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A Strategy for Resolving Europe’s Problem Loans

July 5, 2017 by Shekhar Aiyar, Wolfgang Bergthaler, Jose M. Garrido, Anna Ilyina, Andreas (Andy) Jobst, Kenneth Kang, Dmitriy Kovtun, Yan Liu, Dermot Monaghan and Marina Moretti

Persistently high non-performing exposures (NPLs) in several European countries pose significant challenges to financial stability and are likely weighing on credit growth and economic activity. This paper, which summarizes a detailed IMF analysis (IMF SDN/15/19), examines the structural obstacles that discourage European banks from addressing their problem loans. It argues that a comprehensive approach comprising three pillars is needed to accelerate balance sheet clean-up: (1) intensified banking oversight, to incentivize write-off or restructuring of impaired loans, including fostering more conservative provisioning and time-bound restructuring targets on banks’ NPL portfolios; (2) enhanced insolvency and debt enforcement regimes, and more developed out-of-court restructuring frameworks; and (3) the development of distressed debt markets by improving market infrastructure and, in some cases, using asset management companies (AMCs) to jump-start the market. A variety of facilitating measures could support these three main pillars, including better public registers, the removal of tax disincentives, and debt counseling services.

1. Introduction

Many European countries continue to grapple with large stocks of impaired assets almost a decade after the onset of the global financial crisis. The deep and prolonged economic downturn has weakened borrowers’ debt service capacity, particularly for those borrowers that were overleveraged, leading to an increase in loan defaults and large corporate and household debt overhangs. NPLs in the European Union (EU) stood at about €1.1 trillion (or over 9 percent of the region’s GDP) at mid-2016, more than double the level in 2009. Ten EU countries registered NPLs of ten percent or higher as of June 2016. A similar number of non-EU countries, mainly in central, eastern, and southeastern Europe (CESEE) experienced peak NPLs above that threshold[1]Differences in definitions complicate comparisons of NPL ratios across countries. The EBA introduced new definitions of non-performing exposures (NPEs) and forbearance in 2013, but their application … Continue reading. The NPLs are mostly concentrated in the corporate sector, notably in SMEs, which contribute almost two-thirds of Europe’s output and employment, and tend to be more reliant on bank financing than large firms.
High NPLs so many years after the crisis reflect the slow pace of restructuring, disposals, and write-offs, with only a handful of countries showing lower NPL ratios at mid-2016 compared with their post-crisis peaks. While economic conditions have gradually stabilized across Europe, NPL ratios continue to increase in some stressed economies, albeit at a slower pace. Given the need to support Europe’s still nascent recovery, quickly resolving NPLs to promote new lending is of first-order macroeconomic importance.

2. Macro-financial implications of high NPLs

NPLs influence bank lending through three interrelated key channels—profitability, capital, and funding. Bank profitability suffers because high NPLs require banks to raise provisions, which lowers net income, while NPLs carried on banks’ books do not usually generate income streams comparable to performing assets. NPLs, net of provisions, also tie up substantial amounts of capital due to higher risk weights on impaired assets. Deteriorating balance sheets increase banks’ funding costs due to higher risk and lower expected revenue streams. Together, these factors result in a combination of higher lending rates, reduced lending volumes, and increased risk aversion.
The data shows that euro area banks with higher NPLs tend to be less profitable, have relatively weak capital buffers, face higher funding costs, and lend less. Empirical analysis generates similar findings for a sample of CESEE banks. A growing literature on the macro-financial effects of NPLs finds a robust relation between higher NPLs and weaker credit and GDP growth, with causality going both ways. Banks’ reduced lending capacity undermines the growth prospects of viable firms, and is also likely to disproportionately affect SMEs that are more dependent on bank financing.
Persistent NPLs are linked to unresolved private debt overhangs. On average, the corporate NPL ratio and the level of corporate debt overhang are positively correlated. Corporate debt overhangs are also associated with weaker investment and delayed recoveries. Analysis using firm-level data shows that firms’ employment and investment decisions in response to positive or negative shocks depend on their level of indebtedness. Mutually reinforcing feedback loops exist between bank NPLs and excessive corporate debt. Overextended companies have little incentive to invest because returns must be allocated to debt service. This also implies that their demand for credit is weak, which further weighs on banks’ profitability and makes it more difficult for them to dispose of impaired assets. Thus, when NPLs are large and persistent, they are unlikely to be worked off through a normal cyclical economic recovery. Concerted efforts are therefore needed to address both NPLs and the private sector debt overhang to ensure that a large stock of distressed debt does not hold back growth.

