NPLs remain dangerously to catastrophically high in Italy, Greece, Portugal, and Cyprus.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET .

The bad-debt problem at banks in the Eurozone, an ongoing legacy of cascading loan defaults during the last financial crisis, may have grown smaller overall in recent years but it’s still a major cause for concern. That was the basic thrust of a speech delivered by Andrea Enria, Chair of the Supervisory Board of the ECB, on Friday. And these bad loans remain dangerously to catastrophically high in several countries, including Italy, Greece, Portugal, and Cyprus.

Over the past five years the total stock of non-performing loans (NPLs) on the balance sheets of Eurozone banks has fallen from just over €1 trillion to €580 billion. During the same period, the ratio of gross NPLs in the region has fallen from 8% to 3.8% — the result not just of a shrinking NPL stock but also growth in banks’ total loan balances. Nonetheless, the ratio remains well above pre-crisis levels and is far higher than in other major advanced economies. For example, in the United States and Japan the ratio is 1.6% and 1.1% respectively.

In the Euro Zone there’s also a huge disparity between national NPL ratios, with countries like Germany, Luxembourg, Belgium, Finland, the Netherlands and the Czech Republic clocking in at or around 2%, while Italy’s NPL ratio is 9.5% and three Eurozone countries still have ratios above 10%:

Greece: 43% (down from 50% since 2016)

Cyprus: 22% (down from 49% in 2016)

Portugal: 11% (down from 19% in 2016)

“The problem of NPLs is not solving itself – and it has not yet been resolved,” Enria said. “While it is true that the amount of NPLs has fallen significantly – by almost 50% since 2014 – the stock of NPLs is still very high. It is also very old… For those banks with the highest levels of NPLs, more than half of their NPLs are older than two years and more than a quarter are older than five years.”

To compound matters, Eurozone banks appear to be piling up new bad loans on top of the old ones.

“It seems that inflows of new NPLs are still on the high side – not least when you consider where we are in the business cycle,” Enria said. “It also seems that some banks with high NPLs are still reporting increasing default rates. We find this somewhat worrying, and we urge banks to stem this inflow by rethinking their underwriting standards and engaging with distressed debtors.”

In recent years, EU authorities have launched a raft of policy initiatives aimed at tackling the NPL problem, including rules on minimum loss coverage for NPLs, new provisioning guidelines for NPL stocks and measures to facilitate debt recovery, which is particularly important in countries like Italy where it can take years to recover unpaid debt. As we reported last year, many of the policy proposals were watered down at the last minute, following furious lobbying from bank lobbies and some national governments, including Italy.

Another key game changer was the launch, in 2016, of the “GACS” scheme, which provides banks with a state guarantee on the least risky tranche in bad-loan securitization sales. This means they can price their bad loans higher than their market value would have been, based on the underlying risks — and if that tranche becomes affected by losses, Europe’s unsuspecting taxpayers will get to eat them, rather than bank investors.

As intended, the scheme helped fuel a surge in both the supply and demand of NPL securitizations. “In 2018 alone, banks from across the euro area sold or securitised around €150 billion of NPLs,” Enria said. “For significant institutions with high levels of NPLs, sales and securitisations amounted to around one-third of NPL outflows in 2018.”

Few countries have benefited as much from the scheme as Italy, where an estimated €37 billion of NPLs were sold by banks in 2016, followed by a further €47 billion’s worth in 2017, according to Deloitte. The buyers are often specialist American hedge funds like Cerberus Capital Management or Fortress Investment. Thanks to their voracious appetite for government-guaranteed bad debt, Italy’s banking system was able to almost halve its NPL ratio since late 2015 and late-2018, from 16.8% to 9.5%.

But that’s still dangerously high, even though it pales in comparison with the 43% and 22% NPL ratios that Greece and Cyprus respectively boast. With the amount of bad debt in the Eurozone still too high for comfort despite the prevailing low rate environment and other relatively benign economic indicators, what could happen if underlying economic conditions deteriorate?

This is a question Enria himself is asking, with a certain sense of urgency. “We have to get a handle on this problem. We have to solve the issue of NPLs while the economy is still resilient,” he said in his closing remarks. “If banks have to sail into the next storm with too many NPLs on their balance sheets, they will be less able to weather it and come out safely on the other side.” By Don Quijones.

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