25 May 2021

Banks might not be sufficiently prepared to deal with non-performing loans after COVID-19

A SAFE-CEPR Policy Web Seminar addressed how sufficient the tools are to tackle a possible wave of non-performing loans in the aftermath of COVID-19

Although the resolution progress of non-performing loans has been positive in recent years, they could become problematic for bank's balance sheets in the aftermath of COVID-19. Many credit institutions are inadequately prepared for when after the moratoria by the European Banking Authority (EBA) provided in the Corona crisis also the relief measures for borrowers will terminate. This is a result from a SAFE Web Seminar co-organized with the Centre for Economic and Policy Research. On May 19, SAFE's Department Director of Financial Markets Loriana Pelizzon, the Chair of the Supervisory Board of the European Central Bank (ECB) Andrea Enria, and Thorsten Beck, Director of the Florence Business School of Banking and Finance, discussed whether measures in the European Commission's "NPL action plan" are effective and sufficient to deal with a potential wave of non-performing loans (NPLs) following the Corona crisis.

Enria emphasized the quality of the measures taken. Banks were able to continue reducing NPLs in 2020, especially long-dated ones: "It is the most difficult type to deal with," he pointed out. These good developments are also reflected in the forecasts of analysts and banks. According to the analyses, provisions could be reduced, thus increasing the profitability of credit institutions. However, Enria urged caution: "From our supervisory perspective, we try to put some words of caution in this rosy narrative." He highlighted the relief measures in the Corona crisis for borrowers, which could increase credit risk when they end. Because of the public supports, he said, certain effects could not be predicted. "The moratoria create a sort of blank spot," he described.

Puzzling developments

In the Corona crisis, some sectors of the economy were particularly affected. Banks nevertheless used backward looking indicators that not reflect the pandemic situation and could delay proactive engagement with the distressed borrowers, said Enria. The development of decreasing default probabilities while general credit risks increased, he described as "a bit puzzling". Though, uncertainties would have been reduced and the economic outlook is fairly optimistic, he said, reducing provisions may still be premature. According to Enria, the tools are in place, but 40 percent of the banks fall short in the management of NPLs: "I am not sure we are sufficiently strong," he said.

Loriana Pelizzon agreed that banks are in a better position than in other crises before. However, the risks of a wave of NPLs could be masked by a generous fiscal policy in some banks. This very problem is also addressed in a SAFE White Paper. She stressed that NPLs may not be problematic right now, but in the medium term, not only zombie firms but also zombie banks could emerge. Problematic loans, however, need to be properly identified in a timely manner for banks to fulfill their function as loan providers. Otherwise, also economic growth would be severely slowed down. "In most of the cases, banks do not have the right incentives to implement early NPL-identification," the SAFE researcher said.

Counteracting misdirected incentives

Regulators therefore should meet the individual incentives not to identify NPLs in the portfolios, ex ante through stress tests, appropriate accounting rules, and asset quality reviews. An important element in dealing with NPLs would be a functioning secondary market: "In Europe, we do not have a well-developed secondary market for non-performing loans," she noted. For this to happen, she said, the most important thing is that the true and complete information about the loans is disclosed.

Finance professor Thorsten Beck brought up the trade-off between protecting the economy and "allowing market forces to work again". Exiting from moratoria and relief measures and transitioning to a normally functioning market requires a great deal of caution and coordination among countries and institutions, he said. "There is a visible hand needed from the supervisory authorities," Beck said. He also stressed that banks needed incentives to identify bad loans in a timely manner. This, he said, also requires tools for the banks to sell the loans efficiently and at an acceptable price. Beck also raised the question if the NPL problem also needs Europe-wide coordination. He said that while member states are affected heterogeneously and have different support measures in place, only national solutions would, in the worst case, lead to "zombie lending and a K-shaped economic recovery" - i.e., uneven recoveries depending on the sector.

Rewatch the Web Seminar here