The Eurozone banking system will have to gear itself up this autumn to take over the supply of credit from the Eurosystem, as the Eurosystem’s version of QE – called Asset Purchase Programmes – is wound down.
The winding-down is in stages. There will be no new purchases to start with, and then the proceeds of maturing bonds will no longer be re-invested. There will be no sell-off of the residual portfolio: that would send interest rates up and bond prices into a tailspin. Instead the portfolio will be allowed to run off, and this will be over a 5-7 year period. The Eurosystem has bought bonds only in the secondary market, not primary, so the average life of what they have bought will be somewhat shorter than the average life upon issue of the respective bonds.
The private banking system has now to step up to the plate to replace this liquidity, with new loans.
Preparations for how to create this headroom have been proceeding in the background, against an unprepossessing startpoint: high levels of Non-Performing Loans and accompanying low levels of capital, the CET1 ratio being the key measure of capital to assets.
“Assets” in this case are better termed “Risk-Weighted Assets” or “RWAs”, and are determined by putting the face value of every piece of business through a methodology that adjusts the face value to a value-at-risk, against which the bank should hold between 8% and 10.5% of CET1 capital, depending upon whether it is a Global Systemically Important Bank or not, and, if it is, what level of “GSIB” it is.
These methodologies, in the financial crisis, were shown to have been systematically understating the risks the bank was taking; a bank achieved compliance with its capital ratios by artifically diminishing the RWA figure.
The options for improving the CET1 ratio are limited. Capital markets are broadly closed to banks for raising new capital. Profitability remains low so new capital is not being generated internally. Securitisation of assets has stumbled upon the divergence of valuation between what the bank’s RWA calculations say the asset is worth, and what third-party investors believe it is worth. This only leaves one option for creating the necessary headroom for new lending: accounting actions aimed at the diminution of the RWA figure.
The RWA figure has been weighed down – in countries like Italy, Greece and Cyprus – by the high levels of Non-Performing Loans, or “NPLs”. In Cyprus these remain in the low 40% range of all loans. There has been a public relations campaign to argue that the situation is improving and that these levels of NPLs are not catastrophic.
The Central Bank of Cyprus issued a “good news” story through the Cyprus Business Mail on 13th July 2018 about the NPLs in the Cypriot banking system: they had fallen in March 2018 by almost €2.1bn to €19.9bn compared to February’s figure, and that this was the lowest figure for NPLs since December 2014.
Then on 23rd July 2018 it was announced that Bank of Cyprus was lining up a transaction to sell off a block of its NPLs in “Project Helix” to private equity investors listed as Apollo, Pimco and Lone Star. This project follows a template established in Italy for their banks to reduce their NPLs – a failed template.
The article cheerfully announced that Bank of Cyprus had reduced its NPLs for a 12th consecutive quarter. As of March 31st 2018 its NPLs had a face value (i.e. the amount stated in the loan contracts) of €8.3 billion, with what is known as a 51% “coverage ratio”. This means that the bank had written the value of these NPLs down in its books by 51%, to 49% of face value. This 49% figure is known as the “carrying value”.
The key formula is Face Value less Write-down = Carrying Value.
BoC’s quarterly report as of 31/3/18 bears ample testimony, in sections F1 to F8 on pages 28 to 35, to the manipulation of the NPLs figures such that they do not appear even worse:
- “Forbearance” techniques, meaning things like the unpaid interest has been capitalised or the repayments have been stretched out. The loan then continues to rank as Performing and does not fall into Non-performing status;
- “Restructuring” actions such as taking extra mortgage security, no doubt with suitably lax conditions around the Loan-to-Value, whether there is a re-sale market for the asset if repossessed and so on. The loan is then backed out of the NPLs figure and into Performing.
The Central Bank of Cyprus’ statements in their “good news” story of 13th July 2018 are misleading by omission: “The downward trend in NPFs (non-performing facilities) can be attributed to write-offs, increased restructurings successfully completed by the end of the observance period and reclassified as performing facilities, repayments as well as settlement of debt through swaps with immovable property that is expected to be sold with the aim of a faster cash collection”.
In other words NPLs are reducing because of the application across the industry of “forbearance” – to keep some bad loans classed as Performing – and “restructuring” – to back some loans out of NPL status and into Performing. In both instances the loans is recorded in the bank’s accounts at full face value.
