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In search of a European solution for banks’ non-performing loans

European banks have not recovered from the Global Crisis, in part due to heavy provisions for non-performing loans. This column argues that a comprehensive approach to the issue in Europe could address market inefficiencies and reduce bad loans to bearable levels. The establishment of a European scheme to securitise non-performing loans should form one of the next steps towards recovery.

After ten years of crisis, European banks are far from seeing the end of the tunnel. While US banks have recovered fairly quickly and have reached in 2012-15 a return on equity of 9.3%, European banks are still stuck at a meagre 3.7%, well below their cost of capital (IMF 2016). This gap is explained by two factors: heavy provisions for non-performing loans (NPLs), and high operating costs reflecting overcapacity and inefficiencies in most big countries, including Germany.

If history is any guide, bold actions are needed, but Europe is not following the proposals made since the outburst of the crisis to find a solution similar to the Brady Plan of the 1980s (Spaventa 2009), nor the comprehensive approach of the Nordic countries after their banking crisis of the early 1990s (Borio 2012).

A necessary condition is to remove NPLs from banks’ balance sheets. However, the market for bad loans is affected by information asymmetries that create a wedge between the price at which banks are willing to sell and the price offered by specialised investors. Recently, many regulators have suggested comprehensive plans to address the issue through national schemes of bad banks (Enria 2017, Constâncio 2017). Based on a recent paper (Bruno et al. 2016),1 in this column I propose a securitisation scheme that could create an incentive to sell, while reducing the immediate loss to manageable levels. As in any intervention to solve market failures, public support is needed both for starting the initiative and to help fund the vehicle. Both can be realised in terms compatible with the present European rules that forbid state aid and mandate involving creditors in bank resolutions.

A European problem in search of a European solution

The quality of banks’ loan portfolios deteriorated substantially after the Global Crisis in all advanced countries, particularly in Europe, reaching €1 trillion (Enria 2017). Banks, supervised by the ECB, hold €921 billion, 6.4% of total loans, and nearly 9% of GDP. In six countries (Greece, Cyprus, Italy, Portugal, Ireland, and Slovenia) the ratio is above 10%. In net terms – i.e. taking into account the provisions – the amount is halved to 475 billion, a figure which is close to more than all the capital banks raised since 2011, more than six times the annual profits of the EU banking sector, or more than twice the flow of new loans (Enria 2016).

The problem has implications at the European level. First of all, NPLs are one of the major causes of the financial fragmentation that hampers one of the most important benefits of the financial and monetary union, namely, the sharing of economic risks across borders. Moreover, the fears about banks’ strength keeps high the risk of a revival of the ‘diabolic loop’ between banks and sovereign risk that lies at the heart of the European crisis. Last but not least, the high interconnectedness within the Eurozone financial system (ECB 2015) creates a significant danger of spillovers from peripheral to core countries, entailing systemic risks.

At the individual bank level, managerial resources are absorbed by the problem of resolving the legacy of past bad loans, weakening the impact of the necessary actions in terms of reducing overcapacity and overhauling business models (Enria 2016). As the experience of Nordic countries shows, solving NPLs and drastically reducing overcapacity are two sides of the same coin (Borio 2012).

Individual initiatives have prevailed so far, mainly based on national ‘bad banks’ (Germany, Ireland, Spain, and Slovenia) and with mixed results, as shown by the present high levels of NPLs in Ireland. Meanwhile, regulators have forced a significant recapitalisation. In the Eurozone, the CET1 ratio is now 14%, double the level of 2007 (Constâncio 2017). Looking at the glass as half empty, however, one can say that peripheral banks are condemned to a sort of Sisyphean task – rolling up painful issues of new rights (at prices well below book value) only to see the resources roll down the hill of bad loans.

There are at least two factors that make it so difficult to remove bad loans from banks’ balance sheets. First, inefficiencies in the legal procedures for the repossession of collaterals (that most countries have tried to reform) but more importantly, the information asymmetries in the market for NPLs that discourage banks to sell.

