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Is Europe’s Banking System Breaking Under the Weight of Non-Performing Loans?

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The European banking industry has been struggling for years. The key issues that it suffers from have been known for some time. Indeed, many of them contributed to, and were highlighted by, the financial crisis which began in 2008. Yet they still need to be addressed. Here Anthony Duffy, Director of Retail Banking at Fujitsu UK and Ireland, talks Finance Monthly through a few considerations.

Some banks are still too big, others are undercapitalised and profitability is constrained. Low economic growth, pressure on margins (not helped by negative interest rates existing in some countries), and further regulatory change have combined to impact bank performance. The European Banking Authority reported that average return on equity for European banks was 5.7% in June 2016, down by more than 100 basis points in a year, while total operating income fell by 8.8%.

Of particular concern is the level of non-performing loans (NPL) plaguing already fragile banking systems across the region.

Who is Europe’s sickest man?

The European Central Bank estimates that the total stock of NPL in the EU is estimated at over €1 trillion, or 5.4% of total loans. This ratio is around three times higher than other major regions of the world, such as the United States or Japan. Currently, ten of the twenty-eight member states have an NPL ratio above 10%. The worst performers are Greece and Cyprus, where almost half of all loans are under-performing and where the NPL ratio stands at 46.6% and 49% respectively. Yet, despite the size of the problem being known, progress in addressing it remains painfully slow.

Take Italy, where NPLs amount to some €350 billion, represent around 16.6% of the country’s loan portfolio and form about one third of the EU’s entire stock of bad debts. The country’s government and financial sector have spent the last eighteen months trying to address the problem. But the two “bad bank” funds created to help clean up bank balance sheets – Atlante I and Atlante II – have proved to be too small and underfunded to rise to the challenge. The funds are losing value, as the assets that they have bought continue to deteriorate. Italy’s two biggest banks, Unicredit and Intesa Sao Paolo, have written down their investments in the funds. This may, in turn, discourage others from providing fresh funds to be used to bail out problem banks, which means that further help is limited and so industry weakness continues.

Can the EBA be a game-changer?

One area of possible NPL progress could come from the European Banking Authority. Earlier this year, its chairman called for the creation of an EU-wide “bad bank”, to buy at least some of the underperforming loans which sit on the balance sheets of European banks. Andrea Enria suggested that banks would sell their non-performing loans to an asset management company at a price reflecting the real economic value of the loans. This would likely be below the book value but above the current market price. The asset manager would have up to three years to find other investors and sell on the assets.

If the scheme were implemented, it would probably mean that the banks would have to accept some losses. Should the final sale price turn out to be lower than the initial transfer price, a guarantee would protect the asset management company against potential future losses. These are commonly by the member state of each bank that chose to transfer loans to the asset management company in the first place.

Enria argues that such a scheme would remove the notion of a country’s citizens “bailing out” the banks. Any difference between the market price paid and the price the banks receive for their underperforming loan would be covered by Europe’s taxpayers, rather than national ones.

Such thinking is long overdue.

Time is of the essence

So what is to be done? It’s time to tackle the issue of NPLs head on. Further stress testing should be undertaken to identify weak loans and loan portfolios, which banks should then be required to divest via appropriate secondary markets. The impact of underperforming loans, both on the industry and on wider economic confidence, should not be underestimated. By ignoring the urgency of this, the overall structure of the European banking market has been weakened. It has also undermined the concept of a European banking system.

Instability within the European banking sector has been a feature for some time now, and it will be for some time to come. To date, too little has been done to address underlying key factors. This has to change. And, if not now, when?

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