The idea of an asset management company for the Eurozone is not new. It is based on the observation that bank fragility across several Eurozone countries, including Ireland, Spain, and Italy, has been at the core of the crisis. In addition, bank fragility has put sovereigns under pressure as well as held back economic recovery. Even worse, the bailout of failing banks has forced several governments, such as those of Cyprus and Ireland, to seek a bailout by the Troika, made up of the ECB, the European Commission and the IMF. In other cases, most prominently that of Italy, high sovereign indebtedness might have prevented the government from taking more decisive action. Given the externalities imposed by banking fragility and access to lender-of-last resort facilities inside a currency union, there is a strong case to be made for a Eurozone solution. What is more, the fact that legacy problems associated with the Eurozone Crisis have not been addressed makes the implementation of the new regulatory framework of the banking union more difficult – both technically, as the new institutional arrangements have to address fragility from the start, and politically, as creditor countries are afraid of having to pay for ‘old sins’.
In this column, I take stock of the different proposals and argues for an ambitious programme rather than for a limited solution. Nine years after the start of the Global Crisis and seven years after the onset of the Eurozone Crisis, the problem is still acute. According to the ECB (2016), at the end of 2015, the largest 130 Eurozone banks held around €1 trillion of non-performing assets, with non-performing loan (NPL) ratios above 10% in Slovenia, Portugal, Ireland, and Italy and above 30% in Cyprus and Greece. Differences in the efficiency of judicial systems mask a high variation in possible recovery rates and thus hidden losses on banks’ balance sheets (ECB 2016, Goodhart and Avgouleas 2016). The high stock of non-performing loans holds can result in ‘zombie’ lending (throwing ‘good’ money after ‘bad’ money) and prevents the adjustments in resource allocation which are necessary for economic recovery (Hoshi and Kashyap 2015). Furthermore, the high level of NPLs also poses problems for monetary policy transmission within the Eurozone, as lower interest rates do not necessarily result in lower lending rates (see also Aiyar et al. 2015).
Why not a private solution?
What is the role of government authorities in this context and why are such solutions not being offered privately? More so than other financial markets, the market for non-performing assets is characterised by information asymmetries and private investors would only purchase such assets at high discounts (most likely below already adjusted book values), thus forcing banks to recognise losses (ECB 2016). This ultimately turns the market for distressed assets into a ‘lemons’ market, with non-performing but recoverable loans being pushed out. The problem is exacerbated if loans are more heterogeneous, such as in the case of loans for small and medium enterprises (SMEs), which seem to make up large parts of Italian NPLs. Finally, incentives to sell non-performing loans are even lower if banks have access to lender-of-last resort facilities. It is thus not surprising that centralised solutions covering a large share of NPLs have to be initiated by the government and happen mostly during systemic crises.
Asset management companies: An old and sometimes successful idea
How can an asset management company or a bank for bad loans help? Centralising the restructuring and recovery of bad loans is a technique that has been used repeatedly in past banking crises (Klingebiel 2000), including in Sweden during its crisis in the 1990s. It was also used during the Eurozone crises in Ireland (creating the National Asset Management Agency) and in Spain (creating the Fund for Orderly Bank Restructuring). It involves the purchase of non-performing loans from banks to free up their balance sheets and staff. By taking over non-performing assets, such an agency can prevent pressure on banks for fire sales and thus additional losses. Such a centralised approach also allows scale economies in handling non-performing loans to be exploited, by concentrating expertise and manpower in one agency. In addition, it can break the links between banks and borrowers, often a problem in banks with weak governance structure and lending protocols (Klingebiel 2000). Experience suggests that such a centralised approach works best with real-estate loans. The crucial question is: At what price are these loans being bought? If they are being bought at fair price, it leaves the bank with losses. Buying them at book price involves bank recapitalisation, which might set the wrong incentives.
Why at the Eurozone level?
Asset management companies have traditionally been set up at the national level, so why do we need an asset management company at the Eurozone level? There are several strong arguments for this. First, there might be high costs of setting up such an agency at the national level, so there may be economies of scale. Second, the direct and indirect exposure of large EU banks to NPLs across borders means that the NPL overhang prevents the re-establishment of a single market in banking. Third, there is the ‘tragedy of the commons’ argument (Tornell and Westermann 2012). As banks have access to a lender of last resort and – as discussed above – do not have incentives to address their non-performing assets, there is limited pressure that can be applied at the national level to deal with these assets, which calls for a Eurozone solution. While the establishment of the Single Supervisory Mechanism has reduced regulatory discretion on provisioning, there is still no solution in place to actually address the (previously) hidden losses.
What are the proposals?
While mostly suggested by academics, a recent paper by the European Banking Authority (Haben and Quagliariello 2017), supported in a speech by the EBA chairperson Andrea Enria, also makes a strong case for a European asset management company to reduce the pressure caused by non-performing loans across the Eurozone. However, rather than foreseeing an immediate recognition of losses if banks sell loans to the asset management company above the ultimate recovery value, the idea is to issue equity warrants to governments that can be triggered after three years if the final sale price is lower than the original price banks received. While this provides important incentives for banks and prevents any additional taxpayer money from being committed upfront, it does delay the process of bank restructuring and might simply postpone the ultimate resolution of bank distress.
