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The non-performing loans problem, will Europe follow Japan?

In the early 1990s the asset price bubble in Japan collapsed, it was the start of what later came known as the “Lost Decade” or even “Lost Score”. The Financial Services Agency (FSA), the Japanese supervisory and regulatory institution, waited more than a decade before obliging Japanese banks to take the losses on non-performing loans. At the end of November 2002 the FSA released a schedule the Japanese banks had to obey in acknowledging and taking the hidden losses on their balance sheets. Late March 2005 all non-performing loans had to be halved compared to before the start of the schedule. Afterwards, the balance sheets of Japanese banks could be considered as “cleaned up”. Unfortunately, the Japanese inertia problem seems to become more and more a problem in Europe as well.

Let us consider the parallels between the situation in Europe nowadays and the above scenario. In Europe, most non-performing loans are a remainder of the financial crisis of 2007/2008. Those loans are in default or close to default, because payments are about to being overdue for 90 days. Banks use constructions to avoid having to label a loan as non-performing. In accordance with the bad borrower they can provide a new loan to pay off the old loan. The 90 days will start from scratch and the loan doesn’t need to be labelled as non-performing. As a result, no extra capital is needed to back for the bad loan or no capital has to be used to take the loss on the loan. Alternatively, loans can be restructured by the lender avoiding classifying the loan as non-performing. At first glance it seems a great way to circumvent the rules, however it is not the core business of banks. They need to issue loans. Provide companies with the means to invest, instead of circumventing some capital rules. The described way of banking is also known as “Zombie-banking”.

The European Central Bank (ECB) is the regulator and supervisor of all banks in the Eurozone. Due to contrary opinions over how to solve the non-performing loans problem in the Eurozone, the ECB takes no hard measures to solve this problem. The ECB has no clear view on whether banks have to use a bail-out or bail-in to obtain new capital after writing off bad loans and consequently decreasing their capital buffer. In the past there were multiple occasions the ECB could have used to oblige banks to write off the non-performing loans. But none of these occasions are used by the ECB to solve the problem. The regulatory forbearance with this problem ensures we can’t leave the past financial crisis behind us. Bank balance sheets are not “cleaned up” and strengthened to enable them to better cope with negative future economic and financial shocks. Besides, economic activity is not stimulated at maximum level. Banks need capital and take time to deal with these non-performing loans on their balance sheets, instead of channelling means to their most productive uses.

Another issue, which will not be solved before bank balance sheets are “cleaned up” from the non-performing loans is the establishment of the European Banking Union. This Union consists of three pillars. These pillars are the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the Deposit Guarantee Scheme (DGS). The first two pillars are implemented in Europe. The ECB acts as the direct supervisor for large banks and indirect supervisor for smaller banks in the Eurozone since November 2014. The SRM is active as from 2015. It supplements the Bank Recovery and Resolution Directive and besides has established the Single Resolution Board to ensure that resolution across the euro area is uniformly conducted. The third pillar, the DGS however will not be established as long as the balance sheets are not cleaned from the non-performing loans. The big issue hampering the introduction of the DGS instead of the national DGS is that especially the northern European countries are against the introduction of the DGS. They are afraid that they have to pay for the losses of the weaker southern European banks (in the southern European countries there are many banks that will actually be insolvent after acknowledging the non-performing loans). For this, northern European countries are only willing to support the DGS when all countries in the Eurozone force their banks to take the losses of the non-performing loans and consequently obtain new capital to become viable and solvent again. Until this has happened the DGS will not become active in the Eurozone and the European Banking Union will not fully be implemented.

The ECB as the overall supervisor and regulator of the banks in the Eurozone have had many occasions to solve the non-performing loans problem. In 2013 an Asset Quality Review and Stress Test was conducted in the Eurozone. The ECB could have put temporary intervention laws into place, to immediately act upon the publication of the results. Unfortunately, they didn’t and after the results became available nothing happened. In 2014 the ECB became the Single Supervisor. Before accepting to supervise countries’ banks, they could have obliged countries to solve the non-performing loans issue and recapitalize their banks. The ECB didn’t. Now the ECB is the Single Supervisor and has the power to label banks as insolvent and in resolution. The Single Resolution Board is the institution assigned with the powers to decide whether banks that are in resolution, will be recapitalized or been put into bankruptcy. However, the ECB is reluctant to classify banks in the Eurozone as insolvent and in resolution. Therefore, no immediate action is taken and the problem at stake will not be solved.

Thus, forbearance in the Eurozone more and more is pushing the European non-performing loans issue towards are longer-term problem similar to the problem faced by Japan around the turn of the century. Differing opinions and the lack of urge to act on short notice result in not solving the issue and not re-strengthening the capital buffers of the banks in the Eurozone. In order to stimulate economic activity and increase the resilience of banks, balance sheets have to be “cleaned up”, losses taken and capital buffers increased. Undertaking action is the only option leading to success, forbearance clearly is not the solution as evidence from Japan has showed.

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