Eurozone banks’ NPL crisis threatens to derail recovery

Sid Verma
Published on:

The IMF warns that corporate loan losses for banks in Spain, Italy and Portugal could hit €282 billion over next two years, highlighting the scale of the challenge for the ECB’s asset-quality review amid continued financial fragmentation.

Hidden cracks in the eurozone financial system threaten to derail the tentative economic recovery: the dangerous nexus between weak bank balance sheets and highly indebted corporates.

In a shot across the bows of eurozone bulls, who take comfort from well-anchored peripheral European government bonds, the IMF said, in its benchmark Global Financial Stability Report (GFSR) in October, that banks’ inadequate provisioning for a wave of bad corporate debt threatens growth, investment and employment prospects for years to come, without urgent redress.

Based on annual data from more than three million non-financial firms in Germany, France, Italy, Portugal and Spain, the IMF warned that many indebted borrowers are battling to service their debt – particularly in the cyclical and manufacturing sectors – emboldening the ECB’s mission to review with rigour the health of eurozone banks in its comprehensive asset-quality review (AQR) due in October 2014.

Based on a 45% loss-given default assumption, the IMF calculated gross losses on corporate loans of eurozone banks between 2014 and 2015 – assuming there is no further improvement in economic and financial conditions – by mapping firms’ vulnerability indicators, historical default rates and debt stocks to estimate firm- and country-level probabilities of default.

In Italy, the study concludes corporate loan losses could be as high as €125 billion, exceeding banks’ existing provisions by €53 billion; €20 billion in Portugal, exceeding provisions by €8 billion; and €104 billion in Spain, where provisions are adequate.

The IMF’s analysis showed that in Portugal 50% of corporate debt is owed by firms that have an interest coverage ratio of less than one, meaning they don’t earn enough income to service their debt, compared with 40% and 30% in Spain and Italy, respectively.

The study, a corporate balance-sheet perspective, gives a sense of the scale of the ECB’s challenge when it assesses individual banks’ balance sheets.

José Viñals, head of the IMF’s monetary and capital markets department
In an interview conducted in his office on the occasion of the IMF’s annual meeting last month, José Viñals, the head of the IMF’s monetary and capital markets department, and key architect of the GFSR, sounded the alarm: weak credit growth, amid the overhang of corporate debt, will pose a serious headwind to the regional recovery.

“It is important that banks have adequate buffers to deal with these risks,” he says. “In some cases, there will be a need to have corporate debt workouts that lower the debt burden of the firms to a more sustainable level.”

While the negative sovereign-bank feedback loop in the eurozone has eased, the eurozone corporate sector, including banks, remains heavily indebted at 105% of GDP in the second quarter of 2013 compared with 78% in the US, according to the ECB, in part accounting for Europe’s lacklustre recovery relative to the US.

Many investors in European financials have long argued banks in the eurozone periphery have downplayed expected losses on their bad loan books while providing forbearance to struggling borrowers thanks to ECB life-support, aided by reluctance among some supervisors to see institutions with large loan banks write down assets.

Is the IMF report, asks Euromoney, implicitly charging that banks are playing a Japanese-style game of ‘extend and pretend’ by evergreening loans, delaying the flow of eurozone credit to healthier firms?

Viñals hedges his answer: “We don’t have good evidence of this. There is suspicion that, in general, when you have very low interest rates the opportunity costs of evergreening is lower and, therefore, banks do it more.

“But, in reality, it is very difficult to get concrete evidence of what percentage of loans are being evergreened, without having a very detailed assessment of banks.”

Viñals stresses that provisioning to address deterioration in asset quality in corporate loan books could be covered by operating profits without eroding existing capital buffers.

However, low net-interest margins, and stubbornly weak revenues from fees and commissions given weak economic activity, create an uncertain backdrop for future profits for banks in Spain, Italy and Portugal.

Meanwhile, higher capital requirements, given the leverage ratio and Basel’s new charges in banks’ trading books, will surely further challenge loss-absorption capacity.

Viñals, deputy governor of the Bank of Spain between 2006 and 2009, a period in which corporates embarked on a debt binge, said precise provisioning requirements and capital needs will only be clear through a robust bank-by-bank AQR and argues the ECB should take a strict look at individual corporate loan portfolios.

Previous stress-testing and capital exercises for eurozone bank-balance sheets, conducted by the European Banking Authority (EBA) in 2011 and 2012, were subject to market doubts amid a lack of political will to stomach capital shortfalls.