Is an EU bad bank the answer?

The chairman of the EBA has urged the creation of an EU-wide ‘bad bank’ to deal with Europe’s toxic loans, but the suggestion begs many questions.

What if a single, European Union-mandated vehicle could be created to swoop up the non-performing loans clogging up European banks’ balance sheets and conduct an orderly sell-off?

That was the suggestion this week from Andrea Enria, chairman of the European Banking Authority. Under the regulator’s proposal, a taxpayer-backed ‘asset management company’ would purchase loans at values determined by the fund, creating a centralised and transparent vendor of NPLs.

On paper, it’s a nice idea. Real estate loans have formed a major component of Europe’s toxic debt pile and in some countries – such as the UK and Ireland – banks and state-supported agencies have made huge progress selling loan portfolios to opportunistic investors since 2011.

Some markets have been slower to emerge, and there is NPL gridlock in others. Italy – where the government has approved a €20 billion bank bailout – is one country in which banks remain hamstrung by bad loans burdening their capital ratios.

The idea of a centralised, Europe-wide bad bank has been floated before. Last July, Morgan Stanley economist Reza Moghadam described the NPL mountain as European banking’s “elephant in the room”.

“What is needed,” he said at the time, “is a transparent pan-European programme to clean up balance sheets, using common European standards and at minimal cost to European taxpayers. Hence my proposal for a European Asset Management Company, funded by all eurozone governments.”

Reaction to the suggestion within the real estate loan sales profession is mixed. “It’s an excellent idea, way overdue,” Clarence Dixon, CBRE Capital Advisors’ global head of loan sales said. “But it comes down to the mandate of the management as to how it is incentivised. There are enough skilled people in Europe who could make it work.”

Dixon pointed to his home country, the US, where in the 1990s the US government-owned Resolution Trust Corporation played a key role in dealing with America’s 1980s savings and loan crisis.

Some are sceptical. Speaking in private, one NPL market player said its success would depend entirely on who runs it; while some agencies, such as Ireland’s NAMA, are often credited with running smooth processes, others are berated for their lack of information and professionalism. A mega-bad bank, run from Brussels, could be out of touch with the myriad markets it intervenes in.

The EBA does not have the power to establish such a vehicle. That would need the collective approval of Europe’s central bankers, through the European Banking Committee. That is unlikely to be a short-term fix.

If a European bad bank were to work, the management would need a clear mandate and timeframe within which to liquidate the loans. Valuation would need to be done to market accounting standards in order to win investors’ confidence. Markets in southern and eastern Europe could potentially be opened up.

Indeed, a well-functioning EU bad bank would be a great benefit to European lending, with individual banks freed from the non-core exposure preventing them from lending. The need for a solution remains. In its H1 2016 Deleveraging Europe report, Deloitte estimated that there is as much as €2 trillion of non-core debt in Europe.

An EU bad bank might be a distant prospect, but with the right people and a clear mandate, Enria’s proposal just might work. Though as a first step, Europe’s institutions would have to muster the strength to create this kind of entity. That will not be easy.