3. Obstacles to NPL resolution

In 2015 two IMF surveys were conducted of European countries and banks[2]The “country survey” was completed by 19 countries (Albania, Bosnia and Herzegovina, Croatia, Cyprus, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Macedonia, Montenegro, Portugal, … Continue reading where the aggregate NPL ratio exceeded 10 percent during 2008–2014. These revealed some common themes on structural obstacles to NPL resolution. Deficiencies in the legal framework and underdeveloped distressed debt markets were the two most severe obstacles, but information, supervision, and tax regimes were also found to be lacking in several respects:
1. Prudential supervision. While bank capital buffers were found to be of medium concern, collateral-related issues registered as a medium or high concern. Many countries had begun to allocate more supervisory attention to impaired assets through asset quality reviews, but many banks lacked the expertise, capacity, or tools to deal with NPLs on a large scale, and time-bound operational targets for NPL reduction was rare. Accounting standards were found to weaken incentives to resolve NPLs due to several reasons, including application of an incurred loss approach; leaving too much room for judgment; lack of specificity on write-off modalities; accrual of interest income from NPLs; and lack of guidance on collateral valuation.
2. Legal obstacles. Although many countries had overhauled or upgraded their insolvency regimes, reforms have been uneven and progress slow. Prepack processes and out-of-court mechanisms were underutilized for corporates and there were no personal insolvency regimes in over one-third of surveyed countries. Worrying findings include the slow and inconsistent implementation of insolvency laws; the lack of effectiveness of, and delays with debt enforcement and foreclosure; and the poor efficiency of institutional frameworks (especially judicial systems).
3. Distressed debt markets. The survey found there are few explicit restrictions on sales of NPLs, yet distressed debt markets remain shallow or nonexistent. The impediments included incomplete credit information on borrowers; lack of licensing and regulatory regimes to enable nonbanks to own and manage NPLs; overvalued collateral and lack of liquid real estate markets; low recovery values, partly related to lengthy court procedures; and inadequate provisioning of NPLs. These factors contributed to large pricing gaps between potential buyers and sellers.
4. Informational obstacles. Rules preventing sharing of debtor information and limitations of asset registers and real estate transaction registers were seen as significant obstacles. Credit bureaus typically do not include crucial information for debt restructuring, such as tax payments, social security contributions, and payments to utility companies. Most credit bureaus do not have credit scoring for individuals or for SMEs and larger companies. Debt counseling services were also limited, with few countries offering budgeting or legal advice services for households, and less than half of countries providing credit management training and advice for SMEs.
5. Tax and other obstacles. Some countries impose restrictions on deducting provisions and charge-offs for income tax purposes, thus disincentivizing NPL reduction. Others lack loss carry-forward provisions (e.g. deferred tax assets); or subject debtors to capital gains tax upon debt relief. Debts that involve private and public creditors are often subject to specific problems including privileged (priority) claims of public creditors in debt restructuring; limits on debt relief by the public sector; and poor coordination between public and private creditors.
The different types of obstacles were found to be interlinked, with difficulties in one area compounding challenges in other areas. Empirically the survey-reported severity of structural obstacles tends to be associated with worse NPL outcomes.

