Banks in US, Europe manage to contain NPL scourge

How banks in the US and EU managed to tackle the NPL issue in the wake of the Financial Crisis is a lesson worth learning for the Indian banking system:

Tackling non-performing loans (NPLs) - here in India we call them NPAs, or non-performing assets - is not just a regulatory problem to address for banks in the US and Europe but is a question of managing the balance sheets and increasing profitability. In earlier days effective handling of NPLs would mean efficient management of loans but in the banks in these countries, this concept has been replaced by sound management of exposures. This would in effect ensure better interest income as rates charged on new businesses would substitute for the lower earnings from NPLs. Besides, there would be lower funding cost or lower capital requirements resulting from reduction in NPLs.

Banks, both in the US and Europe, are known to have developed a clear strategy to tackle NPLs and derive the aforesaid benefits. This strategy broadly covers assessment of internal capabilities and resources within the bank concerned and an external assessment of the market condition. Besides with countries introducing the new accounting standard of IFRS 9, banks have better provisioning rules that can take care of recognition of losses. The strategy also includes a time-bound as well as realistic targets and takes into consideration changes in the Risk Weighted Assets and other important implications.

Risk management experts have advised that an internal assessment of the pros and cons of the bank holding the impaired asset should be carried out and a decision must be arrived at whether there is any benefit in disposing the NPLs or whether there is an ‘on-balance sheet’ solution.

A REVERSAL NOW

Most of the big banks in the US, which have successfully recovered from the financial crisis and straightened their operations and have been reporting profits, are of late finding that their commercial lending portfolios have been deteriorating for the first time in nearly 3 years. They are worried now that their NPLs may even rise by 20%, or $1.6 billion, in the first quarter. This is for the first time that these banks have seen a reversal of a continuous improvement in credit quality since 2016. The major reason for this has been ascribed to the defaults by several major borrowers following the crash in oil prices. JPMorgan Chase alone has an estimated $1.9 billion of commercial NPLs out of its $442 billion portfolio. Mind you, US banks have a total of $2.3 trillion in commercial loans, according to the Federal Reserve.

In 2018, just 1.02% of the loans that banks in the US held were non-performing. This means that 99% of loan recipients were repaying their bank back at that time, which is a significant improvement from the 5.3% of non-performing loans in the aftermath of the financial crisis.

LOW-INTEREST REGIME IN EU

Meanwhile, it has not been the easiest of times for Europe’s banks. A low-interestrate environment in the region had badly dented their profitability, and in an increasing number of cases, they are being forced to pass on this burden to their customers by charging negative rates on corporate savings and household deposits. A recent survey by Deutsche Bundesbank found that nearly 60% of German banks are charging negative interest rates on the deposits of their corporate clients, and 20% of banks are doing the same for retail customers.

However, European banks have seen significant reduction of their bad loans, which stand at their lowest levels since the financial crisis. It is estimated that almost half of the toxic debt that remained on European Union (EU) banks’ balance sheets has been cut in the last 4 years alone, according to the latest data from the European Banking Authority (EBA). EBA had done an assessment of 150 EU banks accounting for more than 80% of the banking sector’s total assets. NPLs throughout the EU are now placed at 636 billion, equivalent to 3.1% of the total loans, which is sizably lower than the 1.15 trillion recorded in June 2015 (or 6% of total EU loans at the time).

GOVERNMENT,REGULATORSHELP

EBA in its assessment says the improvement has been on account of supervisory attention and political determination to address the NPL issue effectively, coupled with banks’ efforts to enhance their NPL management capabilities. Besides, the EU region as a whole has shown positive economic growth, remained low interest rate regime and seen lesser levels of unemployment. But EBA is not happy with the bad loans situation which is critical in some countries like Greece and Cyprus. However, Cypress could register a 29.3% reduction in its NPLs during December 2014-June 2019, to 21.5%, followed by Portugal and Italy, which both managed a 9.1% reduction to 8.9% and 7.9% respectively. But, Cyprus’s NPL coverage ratio increased by 15.2% to reach 45.9%. In June 2019, only Greece and Cyprus had NPL ratios in double digits - 39.2% and 21.5% respectively. Among the other countries which have greater than 5% of NPLs in the EU are Portugal, Italy Bulgaria, Croatia, Hungary and Slovenia.

EBA says there are significant ongoing initiatives that aim to further boost the reduction of legacy assets both at the EU level and in specific countries and in many cases, it has been on account of government assistance that these reductions have happened. It points out the case of Cyprus, which it said has achieved its substantial NPL reduction thanks mainly to its banking sector undergoing a major restructuring - basically the Estia Scheme, which aims to boost borrowers’ ability to repay their mortgages rather than defaulting, with the government subsidizing part of the repayment amount of the restructured loan. Similar is the case with Italy, which has seen Europe’s worst distressed loans. According to S&P Global Ratings, the country’s nonperforming exposures have declined from just under 350 billion in 2015 to around 150 billion by the end of 2019 second quarter. Much of this shedding can be attributed to the securitization of bad loans, whereby Italian banks have repackaged their debt and sold it off to investors. The government of the country has introduced the CAGS guarantee scheme, which allows banks to obtain a state guarantee to back the less risky portions of the repackaged debt, which in turn boosts the debt’s profile for potential buyers.

