Europe’s dirty secret - SLI says time is now to resolve the legacy of non-performing loans

Resolving the legacy of non-performing loans (NPL) is critical to the recovery of bank credit, investment and economic growth in Europe, according to Edinburgh-based investment firm Standard Life Investments.

While the tackling of the NPL issue is not a new area of policy in Europe, SLI says it is now time to grasp the nettle.

To date, however, the strategies used to deal with the problems have largely been idiosyncratic and have not been consistently applied.

This is contrary to the direction of EU banking regulation, which is aimed at a full banking union.

Work to address the NPL issue at a European level has increased over the last 12-18 months. This includes working towards a common definition of an NPL, specific guidance to banks on tackling NPLs, and proposals to modify insolvency frameworks aimed at facilitating the restructuring of bad debts.

This issue becomes more complicated when the NPL problem is too large to deal with because the bank’s balance sheet is not strong enough to reach a viable solution without the use of public funds. In these circumstances, the Bank Recovery and Resolution Directive (BRRD) comes into play.

Andrew Fraser, head of financial research (credit) at Standard Life Investments, said: “The introduction of the Bank Recovery and Resolution Directive across Europe in 2015 and subsequent introduction of the bail-in tool from January 2017 has arguably increased the risk for investing in bank debt.

“This is especially the case when the authorities tackle an NPL problem using a market-based solution and the bank in question does not have access to sufficient capital to address the authorities’ concerns on its own.

“2017 has seen four banks fail; Monte dei Paschi, Banca Veneto and Vicenza Banca in Italy and Banco Popular in Spain, crushed by the weight of NPLs on their balance sheet and insufficient capital to offset higher losses.

“In each case, the outcome for subordinated bondholders was very negative, with prices falling by up to 80 points. This reflected the likelihood of zero recovery on an investment in their subordinated debt, although there has been no impairment in the value of the senior unsecured bonds issued by the failed banks.

“The bank failures this year have also raised questions as to whether there is sufficient clarity in the application of the regulatory rulebook. This can leave investors exposed to an uncertain outcome when a bank faces a resolution process.

“The risk of owning bank debt has increased materially. Investors more than ever need to fully understand the risks embedded in a bank’s balance sheet but also the thickness of each layer of a bank’s capital structure which could absorb losses in the event of distress.

“Our approach to bank research encompasses these factors and allows us to not only avoid weak banks at risk of resolution but also to take advantage of opportunities where the risks are exaggerated and valuations provide a good investment opportunity.”