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A European Bad Bank – a necessary tool for financial stability?

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Director of the EY Financial Stability Chair at University of Navarra

Andrea Enria’s recent comments in the Financial Times fanned the embers of the idea of a pan-European Asset Management Company, more commonly referred to as a European bad bank. Mr Enria promoted the idea as a possible tool for strengthening financial stability across the Banking Union’s banking sector.

There is much merit in having a system in place in order to ‘stop the rot’ and weed out non-performing loans (NPLs), and in order to separate viable loans from non-viable ones. It would allow for a clearer picture of the state of EU banks’ balance sheets, and, if managed correctly, could encourage banks to deal with their potential NPL issues in good time. So, the idea of a bad bank is not without merit. However, is it a case of closing the stable door after the horse has bolted? Could we stop the rot of NPLs earlier on and so deal with them more efficiently?

As with many simple ideas, the devil is in the detail. Should European policy-makers spend their time pursuing the idea of a bad bank, or should they concentrate their time and resources on other areas instead? After all, a European bad bank, or even a network of bad banks, will not make losses disappear. The losses, or non-performing loans, transferred to a bad bank will still exist, although some would argue more cheaply.

However, to my mind, pinning all our hopes on bad bank as the solution every time the financial sector hits rocky ground is like putting our focus on the cure rather than prevention. The old adage of ‘prevention is better than cure’ is certainly the better option when it comes to dealing with NPLs. Banks must have risk management structures in place. Another old saying we could use is that ‘a stitch in time saves nine’ – it is vital to deal with potential bad loans early on in the process.

This is even more important in a Europe where there are so many different legal systems facing cross-border groups. In one region, courts may give a great deal of flexibility to both banks and the borrower to work things out, while the time delay in another region could be significantly shorter. While this is not ideal, there are no signs of these differences being resolved in the short to medium term. Working things out between the borrower and the bank is always the most efficient solution. When this is possible, both bank and borrower benefit and often NPLs can be avoided and value preserved. The sooner banks can engage with the borrower, the better. When NPLs cannot be avoided, the message for banks is that the sooner they provision adequately for NPLs, the better. And, to quote the SRB Chair, Elke König, “adequate provisioning has never done any harm”.

Another question about a European bad bank relates to ownership. Who would own it? Would the taxpayer have to step in and fund the new body if it cannot turn a profit? Would these losses, especially those incurred because of Covid-19, be funded by the taxpayer, now that state-aid rules have been relaxed for the time being? To my mind, only the loans least likely to be repaid would be transferred to the bad bank, but how would we determine the price? If the price is not attractive enough, banks might keep their NPLs. If the price makes sense for a private bank, would it make sense for a publicly owned bad bank? The whole purpose of setting up the Banking Union was to put an end to public subsidies for private risk and to move away from the idea that taxpayers’ money is nobody’s money. Importantly, we need to recognise that there are some asset classes more suitable for debt restructuring than others. Pooling 10 failed coffee shops does not create synergies in the way pooling a real estate portfolio does.

That being said, the idea of a network of smaller asset management companies (AMCs), that are not publicly funded could be part of the solution. The Commission, in its recent publication on NPLs showed a level of optimism, which I share, on a network of national AMCs to be privately funded. There are possible benefits to a European network of privately funded bad banks, such as a joint data hub, cross-border cooperation, as well as for sharing best practice and information.

Coming back to my earlier point about protecting the taxpayer, I would caution against solutions that rely on government funding options (e.g. an AMC with state aid) and particularly against the sensitivities and strict conditionality that apply when precautionary recapitalisation is used. Permanent losses in the context of NPLs are likely, which puts into question the precautionary spirit of those measures. Furthermore, it is difficult to reconcile an Impaired Asset Measure with the types of government funding permitted under Art. 32 BRRD in order to avoid the failing or likely to fail process. Against this backdrop, private funding options should be preferred.

To me, the success of the AMC hinges on its scope of application. Concretely, the AMC’s size, suitable asset classes and the geographical coverage are critical success factors. The broader the scope, the greater the questions about how it would be managed in practice.

So, to conclude, it is difficult to justify the idea of a publicly funded and central European bad bank, but when combined with banks implementing appropriate risk assessment measures, a smaller network of national, but privately funded, bad banks may be part of the solution. This is something that will no doubt be the subject of much more debate in 2021. NPLs are going to rise in the coming quarters as the effects of rolling back Covid-19 supports begin to be felt across the EU.

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Antonio Carrascosa
Director of the EY Financial Stability Chair at University of Navarra

Antonio Carrascosa is Director of the EY Financial Stability Chair at the University of Navarra, Spain. He was an SRB Board Member from 2015 to 2020, following three years as Director-General of FROB, the Spanish national resolution authority. He is an economist with a degree in public administration and has held a number of high-level...

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