Another recent proposal is that by Avgouleas and Goodhart (2016) which suggests that institutions selling non-performing assets to the asset management company could be subject to a structural conditionality similar to that undertaken by the UK government during the rescue of the Royal Bank of Scotland, thus also contributing to the necessary bank restructuring in the Eurozone. They propose that banks which have not (yet) entered resolution should transfer NPLs to the asset management company, thus freeing up capital for new lending which would relieve to some extent the Eurozone’s debt overhang.
In a previous Vox column, Christian Trebesch and I make a somewhat more radical proposal to use the Comprehensive Assessment (undertaken in 2014) to refer weak banks to a temporary Eurozone Restructuring Agency for restructuring and resolution purposes (Beck and Trebesch 2013). In the first phase of its existence, the resolution agency would have to separate weak banks into viable and unviable financial institutions. Unviable banks would be liquidated while viable but weak banks would be restructured, preferably by separating the good and bad parts of the bank. Such an approach would still be feasible today, though it might be more difficult under the EU Bank Recovery and Resolution Directive rules of limited state aid.
Once the bail-in of bank creditors is completed, the Eurozone Restructuring Agency would inject capital in the good banks, but in return would receive equity claims in them. One arm of the agency would thus partially or fully own and manage the good banks, and sell them at the best achievable price after the restructuring is finalised. The second arm of the agency would be responsible for liquidating the assets of the bad banks, and these assets would also be partially or fully owned by the agency.
Such a proposal is more ambitious than the non-performing loan agency described earlier, and more politically controversial. But it would allow the Eurozone to address a second important impediment to future growth: the oversized banking system, both in terms of volume and numbers (Langfield and Pagano 2016). By restructuring weak banks – by closing where necessary and merging where possible – the problem of weak governance and entrenched relationships among local politicians, national regulators and bankers can be addressed. And an important step towards a truly European banking system can be undertaken.
The politics of an asset management company
An asset management company for the Eurozone could have been established relatively easily before the adoption of the EU Bank Recovery and Resolution Directive, provided that the political will had been there. However, the tighter rules on taxpayer-funded recapitalisation and state aid concerns make the establishment of such an agency difficult from a legal point of view. Avgouleas and Goodhart (2016) suggest a guarantee by the European Stability Mechanism and the condition that only well-capitalised banks can sell non-performing assets. Even so, the inadequate political will to resolve the legacy problems in the Eurozone banking system seems to be a more serious problem as compared to the legal barriers.
The Eurozone Crisis has been characterised not only by a political stand-off between creditor and debtor countries, but also by a lack of a policy discussion on how to resolve the crisis. The main stumbling block to completing the banking union by using a deposit insurance scheme is the fear of creditor countries (led by Germany) that they would have to pay up for past and on-going bank losses of debtor countries. The solutions proposed by Haben and Quagliariello (2017) seem to rather postpone the ‘day of reckoning’, whereas Avgouleas and Goodhart (2016) primarily rely on national funding, with a Eurozone guarantee as back-up. However, there is a strong case to be made for the distribution of losses at the Eurozone level: by cleaning up the legacy losses, the Eurozone can finally start from a reasonably clean slate and move forward.
But why would creditor countries agree to help in cleaning up legacy costs? In our Vox column, my co-author and I argue that a Eurozone Restructuring Agency has the advantage that positive returns (upside risks) would be redistributed to its shareholders in proportion to their paid-in capital, or in line with agency ownership shares (which are proposed to be similar to ESM ownership shares) (Beck and Trebesch 2013). This means that creditor countries would receive larger pay-offs if things turn out favourably, even if these revenues come from debtor countries such as Italy. We also suggest two possible collateral options to assure that debtor countries (those with many weak banks) bear the fair share of potential future losses. The first one proposes that the ECB’s future seigniorage gains are redistributed from debtor to creditor countries in line with losses incurred on banks headquartered in the respective countries. A second option is that debtor countries post collateral with the Eurozone Restructuring Agency, such as gold reserves or shares in state-owned companies, which could be sold in case the losses turn out to be larger than expected.
Looking beyond this crisis
Another important advantage of a Eurozone-wide asset management company would be to provide an important impetus for institutional reforms in the countries with the highest levels of NPLs. Institutional deficiencies often stand in the way of speedy recovery of non-performing loans. A demonstration effect from successfully restructuring loans might help to spur the necessary reforms. A second important advantage might be the development of a European market for distressed assets, which can become an important component in the development of capital markets, under the heading of a Capital Market Union.
The losses from the Eurozone Crisis and consequent recession have only been partly recognised and addressed and this holds back recovery across the Eurozone. Accommodating monetary policy by the ECB faces limitations if the monetary transmission channel is clogged because banks’ balance sheets are burdened with non-performing assets. As the Eurozone nears the conclusion of its first ‘lost’ decade, ambitious policy solutions are needed to avoid a second lost decade. A Eurozone-level approach to non-performing assets and weak banks is an important component of this agenda.