The European Central Bank’s (ECB) quantitative easing (QE) program—a driving factor behind the euro area's strong cyclical recovery – cannot achieve its full potential unless banks lend more. But, as highlighted in our recent annual assessment of the euro area economy, bank lending cannot fully recover without tackling its mountain of bad debt – the so-called non-performing loans (NPLs).
QE has already notched several important successes. Interest rates have declined and stock markets have soared, while business confidence has improved. The euro has also weakened, giving a boost to exports. Most importantly, the long decline in inflation and inflation expectations has been reversed.
However, lending remains anemic, weighed down by high NPLs. The ECB's Comprehensive Assessment revealed that for the euro area as a whole, nonperforming exposures amounted to nearly US$1 trillion, or over 9% of GDP at end-2014, more than double the levels in 2009. NPLs are particularly elevated in countries such as Cyprus, Greece, Italy and Portugal. High NPLs tie down bank resources that could otherwise be used to expand lending and investment.
To support the recovery, NPLs should be either written off—for loans that are beyond recovery—or restructured to give viable debtors a chance to invest. Write-off rates for euro area banks remain much lower than those of American banks, despite a much higher stock of NPLs (see chart).
A rough calculation suggests that a timely resolution of NPLs could release as much as €42 billion of bank capital, which could in turn unlock new lending of more than 5% of GDP. This would also help address the corporate debt overhang by hastening the closure of “zombie” businesses, while channeling more resources to productive firms.
International experience in countries with high NPLs suggests that a comprehensive approach to accelerating NPL resolution by euro area banks is urgently needed. Such a strategy would have three main pillars.
First, the ECB and national authorities should tighten bank supervision. Creditors and debtors are prone to a state of bad inertia as they may look to postpone resolving their problems while holding out for a strong recovery.
However, decades of international experience show that swift recognition of loan losses is crucial to starting the repair of bank balance sheets. Banks should be encouraged to meet loan restructuring targets within a reasonable period of time.
And they should be required to set aside more capital for NPLs that remain on their books for too long. More conservative provisioning and collateral valuation would encourage banks to resolve NPLs quickly.
Second, structural reforms are needed to make bankruptcy and debt collection faster and easier. There is currently enormous variation in legal frameworks between countries. For example, the average length of foreclosure proceedings in Italy is almost five years compared to less than one year in Germany and Spain. Lengthy court procedures should be shortened, and out-of-court arrangements encouraged as an alternative.
Third, Europe needs more active markets in distressed assets. As seen in Asia after the 1997 financial crisis and elsewhere, a vibrant market for restructuring NPLs can help banks partner with specialist investors with financial resources and experience in resolving impaired assets. In some cases, a publically supported asset management company (AMC, sometimes called “bad bank”) can help kick-start a distressed debt market, such as we have seen in Spain with SAREB.
These measures comprise a challenging but necessary reform agenda to get credit flowing again and nurse the euro area's ailing banking sector to health. As part of a comprehensive strategy including structural reforms and fiscal support, addressing the NPL problem would enhance the ECB's monetary easing program and help secure a more robust and lasting recovery.
*Mahmood Pradhan and Kenneth Kang are respectively deputy director and assistant director in the IMF's European department and head the team responsible for the euro area economic policy analysis.
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