Consider this chart from JP Morgan’s Flows & Liquidity team. It shows the evolution of non-performing loan ratios (as percentages of total loans) across three different Euro area blocks: Germany, core and periphery.
The definition of a non-performing loan (NPL) differs across countries but the picture is definitely not pretty.
From the F&L team (our emphasis):
This week, the Euro area’s non-performing loan problem came further into focus. Press reports suggested the possibility that the ECB may buy non-performing loans. Although this is a low probability event, given the risk that the ECB would have to take onto its balance sheet, it highlights policy makers’ concern that bad debts and non-performing loans may reduce the capacity of banks to lend, hindering the monetary policy transmission mechanism. Bad debts consume capital and make banks more risk averse, especially with respect to lending to higher risk borrowers such as SMEs [...]
It is not surprising that the periphery is exhibiting a rising pattern in terms of NPL ratios. What is worrying is the speed of increase, at 2.5% per year. Within the periphery, Greece is the outlier with a NPL ratio of 25%, and no signs of that abating yet. Ireland follows with a NPL ratio of 19%. Italy (at 13.4%) is above Spain and Portugal (at close to 10%) but this reflects the reporting biases mentioned above. But even if we could accurately adjust for the upward bias in the NPL ratio for Italian banks and the downward bias for Portuguese and Spanish banks, it is unlikely the overall trajectory or even level of the NPL ratio for periphery would be different from that shown in Figure 1. This is because an upward bias for Italian banks offsets to some extent a downward bias for Portuguese and Spanish banks.
Periphery non-performing loans totaled €720bn across the whole of the Euro area in 2012, €500bn of which were with Peripheral banks, €150bn in Other Core banks excl Germany, and €60bn with German banks. This number likely understates NPLs for “Other Core” banks in particular, as with the exception of Italy and Spain for which we have year-end data, for all other countries the latest observation is for June 2012…
The German divergence is making the task of the ECB very difficult both in terms of setting monetary policy for the whole region, but also in terms of dealing with an impaired transmission outside Germany. Draghi clarified in its latest press conference that it is not the ECB’s role to clean up banks’ balance sheets, meaning that the ECB is unlikely to deal itself with the €500bn large non-performing loan problem in periphery.
A prospective ABS purchase program with SME loans as underlying assets and a simultaneous guarantee through the EIB, as hinted by Draghi, is a welcome first step, although design and implementation remain crucial to its success…
However, the problem of NPLs may require more targeted solutions. This leaves the onus on sovereigns, or the ESM or other supranational bodies to deal with the more important problem of cleaning up bank balance sheets from non-performing loans and bad debts.
All fair. One additional interesting nugget is how many people with some knowledge of the ECB point to the coming asset quality review ahead of the single-supervisory mechanism coming into effect as particularly important.
As Citi’s Willem Buiter said in the FT last week:
The ECB will soon start a euro-area Asset Quality Review that is likely to be conducted by independent experts, without excessive interference by captured national supervisors. By the end of this year, the informational and institutional toolkit to dezombify the euro area banking system could be in place.
We don’t know how precisely the AQR will be conducted as the review and recapitalisation processes (which will be crucial and may involve national backstops) haven’t been fully explained yet.
However it is conducted, it will presumably force banks to crystalise their bad loans with the intention of allowing the ECB to say: “actually, we’re taking you guys under our supervisory wing so let’s clear up some legacy issues first.”
It might also help clear a blocked transmission mechanism and get distressed banks lending. And it seems like a sensible move if you are a regulator looking to get an asset backed market based on SME loans moving or at the margins a central bank considering actually buying this stuff.
[But it is always important to remember, as JPM's Gareth Davies and team note, that "existing SME-backed ABS wrapped by supranational entities have not always been every investor’s cup of tea (perhaps due to their small outstanding volumes and thin liquidity?) and may not therefore necessarily be an immediate panacea."]
So it seems this is, as mentioned, mostly about injecting some transparency into the system ahead of the ECB taking over its single supervisory role.
Kind of a good thing if you are bank with some confidence in your balance sheet or a hedge fund looking to pick up a bargain from a less confident institution. Not such a comfortable thing if you are not.
Related links:
Mend the money machine – Economist
99 Draghi trial balloons [updated] – FT Alphaville
Financial stability in Europe and the progress towards banking union – ECB Speech by Jörg Asmussen April 18
‘Violation of Treaties’: Berlin Wary of ECB Plan to Help Southern Europe – Spiegel