The present book value of NPLs broadly reflects the expected recovery value (as suggested by the present accounting principles) and according to many estimates is in line with historical experience (Visco 2017). Of course, the sale must entail a loss, which would probably require a recapitalisation to restore prudential requirements. The net result is that the more banks are convinced to have adopted prudential criteria (broadly endorsed by the supervisors), the less they are willing to sell at prices significantly lower than the book price. On the other hand, the limited size of the market for NPLs (and the limited number of specialised buyers, that often enjoy a monopsonistic position) raises the risk premium potential buyers are asking (the IMF estimates 12%, but anecdotal evidence points to even higher rates), thus depressing the net present value of NPLs. This creates a new version of the ‘lemon’ market where potential sellers have no incentive to sell.

This market failure can be solved by a public initiative that creates a vehicle that could operate on a time horizon long enough to avoid fire sales, financed with tranches of securities bearing different levels of risk. The result brings the sale price closer to the real economic value estimated by the banks, creating a powerful incentive to sell. Securitisation vehicles should be set up at the national level (given the legal problems and the local nature of the market for collaterals) but within a common blueprint worked out at European level.

A securitisation scheme for the Italian banking system

In Bruno et al. (2016), we conduct a simulation for the Italian banking system. On the asset side, drawing on a wide sample analysed in Lusignani and Tedeschi (2016), we assume an average recovery rate of 51.4%, with 30% volatility. A state guarantee covers the senior tranches that receive an investment grade rating (BBB- or higher) by an independent rating agency. This guarantee follows the pattern of the Garanzia statale sulla cartolarizzazione delle sofferenze (GACS) already introduced by the Italian government and approved by the European commission. To cover the cost of the guarantee, the SPV pays increasing annual fees, calculated as an average of CDS spreads on a basket of Italian issuers with ratings from A to BBB-. Contrary to other proposals (Avgouleas and Goodhart 2016), we do not provide for forms of clawbacks that could create uncertainty in the market because of the contingent liabilities implied.

The exercise estimates the par-yield returns for each tranche via Monte Carlo simulations, using a risk-adjusted probability loss distribution of the loan portfolios. Risk premiums are adjusted to account for the volatility of recoveries risk and liquidity risk. The estimates lead to the following results:

  • Senior note: (67% of the total) – nominal value €37.2 billion, amortising coupon bond, eight years, average maturity 4.5 years, coupon rate Euribor + 0.60% with GACS.
  • Mezzanine note (18%): nominal value €10 billion, bullet coupon bond, maturity eight years, coupon rate Euribor + 6.64%.
  • Junior note (15%): nominal value €8.3 billion, bullet zero coupon note, maturity eight years, target return 15.55%.

The average cost of capital of the SPV is 7.09%. Adding legal and servicing fees 11% of recoveries, tax rate 27%, the estimated bid price is 28.1% of the NPLs’ gross book value. Any losses deriving from the recovery process will reach the junior tranche only if the recovery rate of securitised portfolio goes below 28.1%. Mezzanine tranche will be touched by losses only if the recovery rate goes below 24%.

The yields offered by the different tranches can be attractive for a wide variety of investors: mutual funds for the senior tranche; and institutional investors, hedge funds, and funds specialized in the NPEs market for the mezzanine or even the junior tranche. Some form of public support may be necessary, as recently suggested by European regulators.

Since the net book value of bad debts amounts to €83.7 billion (42.3% of gross exposure), their sale at a value of €55.6 billion (28.1%) would imply a loss for the banks of €28.1 billion (€20.5 billion net of tax effect). This is the measure of the immediate loss for the banks and the impact on CET1 ratio, i.e. the price paid by present shareholders. After the sale, the gross NPLs ratio of Italian banks will be reduced from 16.1% to 5.6%, and the net ratio from 8.3 to 3.9%. In other words, the big mountain of Italian NPLs could be reduced to a ‘normal’ size, reducing the issue to €20 billion of immediate losses for the banks and €8 billion of the junior tranche of securities.

