Few subjects unite the views of Italian politicians, US bankers, Brussels technocrats, International Monetary Fund economists and Frankfurt supervisors. One that does is the need for European banks to deleverage their Non-Performing Loans (NPLs).

Achieving this is one of the Single Supervisory Mechanism’s (SSM) key priorities for 2016, though in reality, it may prove to be a 10-year project. To understand why, we explore below what NPL deleveraging involves and the SSM’s role. 

First, what is an NPL? The European Banking Authority (EBA) define it as an exposure that satisfies either or both of the following criteria: (a) it is more than 90 days past-due; (b) the debtor is assessed as unlikely to pay its obligations in full without realization of collateral.

What is the size of the issue? Europe’s largest banks hold approximately €1.1 trillion of NPLs according to the EBA’s latest Risk Assessment. Their weighted average NPL ratio is 6 percent, rising to 10 percent when considering only exposures to Non-Financial Corporations (NFCs). This ratio varies significantly by peer group, between 4 percent for G-SIB banks and 18 percent for smaller banks, and even more markedly by country, between 1 percent for Sweden and 46 percent for Cyprus. By contrast, the World Bank reported average NPL ratios of only 2 percent for the United States and Japan at the end of 2015.

For banks, NPLs tie up part of their capital base without providing a commensurate return, reducing profitability and increasing capital requirements (NPLs have a ‘risk weight’ of 150 percent under the Basel 3 Standardized Method).

For European society, a banking system which is not firing on all cylinders, due to the drag of NPLs, does not have capacity to drive net new lending in particular to SMEs. This constrains economic growth and disrupts the functioning of the monetary policy transmission mechanism (from the central bank to real-economy borrowers). High NPLs are therefore one of the triggers for the European Commission’s Capital Markets Union (CMU) initiative, to deliver alternative sources of long-term finance to EU companies. 

History shows that a majority of NPLs (typically 50-60 percent) need to be ‘worked-out’ by banks themselves, through a combination of re-scheduling payments, seizing collateral, converting debt to equity (and so on). This is hard, specialist work, particularly when loans are syndicated across multiple banks, or are ‘cross-collateralized’. It requires a very different skillset from credit origination and is invariably best done by specialist teams. 

Another key strategy to deleverage NPLs is to sell them, either as ‘single names’ or portfolios. They are typically bought by investment funds, which bring a combination of efficient financial structuring and work-out skills honed across multiple jurisdictions. 

The role of the SSM 

The SSM priority of reducing NPLs is one where it needs to wield influence, rather than having strong statutory powers. It has taken two key actions in 2016:

1. Undertaking a stock-take of NPLs, focusing particularly (we understand) on banks with an NPL ratio above 12 percent.
2. Establishing a Task Force, led by Sharon Donnery (a Deputy Governor of the Central Bank of Ireland), which is developing strategies to reduce NPLs in several countries, jointly with local NCAs, and making recommendations to banks. 

The SSM is also surveying the amount of capital banks consume (or earn) through successful NPL sales, to extrapolate how much they will need to deleverage their whole NPL portfolio. This informs the SSM’s Pillar 2 (SREP) decision. 

NPLs are a multi-stakeholder challenge

As noted above, reducing NPLs is a hot-topic for a broad range of politicians, policymakers and investors. It needs to be – as no individual authority (including the SSM) can fix by the problem by itself.

KPMG member firms have identified five conditions that need to be met in order to achieve successful NPL deleveraging:

1. Legal enforcement: a transparent legal process to obtain control of collateral, with a predictable outcome. (Note that obtaining control of collateral currently takes anywhere between 24 hours and 10+ years, depending on which EU country a bank is operating in. The EC is looking at ways of harmonizing the process).
2. Workout expertise: specialist teams, with hands-on experience of renegotiating / restructuring exposures.
3. Supportive & transparent administration: a centralized land registry and borrower credit database, underpinned by liquid property markets.
4. Macroeconomic environment: a stable economic and banking environment, to support the accurate pricing of risk when buying NPLs.
5. Capital: sufficient capital in the banking system to provision NPLs to a price where they can be sold.

In addition to completing the SSM’s stock-take templates, banks should prepare multi-year Strategic Plans, setting out how they will deleverage NPLs and the expected resources required (people, time and capital). 

Time is of the essence, not only due to SSM pressure, but also due to US funds increasingly re-focusing their efforts on the US distressed debt market (e.g. Oil & Gas sector).

The most critical player on which the SSM depends to achieve its priority of reducing NPLs is the market itself.