4. Tackling high NPLs

A comprehensive strategy for NPL resolution in Europe would combine more robust supervision, institutional reforms to insolvency and debt enforcement regimes, and the development of markets for distressed debt. These measures should be supported by changes to the tax regime and reforms to improve access to information.
1. Supervisory oversight should be enhanced by: (1) issuing guidance on accounting treatment as in Ireland and Cyprus and recently by the ECB/SSM. The guidance should cover provisioning and write-off practices, it should halt accrual of interest for loans past a set delinquency threshold, and introduce time-bound write-off requirements for uncollectible loans where legally allowed; (2) collateral should be subject to enhanced supervisory scrutiny to ensure accurate valuations (reflecting changes in market conditions, cost of sale, and delays in realizing proceeds) and require periodic valuation by independent experts; (3) micro- and macroprudential measures should be applied as necessary, such as time-bound targets for resolving NPLs and increasing risk weights according to NPL vintage; (4) banks with NPLs above a set threshold (e.g. 10 percent) should be subject to more intensive oversight including significantly enhanced quarterly reporting requirements and be required to develop an internal NPL management strategy, which includes ambitious operational targets for NPL reduction; and (5) strengthening the regulatory and sanctioning toolkit, including introducing a code of conduct for borrower engagement.
2. Insolvency and debt enforcement. The legal framework should consist of both legal tools designed to facilitate speedy in- and out-of-court solutions and an adequate institutional framework (including courts and insolvency practitioners) to support the consistent, efficient, and predictable implementation of the laws. Improvements should include: (1) facilitating the rapid exit of nonviable firms and the rehabilitation of viable firms and a fresh start for good faith entrepreneurs within reasonable time periods; (2) out-of-court frameworks with hybrid and enhanced features (e.g., stay on creditor actions, majority voting, mediation or arbitration, or a coordinating committee); (3) simplified debt enforcement and foreclosure processes (e.g., to clearly specify enforceable titles, limit appeals, set short preclusive deadlines, and to introduce e-auctions platforms) to enable swift process. (4) strengthen the judicial system by increasing the specialization of judges, rationalizing fees and introducing performance measures for professionals. (5) eliminate super-priority claims for public debtors, introduce caps on public claims, and provide guidance to public creditors to allow them to participate in and be affected by debt restructuring; (6) aim for convergence of insolvency regimes across Europe; and (7) unify and enhance data collection on insolvency and enforcement processes to enable adequate comparisons and proper assessments.
3. External NPL management and distressed debt markets should be enhanced by: (1) enabling specialist NPL servicing and legal workout agencies to participate through a licensing and regulation regime for nonbanks. (2) improving access to timely financial information on distressed borrowers, collateral valuations and recent NPL sales; (3) facilitating structured finance transactions that remove NPLs from bank balance sheets, perhaps by involving European investment institutions to participate in securitization transactions; and (4) considering use of public and private special purpose vehicles (i.e. AMCs) to centralize creditor discussions, foster specialization, and exploit economies of scale. Public AMCs would need to have strong governance and be compatible with the EU’s state aid rules.
4. Additional supportive measures should include: (1) centralizing and improving public registers. Credit registers should include arrears to utilities and tax and social security authorities and asset registers should contain sufficient information to accurately assess wealth. (2) debt advisory services should be introduced so debtors are well informed and confident to engage with creditors. Households should have access to free or subsidized budgeting and legal advice services and SMEs should have access to credit management training. (3) real estate transaction prices should be published on a website. (4) tax rules should be reviewed and amended to encourage creditors to provision, write-off, and sell collateral and encourage debtors to accepting debt restructuring or write-off deals.

In cases where NPLs exceed a systemic threshold, governments should consider establishing a coordination mechanism, such as a ministerial council. The mandate should be to fully diagnose the obstacles to NPL resolution, set reform priorities, and ensure that all stakeholders are clear on their role in implementation. A coordinated public communications strategy as well as a dedicated project management office would help ensure effective implementation.

6. Conclusion

Reducing the level of impaired assets is essential for restoring the health of the banking sector and supporting credit growth in Europe. High NPLs hold back credit supply by locking up capital that could be used to support fresh lending. Low provisioning and write-off rates hinder necessary corporate restructuring and prolong the debt overhang, depressing credit demand. Given that impediments to NPL resolution are often interlinked, a comprehensive strategy is needed to address the NPL problem. Based on international experience, such a strategy should be based on three key pillars: (1) enhanced supervision, (2) insolvency and debt enforcement reforms, and (3) the development of a distressed debt market. Since European banks operate across multiple jurisdictions—both within and outside the euro area—a successful NPL resolution strategy will require close coordination between EU, euro area, and national competent authorities.


References

Aiyar, S., Al-Eyd, A., Barkbu, B., and Jobst, A. (2015a). Revitalizing SME Securitization in Europe. IMF Staff Discussion Note 07/15, European Department, International Monetary Fund, Washington, May 7.