IRELAND’S PROPERTY CRASH

In Ireland, banks have managed to drastically reduce their toxic debt that resulted from the country’s disastrous property market crash some 10 years ago. Improved market conditions and regulatory changes have helped Irish banks in their efforts to sell large chunks of their bad loans, mainly to nonbanking entities, and thus restructure their balance sheets. By July 2019, Irish banks have sold 6.2 billion of loans, and between December 2014 and June 2019, the NPL coverage ratio had fallen by 15.5% to 27.2%.

EBA is, however, keenly following the operations of EU banks. It did a survey in November 2019 covering 131 banks and found that profitability across the sector dipped to 7% on average in the 12 months to the end of June. This is 0.2% lower than a year earlier. It has ascribed the low profitability t o a de t e r i o r a t i ng macroeconomic environment, coupled with low interest rates and intensifying competition from both banks and fintech firms. It says this will continue to be a pressure on the bank profitability in the region.

According to data i ssued by the European Commission, the NPL levels in banks operating in the EU region are continuing their downward trajectory towards pre-crisis levels. The ratio of NPLs in EU banks has come down by more than half since 2014, declining to 3.3% in the third quarter of 2018 and down by 1.1 percentage points year-on-year. This has been largely due to the regulator’s ongoing efforts to make the banking sector even stronger. The banks in the region are now better capitalized and better prepared to withstand economic shocks. There is also a new robust framework to regulate and supervise banks. However, despite clear improvements, high ratios of NPLs do remain a challenge in some member states. But this should not be a worry as an Action Plan by EU to tackle high levels of NPLs is yet to be fully implemented. Once this is accomplished the Commission believes the NPLs will come down significantly. The Commission has called on co-legislators to quickly agree on its proposed measures around the benchmarking of national loan enforcement and insolvency frameworks and to develop a sharper focus on insolvency in the European Semester process.

SLOWER RECOVERY

Sweden’s central bank, Sveriges Riksbank, in one of its recent reports, maintain that compared to the EU, US banks have been able to tide over the crisis swiftly. It says: “There are several perceivable reasons for why the recovery has been slower in the EU. One important reason is that the EU, at the time of the financial crisis and in contrast with the US, had no common bank supervision. All European banks were under national supervision, with different sets of regulations to follow. There was no common definition of bad loans in the EU, or clear rules for dealing with the bad loans once they had arisen. This has enabled troubled European banks to defer the problems and hence avoid addressing their bad loans on a continual basis. In the US, even before the crisis, more uniform bank supervision and relatively strict regulations were in place. This allowed many of the problems that emerged in

Europe to be avoided. For instance, in the US there were clear rules setting out when, at the latest, bad loans must be written down in their entirety, and rules for the valuation of underlying collateral. There are also differences in the taxation system compared with European countries, which give banks in the US stronger incentives to manage their bad loans at an early stage.”

In the case of the UK, NPL ratio stood at 1.1 % in December 2018, compared with the ratio of 0.7% in the previous year. The ratio has reached an all-time high of 4% in December 2011 and a record low of 0.7 % in December 2017.

FALLING NPL IN US

Coming back to the NPLs of US banks, while studies claimed consumer and commercial debt hit record highs, charge-off and delinquency rates remained at low levels. The total NPLs of US banks stood at an absolute value of $90 billion at the end of Q3 2018. The number has been falling and is way down from $375 billion at the end of Q1 2010. However, not all NPLs are considered losses because there is recovery of at least some assets particularly for secured loans.

One significant event in the banking domain in the US was the January 2019 bankruptcy filing by PG&E, the California utility facing liabilities associated with its role in the state’s wildfires. Bank of America, JPMorgan Chase and Wells Fargo were the big banks which had exposure in the utility - estimated to be around $3 billion.

CANADA BANKS STRONG

Canada had an average NPL value of 0.67% during 2005-2017 with the minimum value at 0.42% in 2006 and maximum value of 1.27% in 2009. This reflects the health of the banking system in the country. The country’s top 5 banks have continued to perform strongly with the housing market buoyant and growing demand for credit. However, in recent times, rising household debt levels and elevated housing prices have made the economy more vulnerable to external risk factors and individual households unable to absorb external economic shocks. There is also growing unemployment in the country and higher interest rates are impacting credit offtake. These factors may have significant impact on the financial performance of the top 5 banks in the country and possibly NPLs may go up in future.

NPL AND BAD BANK

When issues relating to NPLs are being discussed, it is pertinent to understand the concept of Bad Bank. Several countries have set up bad banks with the purpose of buying bad loans or non-performing assets of other banks/financial institutions, which these institutions are not able to recover. After taking the bad loans, bad banks try to recover the amount by using various recovery methods. The original bank, after transferring the assets to the bad bank, will be able to clear their balance sheets. The most recent instance of a bad bank operation is Deutsche Bank’s transferring its ailing stock trading business worth 75 billion risk-weighted assets to a bad bank.

The first instance of a bad bank is Grant Street Bank, which was created in 1988 to house bad assets of the Mellon Bank, which in turn became the first bank for using this strategy. Grant Street Bank then, got hold of bad loans of Mellon Bank worth $ 1.4 billion. It was dissolved in 1995 after it repaid the amount of all bondholders and met all its objectives.

PROS AND CONS

There are both advantages and disadvantages in creating bad banks. Among the advantages are a bank can by segregating the bad loans from the other loans, keep NPLs away from contaminating good ones. Likewise, a bad bank can fully