By Piers Haben, Director of Oversight, European Banking Authority (EBA)
(These are the views of the author and not the EBA.)
The process of repair of the EU (European Union) banking sector is well underway. Regulatory pressures combined with banks’ own efforts to boost their resilience have seen capital ratios strengthened significantly. Lending growth has resumed in 2015, albeit modestly, and profitability is creeping up, although it is still at low levels. Despite protestations that the confluence of regulatory initiatives is the main impediment to a final step towards sustainable profitability and renewed lending, higher capital ratios are actually associated with higher lending. Instead, an inability, or unwillingness, to tackle poorly performing assets is the key barrier to unlocking the levels of renewed lending necessary to ensure banks, alongside market-based finance, play their part in the EU’s economic recovery.
This short article addresses three beliefs about the process of repair, and it attempts to either refute them or to provide context for them. The three beliefs are:
(1) Higher capital requirements are the main impediment to lending;
(2) It is in a borrower’s interests for banks not to take pro-active action on NPLs (non-performing loans);
(3) Structural challenges prevent supervisors and banks from taking action unilaterally to address NPLs.
The process of repair
The EU’s banking sector has taken a number of key steps to strengthen its resilience. After the EBA’s 2011 stress test, the EBA issued a Capital Recommendation for all banks to raise their capital levels to 9 percent CT1 after accounting for sovereign bonds, which prefigured several years of capital raising that has seen the average CT1 ratio amongst the largest EU banks rise to more than 12 percent, levels comparable to the largest US banks. Getting the capital right took priority, and it was subsequently with the EBA’s single definition of forbearance and non-performing loans, used in asset-quality reviews across the EU in 2014, that attention focused on dealing with legacy assets. Recognising the problem is a major first step. Dealing with it takes longer but is equally necessary. There is a risk that as attention returns to potential regulatory impediments to sustainable lending, the need to deal urgently with legacy assets will be forgotten.
CT1 capital for the largest EU banks
What do we see?
Despite improvements in capital ratios, lending growth has remained subdued on average across the EU.
Loan volumes for largest EU banks
Thus, whilst lending has not on average decreased significantly, this hides both differences between sectors and countries and the fact that measures of the stock of lending hides challenges in the flow of new lending. Moreover, profitability remains very challenging. Average return on equity for EU banks remains below the average cost of equity—on average, return equity of 3.6 percent as of December 2014, according to EBA data, while the reported cost of equity appears to be on average around 10 percent across EU banks. We also see high levels of non-performing loans across the EU. To put this into context, the average EU figure of more than 6 percent non-performing loans is at least double the rates in the US, although direct comparisons are currently difficult because of differing definitions. And more importantly, this amounts to at least a trillion euros of non-performing assets.
Specifically based on the EBA’s own risk-assessment report of June 2015, the EU’s weighted average NPL ratio was 6.5 percent in December 2014, after a small decrease from September (6.8 percent). Financially stressed countries in general show the highest NPL ratios. This results from the general economic crises from 2008 onward, but is also influenced by differences in the legal systems of the countries (e.g., bankruptcy laws and their influence on time to recovery for NPLs or on the possibility to sell NPLs or write them off after collateral repossession). Non-financial corporates’ weighted average NPL ratio at 2014 yearend was 11.5 percent and households’ 5.3 percent. Household loans show for the EU average as well as for most countries a lower NPL ratio than non-financial corporates. Within non-financial corporates, large corporates’ NPL ratio is 9.3 percent, and SMEs’ (small and medium enterprises’) NPL ratio is 18.7 percent. The high NPL ratio for SMEs may indicate that these loans suffer most in times of a crisis, and restructuring may be most challenging and longer for them (e.g., if a small business goes bankrupt, it might be more difficult to restructure it). Accordingly, this might also be the reason that SME loans are less often considered in NPL transactions.
Non-performing loans by country of counterparty and sector (Q4 2014)
Preparation to deal with non-performing assets is seen as key to building capacity and willingness to deal with the issue. And here again we see differences remain among countries, with countries’ coverage ratios ranging between 30 and 70 percent. An increase in loan-loss provisioning (and as such in coverage ratio) might motivate banks to sell loans.
A return to lending?
