Across the globe, businesses and people are attempting to fight the COVID-19 pandemic. The banking sector is no different. Banks have offered payment breaks to customers to attempt to ease cash flow concerns. In turn, central banks and regulators, including the European Central Bank and Federal Reserve have implemented measures to try to give banks comfort. They have also allowed for flexibility in liquidity buffers and State aid rules. The health of the economy and the health of banks are inextricably linked. However, an increase in non-performing loans (NPLs) will have a destabilising effect on banks. We consider options for dealing with NPLs. We also examine whether a Eurozone “bad bank” is the solution or if there are other national solutions for Member States.
Why are NPLs a concern for banks?
Since the financial crisis of 2009, there has been an increased focus on strengthening the banking sector. Irish banks are subject to stricter requirements than our European neighbours. Banks must set aside a certain amount of cash and capital reserves to cover potential losses due to NPLs. There has also been a greater focus on improving the asset quality of banks.
This means that banks’ time and money has been poured into dealing with loans that do not generate any returns. The necessity to set capital aside against possible NPLs reduces the capital banks have to lend. This affects the amount of credit banks can give to companies and individuals and this, in turn, impacts the economy and labour market.
How have the Irish banks sought to deal with NPLs?
Over the last number of years the banking sector has been working to build resilience and strength in order to better absorb economic shocks. In addition to the Irish “bad bank” NAMA, Irish institutions have all completed EU mandated deleveraging projects. Other Member States have also set-up domestic asset management companies or “bad banks” like NAMA to deal with NPLs.
The good news is that the Irish banks are better capitalised now than during the last economic crisis. Loan to deposit ratios are much stronger. The average NPL ratio across the banks has been substantially reduced from an average of 17% in 2016 to around 5% at the end of 2019.
A wave of NPL sales and securitisations has resulted in the development of a strong and competitive secondary market for NPLs. The asset classes that have been traded have evolved from commercial real estate and SME loans to residential property loans. In recent times the main Irish banks had even started buying portfolios of performing and re-performing loans in order to boost their asset quality and NPL ratios.
What measures have Irish and European banks taken as a result of COVID-19 so far?
Irish banks and certain retail credit and credit servicing firms introduced three breaks on mortgages, personal loans and business loans for some business and personal customers affected by COVID-19. Over 65,000 mortgage payment breaks and over 22,000 SME payment breaks have been processed and the initial three month period has been extended to six months.
In turn, a number of measures have been introduced to give comfort and flexibility to banks to enable them to assist businesses and households in the current climate:
The European Central Bank (ECB) announced on 12 March 2020 that banks can fully use capital and liquidity buffers to continue to finance households and corporates experiencing temporary difficulties. In Ireland this allowed the Central Bank to reduce the countercyclical capital buffer from 1% to 0% making available €1 billion of capital to provide credit and facilitate loan restructurings
The EU-wide stress test has been postponed to allow banks to prioritise the management of their own loan books and the ECB has also said it will be flexible on NPL reduction targets, and
The European Commission, on 28 April as a “quick fix”, said it would offer flexibility to banks in how they calculate and set aside provisions for bad loans. It also introduced amendments to the Capital Requirements Regulations which will free up capital relief to support extra lending. The new amendments also include flexibility on the implementation of IFRS 9 and changes to leverage ratio requirements. This triggered a small recovery in the share price of AIB (20%) and Bank of Ireland (10%)
What does this mean for Irish banks and NPLs?
For the last number of years, the Irish banks have struggled for profitability largely due to the “lower for longer” interest rate environment. These pressures will be exacerbated by the COVID-19 pandemic.
Even allowing for the “bounce factor” experienced in Irish bank shares following the stimulus measures, the stock market has wiped huge values off Irish bank shares. Indeed, the share prices in the Irish banks have been hit harder than their European counterparts. The ratings agency, Standard & Poor’s, put AIB, Permanent TSB and Bank of Ireland on a “watch list” for a potential credit downgrade. The profitability prospects of Irish banks are seen to be weak given the potential impact of the pandemic.
Over 45,000 Irish employers have declared a probable decrease in turnover by at least 25% due to the pandemic and have availed of the Government’s COVID-19 temporary wage subsidy scheme. State subsidies cannot continue indefinitely and certain companies will fail. As a result of this and the agreed payment breaks, banks will receive fewer payments from customers.
The European Banking Authority has made it clear that it is supportive of payment breaks but it has also stated that after the moritoria, banks should carefully assess the credit quality of loans and identify borrowers that are unlikely to pay. Therefore, any further payment breaks may well require additional provisioning by banks as additional payment breaks are not guaranteed to be exempt from standard default provisioning. Given the economic situation and the rise in unemployment, this is likely to result in a rapid rise in NPLs.
As we emerge from lockdown the economic future is one of a deep recession. The difficulty is that no one knows how deep that recession will be and what shape the recovery will take.
What we can predict is a severe spike in NPLs. There has been much debate at European level as to how prepared Member State banks are for such a surge in NPLs.
Banks will play a crucial role in the economic recovery from this crisis. To ensure a strong economy, we need strong banks. How can we ensure Irish banks are as healthy and sustainable as possible?
Are “bad banks” the solution?
