The European Central Bank has just announced further steps for dealing with non-performing loans in response to continuing excessive levels of old debt in bank balance sheets. Critics are wondering whether banks are being given too much leeway with problem loans because supervisors aren’t setting generally binding rules.
But on closer inspection the new rules have a lot more bite than it seems at first glance. The ECB expects that in the medium term, full risk cover will be achieved for every non-performing loan after seven years at the latest — and far earlier than that for unsecured loans.
The economic crisis has left a tough legacy for some banks in the euro zone. Non-performing loans, or NPLs as they’re known in the industry, remain a burden on balance sheets even though the economy has recovered. To be sure, there has been appreciable progress in recent years. But even though the average share of non-performing loans at large banks in the euro zone has fallen by more than a quarter since the end of 2015, debt levels remain far too high.
In addition, the reduction isn’t happening at the same pace everywhere. The average NPL ratio remains in the double digits at big banks in around a third of euro countries. We can’t content ourselves with that.
That is why the ECB created a comprehensive supervisory framework for NPL. It already outlined in March what risk provisions it expects for new problem loans. In doing so, it limited the future increase in risk. The ECB last week announced what it expects from banks in terms of reducing the risks for existing problem loans.
Why the rules work
These new requirements are the missing piece of the puzzle in the overall strategy to cut NPL, and they have three main strengths.
Firstly, the requirements are ambitious. They aim to reduce the risks from bad loans at all banks under direct European supervision over a foreseeable period of time. And all countries involved support this.
Secondly, the requirements are flexible. The ECB has opted for bank-specific expectations to deal with the stock of NPL.
There’s a good reason for this: The distribution of bad debt doesn’t just vary greatly among countries, but among individual banks as well. A bank whose loan portfolio has only a small percentage of bad debt needs a different strategy and timeframe from one that’s starting out with a ratio of 40 percent or more. With a uniform plan, the one bank would be under-stretched and the other overstretched.
The bank-specific approach means that the weakest banks won’t dictate the pace. All banks must fulfill the expectations set for them – if they don’t, the supervisory authority will take strict action.
Thirdly, the requirements are consistent. Despite all the necessary flexibility, they make sure that comparable demands are placed on similar banks.
The approach is therefore bank-specific but comparable across the banking sector. Banks with the same conditions are treated equally. The requirements are also consistent in their outcome. Over the medium term, the aim is to arrive at the same level of risk provisioning for the stock of bad debt as for newly emerging problem loans — resulting in full risk cover. This consistent treatment of all non-performing loans is essential for ensuring that the reduction in bad debt isn’t dragged out.
Ambitious, flexible, consistent. The new requirements form a firm foundation for the ECB’s treatment of non-performing loans. Responsibility for finding the best strategy for reducing the risks remains with the banks.
The ECB can’t be expected to come up with one generally applicable rule because it doesn’t make laws — it only implements legal requirements on a case-by-case basis. But it keeps on putting its finger on the wound to make sure that risks keep getting reduced.
The new rules are an effective way to drive forward the reduction in bad loans left over from the financial crisis. This is also decisive for the development of the European banking union. Only if we succeed in reducing debt risks can we create the conditions over the medium term for a backstop for the Single Resolution Mechanism and finally also for a common European deposit guarantee scheme.
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