It is not possible to replicate the same exercise for other European countries, as granular data on loan portfolios are not available. However, based on some heroic assumptions, our paper estimates that the impact for the banks of the entire area would be a loss of about €70 billion (€51 billion net of tax). The total loan disposal value would be €173 billion, financed by a senior note of €116 billion (67%), a mezzanine note of €31 billion (18%), a junior note of €26 billion (15%).

Are these costs bearable and it is worth paying them? As for the banks, there are many possible ways of reducing the impact.

  • First, many banks have a buffer of capital assessed by the Supervisory Review and Evaluation Process (SREP). For them it could make sense to use this buffer to get rid of the problem loans once and for all.
  • Second, the disposal of NPEs at prices lower than the book values decreases the capital, but also risk-weighted-assets, therefore the effect on capital requirements is partially absorbed.
  • Third, a few banks may fall under Article 107(3)(b) of the BRRD, which allows for activating government support (in terms of guarantees and/or funding) in a precautionary recapitalisation without bail-in.
  • Finally, resolutions with bail-in can be restricted to a limited number of cases.

As for the junior tranche, it must be stressed that its yield is close to the rate of return presently required by market participants.  Therefore, a public intervention (directly or through the ESM) must not be considered as a state aid, but only as a necessary move to overcome market failures. On this topic, the European Commission proved to be very flexible in the past and leading regulators have recently asked for some form of public support (Enria 2016, Regling 2016, Constâncio 2017).


We show that a comprehensive approach to the issue of NPLs in Europe could be a remedy to market inefficiencies and reduce the problem of bad loans to bearable levels. The advantages are threefold: to remove once and for all the legacy of bad loans from banks’ balance sheets, to restart the engine of loan supply, and to avoid the Armageddon scenario of massive resolutions of ailing banks under the Bank Recovery and Resolution Directive regime. The set-up of a European scheme to securitise NPLs should rank high in the agenda of structural reforms that are considered a necessary step for a real European recovery.


Avgouleas, E, and C Goodhart (2016), “An Anatomy of Bank Bail-ins – Why the Eurozone Needs a Fiscal Backstop for the Banking Sector”, in European Economy, Banks, Regulation and the Real Sector, No 2.  

Borio, C, B Vale and G von Peter (2010), “Resolving the Financial Crisis: Are We Heeding the Lessons from the Nordics?”, BIS Working Papers No 311.

Bruno, B, G Lusignani and M Onado (2016), “A securitisation scheme for resolving Europe’s problem loans”, Mimeo, 7 December.

Constâncio, V (2017), “Resolving Europe’s NPL burden: challenges and benefits”, Speech at Breugel Conference, ECB, 3 February.

ECB (2016), “Addressing market failures in the resolution of non- performing loans in the euro area”, Financial Stability Review, November.

Enria, A (2016), “Financial Markets 2.0 – R (evolution): Rebooting the European banking sector”, 7th FMA Supervisory Conference - Vienna, 5th October.

Enria, A (2017), “The EU banking sector - risks and recovery: A single market perspective”, Presentation at the ESM, 30 January.

IMF (2016), Global Financial Stability Report, October.

Lusignani, G, and R Tedeschi (2016), “NPLs: a New Asset Class for Institutional Investors?”, Prometeia Working Paper, September.

Regling, K (2016), “The Next Steps to Make Monetary Union More Robust”, Speech at EMU Forum Oesterreichische Nationalbank Vienna, 24 November 2016.

Spaventa, L (2008), “Avoiding Disorderly Deleveraging”, CEPR Policy Insight, no. 22, May.

Ignazio Visco, I (2017), Intervento del Governatore al 23° Congresso ASSIOM Forex, Banca d’Italia, 28 January.


[1] An abridged version of this paper forms one of the policy papers of the Restarting Long-Term Finance in Europe project, jointly developed by Assonime and CEPR, and directed by Colin Mayer.

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