So what will herald a return to profitability and sustainable lending? Simply waiting for interest rates to rise in the hope that net-interest margins will recover to previous levels is unlikely to be the most direct pathway back to sustained profitability—even if rates do increase, bank customers appear more footloose than ever, and competition from banks and non-banks is growing. Hoping that the new suite of regulations implemented as a response to the crisis at the behest of the G20 will be rolled back is unlikely to bear fruit, and anyway lower capital ratios are not associated with sustained lending.
This point brings us to the first widely held belief that higher capital ratios, as required by the new Basel 3 standards and enforced by supervisors—including Pillar 2 requirements and the combined buffer—are the major constraint on lending. But the evidence shows us that it is not higher capital levels that impede lending. All the evidence suggests that it is only well-capitalised banks that lend in good times and bad. And indeed in recent years, it is only when banks have raised capital that they have been able to increase lending the following year. There is a strong and positive correlation between higher capital levels and lending.
The impact of high NPLs
Another hopeful route to profitability is to assume that your customers will somehow return to form in a linear fashion with economic recovery. This is potentially circular as it is new lending that will assist in the economic recovery. Higher levels of NPLs impact banks’ ability to lend through their drag on capital, their impact on profitability and higher funding costs. This bring us to the second widely held belief that it is in the interests of banks, their customers and the general economy to extend and pretend and not deal with problems as they emerge.
Conversely, higher levels of NPLs are associated with lower profitability and subdued lending. How does this happen?
The first and most straightforward component is that of banks themselves. All the evidence suggests that higher NPL levels are associated with lower profitability and lower capital levels. Indeed, taking a proactive approach to dealing with NPLs appears to herald a swifter return to profitability. More contentious is the notion that it is in a customer’s interests for a bank to extend forbearance indefinitely under the assumption that the borrower will return to performing status organically. However, a longer period of non-performing status is associated with deteriorating credit quality and eventual write-off. Clearly this is expensive for the bank, and it is hard to argue that it is in the interests of a bank’s customer to keep paying interest, even partially, on an asset he or she will eventually end up losing. Finally, as noted above, for economic recovery new lending is required, whereas capital trapped in legacy assets is servicing poorly performing old assets, and new lending is stifled.
There are significant cross-country differences in dealing with legacy assets. In the US, banks have dealt swiftly and effectively with non-performing loans. They are helped, of course, by the structure of Freddie Mac and Fannie Mae. But they are also helped by a legal, accounting and tax regime that ensures that non-performing loans are written off after a year. And with a wide and liquid secondary market for bank assets, price discovery is easier and assets are moved off balance sheets quickly. This brings us to the third and perhaps most reasonable widely held belief—that it is structural factors that determine banks’ ability to deal with non-performing loans.
There is a degree of truth in this. Surveying the literature from the US, Asia, Europe and South America certainly demonstrates that there are significant differences in tax and legal regimes, and these differences are in turn often reflected in the definitions of non-performing assets used for regulatory purposes, with less incentives to measure, monitor and take action on non-performing assets where the other structural factors are not in play. But whilst structural factors are a key that needs to be addressed, banks and supervisors can nonetheless move forward on measuring, monitoring and taking action on non-performing loans.
Such measures include: effective classification of loans, including loans that are forborne and non-performing, with sufficient attention paid to the status of the borrower over and above simple days-past-due metrics. The EBA moved in this direction with the publication of a single set of definitions even if globally differences remain. Having established effective measurement, monitoring asset quality is then key for effective early intervention, which requires investment in effective “in arrears” management systems and resources. And action is then required in the form of both working with borrowers to find effective ways out and wholesale efforts to deal with legacy assets, including removing them from the balance sheet for which improved transparency can help to improve price discovery whilst effective incentives for banks’ management can spur action.
That does not mean that policymakers should ignore structural factors. They truly are key—a combination of more appropriate tax and legal regimes combined with steps to improve price discovery through greater transparency and uniformity of data is vital. And there are clearly other equally pressing issues in banks’ plans to return to sustainable profitability and maintain lending in the real economy. Reduced uncertainty along with increased transparency in their operating environments, including regulation and supervision, are one. Dealing with the emergence of financial technology and carving out the key role that banks can continue to play is another. But dealing with legacy assets is pressing right now, and action is possible and vital.