Progress made; progress needed
20 March 2018
The recovery following the financial crisis has seen banks make progress in reducing their impaired assets, with EU-wide initiatives such as stress testing and progress towards a banking union helping to increase oversight in the sector. Banking union rests on three pillars: the Single Supervisory Mechanism (SSM) within the ECB, the Single Resolution Mechanism (SRM) to implement the Bank Recovery and Resolution Directive, and the Common Deposit Insurance System (CDIS). The benefits of completing union are clear: it will delink banks from sovereign countries to reduce economic and regulatory risk, as well deepen capital markets across the union. While the SSM and SRM have been introduced, progress has stalled on the CDIS. Importantly, key northern countries like Germany and the Netherlands are keen for banks to proceed further with significant risk reduction before approaching common deposit insurance. There is a fear that establishing the CDIS before resolving disparities would result in moral hazard and lower the pressure for banks and regulators to address balance sheet issues.
The issue of non-performing loans (NPLs) dominated the policy and market space in the wake of the crisis but the data shows encouraging progress. In the euro area, the non-performing loans ratio came down from 6.5% in Q3 2016 to 5.15% in Q3 2017, with a number of high-profile individual cases of progress in the particularly problematic Italian and Spanish financial systems in recent years (see Chart 6). The ECB’s guidelines and the European Commission’s latest proposal in pursuit of risk reduction focus on this issue of NPLs going forward. The ECB has advised that as of 1 April, banks should hold 100% of the value of uncollateralised loans in capital after two years; collaterised loans would have the same requirements but with a seven-year allowance. Banks have been given three years to comply, though these rules are not legally binding. The solution proposed by the European Commission seeks to legally force banks to have higher capital reserve requirements for NPLs via a similar ‘prudential backstop’, while also proposing a regulated secondary market for NPLs. This proposal will now need to get through European parliamentary proceedings before becoming law, but the trajectory for regulation is clear.
Broadly speaking, much progress has been made by major banks to repair asset sheets and regulators to increase oversight in recent years. However, although these latest European proposals can improve asset quality metrics for new loans in the future, both plans have been criticised for failing to radically address the politically thorny issue of existing NPL stock. Importantly for politicians concerned about a banking union, there is still a lot of variation in NPL ratios across countries, ranging from Germany’s 2% up to Italy’s 12%, Portugal’s 18% and Greece’s 46.6% (See Chart 7). Herein lies the problem; northern countries with lower risk profiles in their financial system do not want to proceed to a common insurance scheme while large variation in bank safety remains. As with broader European integration, we return to the problem of the chicken and the egg: a lack of strong European political and economic identity makes progress difficult, necessitating patience and sensitivity to national issues; without integration, European political and economic unity is tediously slow.