Banks need to act to prevent a new NPL crisis

Gifford West of loan sale advisor DebtX argues lenders should begin to shed troubled loans before the problem becomes too big.

The European Central Bank’s plan to create a pan-European asset management company – a ‘bad bank’ – to handle a potential $1.4 trillion in pandemic-related non-performing loans, including real estate debt, is a positive step in a time of crisis.

But it should not preclude European regulators at the country level from encouraging their financial institutions to address the looming distressed debt crisis, starting now.

On 26 October, Andrea Enria, chair of the ECB, writing in the Financial Times, supported the formation of a coordinated network of AMCs. He makes a compelling case that Europe must prepare for the worst to protect banks, and their customers.

However, the benefit of this initiative could arrive too late to blunt the impact of the pandemic in the next 12 months.

If banks do not begin the process of disposing of problem loans in the near term, a repeat of the 2008 recession becomes more likely. Banks could again be gridlocked, meaning they can lend less.

In some industry segments, such as UK residential lending, more than 20 percent of borrowers are in some form of payment holiday. Banks have been generous with deferrals, interest holidays and covenant waivers since the pandemic began, but they can only hold on for so long.

Incentives need to change

The regulatory environment across Europe does little to dissuade ‘extend-and-pretend’ – the practice of banks retaining NPLs early in the cycle in the hope of a less onerous impact later. Banks roll losses forward in the hope of an appreciation of the underlying collateral. The result in the last crisis was that banks waited until losses became too large to ignore. This led to bulk sales to large private equity firms in less than transparent processes.

Giffiord West
West: banks need to start selling NPLs

An alternative option is to use private NPL platforms to sell loans. In contrast to the opaque and largely closed processes of bilateral sales to a small circle of private equity firms, technology enabled NPL platforms encourage price discovery and greater transparency. They create liquidity by standardising sales by multiple sellers and opening them to a large universe of vetted buyers. In the last crisis, in Germany, Ireland and the US, banks and public agencies leveraged existing entities that were serving the bank sector.

Liquidity in the secondary NPL market needs to be encouraged now. Regulators will need to navigate from a strategy of covid-relief, such as payment holidays and liquidity programmes, to one of protecting the survival of banks, by requiring aggressive write-downs and the sale of NPLs.

Banks need to be incentivised to sell NPLs now in smaller tranches, to minimise the need for bulk sales. These incentives could take many forms: regulatory relief, discounted funding or preferential accounting treatment. In the US during the 1980s and 1990s savings and loan crisis, a ‘regulatory capital goodwill’ mechanism was tried, allowing banks to defer purchase premiums over a 40-year period. A similar mechanism could be used to defer losses taken beyond current loss reserves.

NPLs will become a huge problem as soon as government liquidity programmes end. That sense of urgency is why European regulators should embrace a private sector solution for creating liquidity for NPLs in the short-term. The mistakes of the last recession can be avoided in this cycle.

Gifford West is managing director of international operations for DebtX, a loan sale advisor which operates a marketplace for loans.