March 14, 2017

The trillion euro problem

by Breakingviews

A European bad bank is a bad idea. Policymakers are calling for the creation of a pan-European fund to soak up dud assets across the region. The record for such schemes is mixed, though, and hard to apply to European lenders’ diverse problems.

The European Banking Authority and the European Central Bank have a straightforward argument for setting up a continent-wide bad bank. Lenders have 1.15 trillion euros of bad debt, which depresses returns and discourages them from extending credit. The loans can’t be sold because private buyers demand too-low prices. A new entity with public backing could solve that market failure by acquiring bad loans at higher prices while still earning a decent return.

Yet bad loans are not a uniformly pan-European problem. Roughly a third of the total is in Italy. In six countries non-performing loans account for more than 10 percent of total assets, but the average for the euro zone is about 6 percent, according to the ECB. There’s also little evidence that dud assets are pushing up lending rates: Italian corporate loans cost just 15 basis points more than the average, according to ECB data.

The other challenge is determining a fair price for the bad loans. If the value is too high, shareholders get a bailout at the expense of taxpayers. The transfer worked well in Ireland, where the 2008 real estate crash was followed by a speedy recovery. But Spain’s bad bank has had to write down loans and convert debt to equity, despite an economic recovery. In Portugal, Italy or Greece many loans are to small companies, which require local knowledge.

Private investors’ reluctance may reflect the high cost of foreclosing on a delinquent creditor. In Italy, nearly half the difference between the bid and ask price for a dodgy loan reflects legal costs and lengthy recovery periods. In Greece, buyers are deterred by costs, legal risks, and political uncertainty.

There are some ways around these obstacles. The EBA proposes a system of warrants and clawbacks to reduce the fiscal transfer between states. Yet a series of national bad banks would probably be simpler. The real solution to the NPL problem, however, must come from reforming bankruptcy laws to make it easier to foreclose on bad loans. That is where governments should focus their attention.

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