EU Papers Examine NPL Resolution Strategy After Pandemic

The paper on policy implications highlights the importance of early and realistic assessment of loan losses to avoid adverse incentives for banks. Secondary loan markets would help in this process and further facilitate bank resolution as laid down in the Bank Recovery and Resolution Directive (BRRD), which should be uphold even in extreme scenarios. In the empirical analysis, the authors of the paper find that aggregated bank capital seems to be large enough to absorb potential NPL losses, even in an adverse scenario. However, relevant buffers above and beyond the minimum required capital may not always be sufficiently high. To find an effective and efficient strategy dealing with potentially high NPL levels in the future, the paper examined previous crises and established certain key lessons on NPL identification, recognition, and resolution that are all also likely to be of importance during the COVID-19 pandemic:

• If NPLs are not identified and recognized efficiently, both in terms of speed and scope, NPL resolution effectiveness is undermined.
• Regulators and supervisors should ensure that banks assess current loan values realistically, which can be achieved by effective Asset Quality Reviews, stress tests, adequate accounting rules (such as the new IFRS 9 standard), and inspections that impede banks masking their risk. Realistic loan value assessment will incentivize banks to recognize NPLs early and to handle NPLs efficiently, either by internal workouts or by selling them on secondary markets.
• Forbearance or public bank recapitalization (and other state aid) are not well-suited to solve the NPL resolution problem efficiently, as they provide adverse incentives to banks.
• European secondary market for NPLs has the potential to be an important component of a successful NPL resolution. Policy makers are well-advised to overcome existing obstacles hindering the development of these markets, such as information asymmetries between the seller and buyer and the banks’ lack of  incentives to sell loans at market prices.

Regarding the EC Action Plan, the authors of the paper agree that a vitalization of the secondary loan market may be a promising step toward more resilient banking system. A liquid and transparent secondary loan market would allow banks to achieve higher prices when forced to sell NPLs, thus lowering their loss of capital even in critical times. A strong and well-developed secondary loan market, therefore, can contribute to the stability of the banking sector in an economy. Moreover, it can improve the loan-quality information that is available for investors and originators alike. Thus, the report notes that any plan to deal with NPLs should consider bank restructuring and resolution as the alternative, probably the preferred alternative, to recapitalization or any other rescue measure. 

Related Links

• Paper on Impact on Banks (PDF)
• Paper on Policy Implications (PDF)

Keywords: Europe, EU, Banking, COVID-19, NPLs, Resolution Framework, BRRD, Systemic Risk, Credit Risk, Recovery and Resolution, Regulatory Capital, European Parliament