The European Commission has summarised certain key operational factors that support a good "bad bank", each of which go to the value of the assets:
The importance of clean and accurate data
An adequate legal framework with sufficient enforcement powers
Skilled management for a variety of objectives, ie restructuring or enforcement
Appropriate servicing of assets, and
A stable valuation framework
A European solution
The ECB has recently resurrected the idea of forming a Eurozone "bad bank" to deal with NPLs in the Member State Banks. The suggestion of a Eurozone "bad bank" is not new and had originally been suggested over a decade ago to deal with the financial crisis. The reason why this didn’t gain traction is due to Members States’ success in reducing national NPL ratios. Member States did set up domestic "bad banks", notably NAMA in Ireland, Sareb in Spain and FMS in Germany. These domestic asset management companies have been praised as being quite successful. Is now the right time for a Eurozone “bad bank”?
The points in favour of a Eurozone “bad bank” are that it would:
Increase transparency regarding how Member States deal with NPLs
Boost the secondary market for NPLs and therefore assist with the core aim of the European Commission’s 2018 NPL Directive, and
Be more attractive for investors to deal with one institution across Europe
However, critics point to the economic and political factors which suggest that a Eurozone “bad bank” would not work, these include:
It would be difficult to set-up and manage due to the differences in approaches Member States have to NPLs and enforcement and insolvency regimes
It would be unfair to require all EU countries to share the risk equally as some countries such as Greece, Italy and Spain have much higher NPL ratios than others such as Germany or the Netherlands
There is too much uncertainty at the moment regarding transfer pricing and provisioning implications, and
Most importantly, who would pay for a Eurozone "bad bank"? A European solution may involve the recapitalisation of the Member State banks which is ultimately paid for by taxpayers. This is likely to be deeply unpopular in the current climate
These issues mean that it would be difficult for a Eurozone solution to satisfy the good “bad bank” qualities set out above. In addition, the resistance to a Eurozone “bad bank” means that it is unlikely to be set up in the immediate future. The discussion then turns to whether there is a national level solution.
National Asset Management Companies
Ireland has had a fully functioning “bad bank” since 2014. From a financial perspective NAMA has performed well. It is scheduled to deliver a €2 billion surplus to the Irish taxpayer during 2020.
The European Commission credited NAMA for its “factory approach” to its loan book. Unlike other European countries, Ireland did not sit on its assets or “warehouse” them to wait for values to recover but actively managed its portfolio and by doing this generated increased fiscal returns. An example of this is the completion out of developments or providing extra credit lines to developers and receivers to complete schemes. NAMA has already gone beyond its primary mandate by focusing on social housing and aims to fund 20,000 residential units by the end of 2020.
Should NAMA be repurposed to play a role in the current crisis by acquiring existing NPLs from the Irish banks to free up capital and capacity for the expected surge over the next 12 months?
In many ways, this seems like a very logical solution. NAMA could continue the work it was designed to do, that is coming up with efficient methods of handling bad debts. It could hold the loans until they are re-performing and sell them back to the banks at that stage. Alternatively, it could dispose of them on the secondary market if they continue to be classified as NPLs.
The advantages of a NAMA-type solution are:
NAMA is a known quantity in the Irish market
It has performed a role in the last economic crisis and has the infrastructure and employees in place
NAMA legislation is in place which gives NAMA greater powers than any of the other domestic institutions
Investors would only have to deal with one institution rather than a number of different banks, and
It would give the Irish banks extra capacity to deal with the new flow NPLs and to focus on other issues that adversely affect their balance sheets
However, there are unique challenges to repurposing NAMA to deal with post COVID-19 NPLs:
Detailed due diligence would need to be carried out on any assets that would be transferred to NAMA
In order to avoid compromising the value of the assets being transferred, clean asset data and a full suite of documentation would be required
The landscape is now very different to 2009 when NAMA was established. During the NAMA era its portfolio was made up of commercial real estate and development loans. However, the asset class that makes up a large proportion of the current NPL ratios in Irish banks is private dwelling houses and other residential properties
The diligence process is more costly given the granular nature of these portfolios
Traditionally international distressed debt investors viewed the Irish judicial system as predictable and reliable from an enforcement perspective. The Irish experience over the last number of years has been a move towards a more consumer focused environment with increased regulation of credit servicers. Consumer friendly legislation now operates to protect the family home and to lengthen the enforcement process. The length of time to enforce on a principal private residence is on average seven years, and
Amendments may need to be made to NAMA’s statutory powers to harmonise the approach with important consumer legislation
While there is still appetite for all types of Irish NPLs, the pool of bidders has become smaller. A number of the Irish banks have turned to the capital markets with an increase in residential backed mortgage securitisations in the last two years.
Ultimately, the national question on asset management companies is the same as the European question. Who pays for it? The Irish taxpayer has already funded the recapitalisation of the Irish banking system once in the last ten years. There will be little, if any, demand to do so again.
In our view, Ireland can expect:
Further State support for the damaged areas of the economy, particularly for SMEs
An increase in default rates
Further discussions regarding a Eurozone "bad bank", the repurposing of NAMA or a consolidation of Irish retail banks, and
Opportunities for private equity funds to contribute to the rebooting of the Irish economy.
NPLs have always been a challenge for banks but due to the work done since the last financial crisis, Irish banks are resilient and stronger than ever. Irish banks have already demonstrated their ability to tackle NPL issues. Post COVID-19 NPLs will be no different.
For more information contact a member of our Banking & Financial Services team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.
 EC Discussion Paper 036 “What makes a good “Bad Bank”? The Irish, Spanish and German Experience”.