Thursday, 16 February 2017

Fitch: EU Bad Bank Faces Significant Hurdles

In World Economy News 16/02/2017

There are substantial hurdles to establishing an EU-wide bad bank, or asset management company (AMC), to deal with banks’ bad loans, and EU state-aid rules would probably require losses for junior debt to cover associated asset write-downs, Fitch Ratings says. An EU-wide AMC could be positive for banking systems in countries with large volumes of non-performing loans (NPLs), helping banks to clean up balance sheets and reducing earnings volatility from loan loss provisions, which would benefit senior creditors.
Recently, senior policymakers have discussed the prospect of a bad bank to deal with NPLs in the EU. In a presentation at the end of January, EBA chairperson Andrea Enria identified 10 countries with an NPL ratio above 10% and said that asset quality was an EU-wide problem. ECB Vice-President Vitor Constancio said in a speech on 3 February that high NPL levels weigh on bank profitability and that a European AMC would be a “welcomed initiative”.
Both policymakers envisaged that any AMC would operate within the EU bank-resolution and state-aid frameworks, and both discussed a “precautionary recapitalisation” approach with state funds used to help banks absorb the losses associated with offloading their NPLs to an AMC.
We consider the creation of an EU- or eurozone-wide centrally funded AMC unlikely in the near term and believe any move towards further risk-mutualisation in the eurozone would be politically difficult, notably in Germany. Moves towards a eurozone-wide deposit insurance scheme stalled last year as several countries wanted further progress on risk-reducing measures before agreeing to share risk from other countries’ banking systems.
Fitch believes the most feasible AMC approach in the short term may be a “European blueprint” applied at a national level. Such a blueprint could help countries with high NPL levels to navigate the complications of the EU’s Bank Recovery and Resolution Directive and state-aid framework. Under this approach, the actual AMCs would probably be set up at national level, with capital injections or other state support funded by governments. Depending on its size and nature, state support could increase pressure on some sovereigns’ finances, especially if it causes official debt statistics to worsen.
Finding the appropriate price for NPLs is difficult. Investors want deep discounts to compensate for lengthy court proceedings and difficulty in realising collateral. Reduced valuations require banks to make additional provisions to increase coverage levels before selling assets or transferring them off balance sheet, which increases pressure on capital. We recognise EU-wide efforts to reform insolvency law and practice, but believe it will take time for these to be fully effective across the EU.
The EBA presentation envisaged transferring NPLs at a “real economic value” (20% above market values), with a potential clawback later if the eventual sale price is lower than the transfer price. Such an approach could make it easier to meet EU rules that prohibit using a precautionary recapitalisation to offset losses already incurred or are likely to be incurred in the near future. However, we believe this approach creates a contingent liability for the bank and would reduce transparency, potentially hampering attempts to attract private capital.
Under EU rules, a precautionary capitalisation requires a capital shortfall to be identified via a stress test. The EBA is not planning a stress test in 2017 but intends to run an exercise in 2018, although local supervisors are required to undertake annual stress tests.
We would not expect an EU-wide AMC to lead directly to a greater lending supply. Other factors, such as economic prospects, are also important in stimulating lending and loan demand from creditworthy customers is being amply served by a strong supply of liquidity.

Source: Fitch Ratings