hazard. This could take a variety of forms, from a tax credit to a zero-interest loan with backloaded repayment, financed either by the national budget or by a European vehicle.

Such a debtor-centred approach would also avoid the social and political backlash that would inevitably follow a shift to heavy-handed loan servicing and recovery procedures.

Finally, there is a European dimension to this. Six countries still have double-digit NPL ratios, representing 9 per cent of eurozone GDP. This is preventing progress toward completing the banking union, as countries whose banks have higher asset quality are concerned that they will end up paying for the poor lending decisions of others. Implementing a debtor-focused approach across the EU therefore remains a priority.

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