Aiyar, S., Bergthaler, W., Garrido, J.M., Ilyina, A., Jobst, A., Kang, K., Kovtun, D., Liu, Y., Monaghan, D., and Moretti, M. (2015). A Strategy for Resolving Europe’s Problem Loans. Staff Discussion Note 15/19, International Monetary Fund, Washington.

Aiyar, S., Bergthaler, W., Garrido, J.M., Jobst, A., Kang, K., Liu, Y., Monaghan, D., Moretti, M., and Portier, J. (2015b). Policy Options for Tackling Non-Performing Loans in the Euro Area. Euro Area Policies: Selected Issues, IMF Country Report 15/205, International Monetary Fund, Washington, pp. 57–86.

Barkbu, B., Jassaud, N., and Kang, K. (2013). Strategy for Fostering a Market for Distressed Debt in Italy. IMF Country Report 13/299, International Monetary Fund, Washington, pp. 71–8.

Bergthaler, W., Kang, K. Liu, Y., and Monaghan, D. (2015). Tackling SME Problem Loans in Europe. Staff Discussion Note 15/04, International Monetary Fund, Washington.

European Commission. (2015). Building a Capital Markets Union. COM (2015) 63 Green Paper, European Commission, Brussels, February 18.

European Commission (2014a). Commission Recommendation on a New Approach to Business Failure and Insolvency. C(2014) 1500 Final, European Commission, Brussels, March 12.

European Commission (2014b). Study on a New Approach to Business Failure and Insolvency—Comparative Legal Analysis of the Member States’ Relevant Provisions and Practices: Annex 2 (Part 1: Confidential Proceedings). Tender No. JUST/2012/JCIV/CT/0194/A4, INSOL Europe, European Commission, Brussels.

Goretti, M., and Souto, M. (2013). Macro-Financial Implications of Corporate (De)Leveraging in the Euro Area Periphery. IMF Working Paper 13/154, International Monetary Fund, Washington.

Hagan, S., Kalter, E., and Weeks-Brown, R. (2003). Chapter VII: Corporate Debt Restructuring in the Wake of Economic Crises. In Managing Financial Crises: Recent Experience and Lessons for Latin America, edited by Charles Collyns and G. Russell Kincaid. IMF Occasional Paper 217, International Monetary Fund, Washington, April 10.

Ingves, S., Seelig, S.A., and He, D. (2004). Issues in the Establishment of Asset Management Companies. IMF Policy Discussion Paper 3/04, International Monetary Fund, Washington.

International Monetary Fund (IMF). (2013). Transition Challenges to Stability. Global Financial Stability Report, Chapter 1, International Monetary Fund, Washington, April.

Jassaud, N., and Kang, K. (2015). A Strategy for Developing a Market for Nonperforming Loans in Italy. IMF Working Paper No. 15/24 (Washington, D.C.: International Monetary Fund).

Liu, Y., and Rosenberg, C.B. (2013). Dealing with Private Debt Distress in the Wake of the European Financial Crisis: A Review of the Economics and Legal Toolbox. IMF Working Paper 13/44, International Monetary Fund, Washington.

Woo, D. (2000). Two Approaches to Resolving Nonperforming Assets During Financial Crises. IMF Working Paper No. 00/33 (Washington, D.C.: International Monetary Fund).

Footnotes[+]

Footnotes
↑1 Differences in definitions complicate comparisons of NPL ratios across countries. The EBA introduced new definitions of non-performing exposures (NPEs) and forbearance in 2013, but their application beyond the larger euro area banks has been uneven.
↑2 The “country survey” was completed by 19 countries (Albania, Bosnia and Herzegovina, Croatia, Cyprus, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Macedonia, Montenegro, Portugal, Romania, San Marino, Serbia, Slovenia, and Spain). The “bank survey” was completed by 10 banks (Alpha Bank, Intesa, NBG, Piraeus, Pro Credit, Raiffeisen, Societe Generale, Unicredit, Eurobank, and Erste Group). Both surveys were completed by June 2015.

From Issue 2017.1 - Proposals

About Shekhar Aiyar

Shekhar Aiyar is a deputy chief in the IMF's European Department. He has worked on a broad range of countries in Europe, Asia, and Africa. His research interests include international macroeconomics, bank regulation, economic growth, and the role of luck in international cricket. He holds a PhD from Brown University.

