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Greek NPLs: reforms under the ESM programme are yet to make a big dent  

With €90 billion in non-performing loans (NPLs) as of late 2018, equivalent to 43% of all loans, Greece remains a crucial testing ground for the strategy on ‘risk reduction’ in the currency area.

Economic growth resumed in 2017, though it will not be sustained unless the banks’ deleveraging ends. This will need to be backed by a comprehensive transfer of bad loans from bank balance sheets, combined with private debt restructuring.

The high ratio of NPLs in Greek banks was an early and highly visible effect of the financial and economic crisis in the country. The NPL ratio increased to a peak of 47% in mid-2017, the highest in the EU. The , which took stock of the just-concluded ESM programme, acknowledged that the extended recession has been the root cause of the banking-sector troubles. More recently, moral hazard fostered by poorly targeted debtor protection schemes also played a role.

Over the two years to mid-2018 the absolute stock of NPLs fell by over €20 billion, largely through write-offs. Under the ESM programme several measures have also improved the framework for NPL resolution:

• an out-of-court debt restructuring framework, which also included a write-down of tax arrears, though only a few cases were concluded under this procedure;
• a reform of the insolvency regime for households and enterprises;
• acceleration of the sale by banks of collateral in defaulted loans through electronic auctions;
• the simplification of the sale of NPLs through the liberalisation of the loan-servicing regime.

Ambitious targets for NPL reduction were agreed between the four largest banks and the ECB, and under a similar framework by the Bank of Greece for smaller banks. NPL ratios are to fall to 35% by the end of this year, and possibly to 20% by the end of 2021. The reforms in regulation, supervision and the functioning of the judiciary will not accomplish such a sizable reduction. Two more wide-ranging solutions are therefore under discussion.

A common ‘bad-bank’

The central bank in late November a scheme under which a single private special purpose vehicle (SPV) would be established. This is effectively a ‘bad bank’ which would acquire nearly half of the NPL stock from the four largest banks. But there would be important differences from the earlier European asset management companies that helped overcome the financial crisis, such as those in Ireland and Spain.

First, the new entity would need to acquire various asset types, including the more problematic SME and mortgage loans, where poorly targeted borrower protection has been a problem. Unlike in other euro-area crisis countries, loan delinquency in Greece is evenly spread between household and corporate sectors. Should a wide range of assets types be transferred this would put some strain on capacity for restructuring and enforcement within the new entity, or in contracted servicing agents.

Secondly, the capital base of the new entity would be more complex. So-called ‘deferred tax credits’ (DTCs) would be transferred by the banks to cover the difference between net book values (after provisions) and current market prices. DTCs were approved as a form of bank capital under state-aid procedures by the Commission, but additional legislation would be required to make them suitable as a capital base for the new entity. In any case, banks will need to re-build capital coverage following the asset transfer.

Lastly, the SPV’s acquisition of assets from the banks would be funded through the issuance of securitised notes backed by the NPL stock. The lowest-quality tranche of these securities would be purchased by the participating banks and the Greek state, others would be sold on the market. The assets underlying these securities will be hard to value, and pooled from various loan classes and from banks with different internal standards. To achieve a relief on the banks’ capital requirements a sale would need to imply a near complete transfer of risks.

A government guarantee scheme

An alternative proposal originated in the Hellenic Financial Stability Fund (HFSF) and is developed by the government. It would involve the establishment of a series of SPVs by each of the four systemic banks, which would purchase NPL portfolios funded by the sales of asset-backed securities to private investors. The NPL portfolios should be worked out by independent servicers. Only the most senior tranches would be guaranteed by the government, once a large enough share of the riskier tranches has been sold to other investors (only then would supervisors treat the NPL portfolios as no longer requiring capital coverage by the bank).

This proposal is very similar to the Italian scheme ‘GACS’, which in 2016 was approved by the European Commission following protracted discussions over a ‘bad bank’ scheme in Italy. The key idea of both the Italian and the Greek guarantee schemes is that government backing helps bridge the wide gaps between the pricing of NPL portfolios sold by the banks, and prices currently offered by investors in very illiquid markets. Because this sovereign guarantee would be remunerated by the originating banks on market terms this would not be considered state aid.  

Additional capacity in debt restructuring is needed

Unlike in other euro-area crisis countries, most notably Italy, there have been only a few NPL sales by banks in Greece. Restructuring and enforcement strains the banks’ capacity, and in mid-2018 the rate at which debtors defaulted still exceeded the rate at which loans returned to sustainable good performance.

Both proposals could succeed in shifting large stocks of bad loans into legally separate entities, thereby freeing bank capital and capacity to engage in fresh lending. Both are designed to navigate the EU’s restrictions on state aid which could be an issue where loans are transferred above market values. They could stimulate investor interest in assets that inherently lack transparency, are exposed to political interference in restructuring, and which depend on the outcome of legal proceedings in an inefficient judiciary. Financial engineering of loans that are defaulted or in legal proceedings, and which originated in different banks and asset classes, would be a challenge.

The central bank’s bad-bank-type common SPV would create new capacity to structure portfolios that are more attractive to investors than those of individual banks, and could overcome coordination problems where defaulted borrowers are exposed to loans from several banks. Independent loan servicing agents could enforce more effective restructuring solutions.

Greece has a significant problem with ‘zombie firms’ – enterprises that are loss-making and over-indebted, and which are unlikely to recover following any further debt restructuring. In these cases a new agency would need to be empowered to foreclose. In firms that are potentially viable, many of the banks’ own restructuring solutions seem to have failed. A single common institution may be more effective in restructuring efforts. But this will require scarce skills, and perhaps additional capital and special privileges under the law.

The other proposal envisages a series of transactions by individual banks. This would offer more transparent assets to investors, and could be done on the back of an EU state-aid ruling for a similar scheme in Italy. The sovereign guarantee of portfolios will likely be costly, as the Greek state remains below investment grade. This could be a sensible complementary solution to create further investor demand, in particular for loans that are already in legal proceedings.

Lack of bank capital to cover a further write-down in asset value is the underlying constraint in dealing with private debt and loan delinquency in Greece. State backing for a scheme that engages private investors in this process can bridge some market failures inherent in dealing with bank assets, though the sovereign’s capacity to extend guarantees is limited. A single asset management institution that is jointly supported by the key banks would be a valuable addition to the process of private debt workout. Only some asset types will be suitable, and a significant amount of restructuring will remain with the banks.