A banking revolution may open up possibilities

To put everything in perspective in a nutshell, it doesn’t seem likely that the stock of non-performing loans (NPLs) in the Cyprus banking system will be worked down to manageable, and economically sustainable, levels any time soon, via conventional or rationalised management.

It doesn’t seem at all likely, either, that large portions of debt can be sold off at prices which would not jeopardise banks’ solvency, at least in the foreseeable future. And the pressures are, and will keep on, mounting. To re-cap:

- The slow improvement in the reduction of NPLs, has led the recent EU mission to Cyprus to recommend “more forceful loan restructuring efforts, notably by making full use of all available tools, in order to accelerate the pace of NPL reduction”

- Moreover, as the mission has noted, “the prevalence of restructurings of already restructured loans suggests that the quality of restructuring solutions needs to be further enhanced”. The re-default rate of restructured loans appears to be around 28% as per the latest statistics published by the Central Bank of Cyprus, but this percentage is not further broken down into a vintage analysis to assess how the older, more mature, restructurings are behaving

- Provisioning is still on the low side, given that the local banking coverage average is below that of the EU. Inadequate provisioning invariably gives rise to large pricing gaps between potential buyers and potential sellers of loans

- Corporate governance issues and cultural impediments may not afford a bank the flexibility in restructurings or resolutions that would be needed to make a substantial impact on NPL reduction and on debt servicing sustainability over the longer term

- Banks’ profitability is under severe stress by pressure on net interest margins and the need for additional provisioning

- Competition for the few healthy borrowers, in combination with the undisputable excess capacity of the local banking sector, is intensifying and is further pressing interest margins down whereas, as experience has repeatedly shown, it increases the risk of more lax credit standards and a possible new round of lower quality loan granting

- Repeated waves of regulation do not leave much breathing space to banks.

It is for these very or similar reasons that there has been much recent talk, among the European Central Bank, the European Banking Authority and the European Stability Mechanism, about the benefits of the set-up of a Europe-wide or, at the very least, local Asset Management Companies (AMCs) to deal with what is seen as excessive and nonmanageable NPL stocks. For clarity’s sake, it is reminded that this ‘non-manageable NPL stock’ is equal to 5,1% on average across the EU, with only 7 countries reporting double digit percentages, all of which are mostly well below 20% (apart, of course, from Cyprus and Greece which exhibit official figures in the high forties).

“History has proven that AMCs can swiftly clean up NPLs from bank balance sheets and resolve them over a longer period of time”, says Vitor Constancio, Vice-President of the European Central Bank. Andrea Enria, chair of the European Banking Authority, firmly believes that “without a European AMC, the lending function of the region’s banks will be impaired for a longer period of time than it would otherwise be”. The chairperson of the Single Supervisory Mechanism, Daniele Nouy, says, on the other hand, that an AMC “is not a panacea”. It can nevertheless undoubtedly “allow [precious] time for a smoother and longer resolution of bad loans, preventing in the process fire-sale pressures for banks”, until circumstances are mature for the sale of debt which will at least keep banks in a capital-neutral position.

The concept is simple and has served certain countries well in the past few years – Ireland, Spain, Slovenia, Hungary, Sweden, Malaysia, Indonesia to name but a few. By segregating between the good and the bad loan portfolios, the bank keeps the bad assets from contaminating the good. AMCs bring economies of scale, which may help banks, smaller ones in particular, to resolve problem loans by introducing specialisation and sufficient resources, reducing the fixed cost of debt resolution and increasing at the same time the efficiency of recoverability (IMF Staff Discussion Note, A Strategy for Resolving Europe’s Problem Loans).

And the split between good and bad loans brings in much clearer strategic direction and focus, accountability, responsibility and rigour in the servicing and management of distressed loans, the modus operandi of which is entirely different compared to normal core banking business. “A bad bank should also function as a work-out bank, which resolves the over-indebtedness of borrowers”, says Klaus Regling, Managing Director of the European Stability Mechanism.

But while the idea is simple, the practice is quite complicated. And in most cases, the state has taken central role in the establishment and financing of AMCs. Indeed, Enria suggests that “you cannot deal with NPLs in a speedy way without the public sector”. Which brings us to two major and possibly insurmountable problems, namely

- a. the state’s financial / fiscal capacity to undertake such a pivotal role, and

- b. constraints resulting from, rules.

So then, what can we expect next from our banks? What actions can they actually take to maximise their chances of survival? Is the rationalised approach taken to date enough to do the trick? Can they continue juggling with all these airborne “balls” or will the “balls” all come tumbling down upon the banks with a bang?

In all honesty, it is not at all clear how the show can go on for much longer despite our banks’ best intentions and valiant efforts. Banks cannot afford to absorb sizeable chunks of real estate property in debt to asset swaps nor can they really take the bull by the horns unless they make bold moves to counterbalance and reduce, in justifiable cases and in a fair and equitable way, the excessive-cum-unsustainable indebtedness of corporates and households alike.

Indeed, it is high time that our banks stop rationalising and start debating more radical and revolutionary ways, which may better sustain them in the medium to long term future. Accordingly, each bank’s peculiarities and appetite will ultimately drive the individual strategies they will follow.

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alia, EU

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