About Wolfgang Bergthaler

Wolfgang Bergthaler is senior counsel at the International Monetary Fund’s Legal Department, where he works on a broad range of legal issues including IMF financing operations, surveillance, exchange system, and financial sector issues, as well as sovereign debt, corporate and household insolvency, and judicial reform issues. Before joining the IMF in 2006, he practiced as an attorney in international law firms in Europe. Wolfgang is a graduate of Karl-Franzens Universitaet Graz (Austria) and Georgetown University Law Center (US).

About Jose M. Garrido

Jose Garrido is Senior Counsel in the IMF's Legal Department and coordinator of the Working Group on insolvency and creditor rights. He is a specialist in insolvency and debt restructuring, with ample comparative experience.

About Anna Ilyina

Anna Ilyina is a Division Chief (Poland-Baltics) in the European Department at the International Monetary Fund (IMF). Previously, she headed the Emerging Economies Division in the IMF’s European Department and was responsible for the production of the biannual Regional Economic Issues Report on Central, Eastern and Southeastern Europe. In recent years, she also worked on the IMF’s Global Financial Stability Report, on the IMF’s Early Warning Exercise and on a range of countries. Her research interests include growth and financial development, macro-financial linkages, international economics, financial stability and cross-border spillovers. She has publications in the Journal of Monetary Economics and in the Journal of Money, Credit and Banking, among others. She holds a Ph.D. in Economics from the University of Pennsylvania.

About Andreas (Andy) Jobst

Andreas (Andy) Jobst is Adviser to the Managing Director and Chief Financial Officer of the World Bank Group. Until 2016, he was Senior Economist at the International Monetary Fund (IMF), where he was responsible for monetary and financial sector policy of the Euro Area. Previously, he was as Chief Economist and Deputy Director (Supervision) of the Bermuda Monetary Authority (BMA). Mr. Jobst holds a Ph.D. from the London School of Economics.

About Kenneth Kang

Kenneth Kang is an Assistant Director in the European Department of the International Monetary Fund, heading the Advanced Economies division. He has worked on a broad range of countries, most recently on Italy and Japan. He also served as the IMF’s Resident Representative in Korea during 2003-06. He has a PhD from Harvard University.

About Dmitriy Kovtun

Dmitriy Kovtun is a Senior Economist at the Western Hemisphere Department of the IMF. After joining the IMF in 2004, he worked in the African, Strategy and Policy Review, European and, currently, Western Hemisphere Departments. He holds a PhD in Economics from the University of Kentucky (Lexington).

About Yan Liu

Ms. Yan Liu is Assistant General Counsel in the Legal Department of the International Monetary Fund. In this capacity, she supervises the work of the Legal Department on the development and implementation of polices on sovereign debt restructurings. She leads a team of lawyers providing advice on private sector debt resolution with a focus on corporate, household and SME insolvency reform, enforcement of creditor rights and nonperforming loan resolution. Ms. Liu also supervises the Financial Integrity Group of the Legal Department that deals with anti-money laundering and combating the financing of terrorism, tax evasion and anticorruption issues at both the policy and the individual member country level in the context of the IMF’s surveillance, program and capacity building activities. Finally, she oversees the Legal Department’s work on the development and implementation of capacity development (technical assistance and training) strategies and policies. Prior to joining the IMF Legal Department in 1999, Ms. Liu was in private practice at Fried Frank Harris Shriver & Jacobson and Milbank Tweed Hadley & McCloy in the United States. A native of China, Ms. Liu received her legal education in China and the United States.

About Dermot Monaghan

Dermot Monaghan is a senior financial sector expert in the Monetary and Capital Markets Department of the International Monetary Fund. He has worked on a broad range of financial crisis related issues, mainly in Europe and Asia. Previously he worked as Chief Risk Officer, in the Department of Finance in Ireland, and before that he worked at the Central Bank of Ireland, a large German bank, and an Italian hedge fund. He has a PhD from Queen’s University Belfast (UK).

About Marina Moretti

Marina Moretti heads the Financial Crisis Preparedness and Management Division in the IMF’s Monetary and Capital Markets Department. Since joining the IMF in 1999, she has focused on crisis management and regulatory policy issues, and led Financial Sector Assessment Program missions in several countries. She was a member of the Financial Stability Board secretariat between 2008 and 2010.

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