If there really was any good news CBC’s statement would read: “The upswing of the economy, rising disposable incomes and business confidence have enabled many borrowers – personal and business – to clear the arrears on their debts and even manage increased capital repayments”. But it doesn’t say that, because none of this is happening.
We thus have NPLs mis-valued at two levels. Firstly there is a block of Performing Exposures which should be held as NPLs and written down to a “carrying value” below 100%. Then the NPLs that are admitted to are substantially over-valued.
Applied to Italy, we have a policy brief issued in September 2018 by the LSE called “A Stylised Narrative Of Italian Banking problems”, by renowned economists Lorenzo Codogno and and Mara Monti. The key paragraph is:
“The decrease in bad debt net inflows (down from €24.7 billion in 2015 to €10.8 billion in 2016 and -€19.6 billion in 2017) is mainly related to the recovery of the economy and NPL internal management by banks. Securitisation and sales of NPLs increased from €7.1 billion in 2015 to €17.9 billion in 2016 and €38.7 billion in 2017. The combined effect of these flows has allowed for a reduction in the stock of NPLs. In December 2015, they were €200.7 billion. They stayed broadly unchanged at €200.9 billion at the end of 2016, but they declined to €167.4 billion at the end of 2017 and to €127.5 billion in July 2018. Despite the pace of write-offs having increased significantly and despite the fact that loan loss provisions cover more than half of the total amount, the stock of NPLs as a percentage of total loans remains high”.
The analysis is flawed firstly in not clarifying whether it is the Face Value of NPLs that has changed or the Carrying Value. If it is the Face Value, then half of the entire figure for securitisation in 2017 can be attributed to Unicredit’s FINO project, where a substantial block of NPLs has been moved off the balance sheet, but where only about 40% has been successfully refinanced. The first tranche was securitised at or below the 13% Carrying Value in Unicredit’s books, and they have not been able to complete any more tranches, leaving 60% of the FINO portfolio in suspended animation.
In our view the reduction in the amounts of NPLs shown by banks has everything to do with “NPL internal management by banks” and nothing to do with “the recovery of the economy”.
In other words the reductions are 0% attributable to economic upswings and debtors paying, and 100% due to “forebearance” and “restructuring”.
The application of these techniques has allowed loans to be backed out of NPLs without borrowers paying anything.
Where a “restructuring” is completed in accordance with the central bank’s rules, the loan cannot fall back into NPLs for a grace period whatever happens.
“Restructurings” invariably involve the placing of extra security on real estate.
The thinking of the ECB on this matter was revealed by Mme Daniele Nouy, their chief banking supervisor, in a speech at a conference in Linz in July 2018, which was under-reported. It is of huge significance. Mme Nouy stated that Eurozone banks should be granted exceptions from global banking rules when it comes to mortgages and lending to companies.
All of this added together would result in four massive reliefs for the Eurozone banking system, in terms of diminishing the RWA number that the bank’s CET1 capital is divided into.
Firstly, Performing Loans with real estate security can be backed out of the RWA calculation.
Secondly, Restructured NPLs with real estate security can be backed out of NPLs into Performing Loans and also out of the RWA calculation.
Thirdly, Restructured NPLs without real estate security can be backed out of NPLs into Performing Loans, and can be allocated a much lower risk-weighting in the RWA calculation.
Fourthly, NPLs to which forebearance techniques have been applied can be backed out of NPLs into Performing Loans, and can be allocated a much lower risk-weighting in the RWA calculation.
A big issue with the recording of NPLs in Italy, as in Cyprus, has been that, although the loans have been written down from their Face Value to a lower Carrying Value, there was no evidence that the Carrying Value was being realistically weighted within the RWA calculation. It was being risk-weighted as if the Carrying Value was a Performing Loan and not part of an NPL.
The way out of that is not to assign a realistic risk-weighting to the Carrying Value, but to use these techniques to write the Carrying Value back up to nearer the Face Value or indeed to the complete Face Value, and then to assign an unrealistically favourable risk-weighting in the RWA calculation to the Face Value. The value is unrealistic because the loan was in default and the debtor has not had to come up with a single euro in debt service payments to enable the loan to be reclassified as Performing and for the RWA weighting to be reduced/eliminated.
The upshot is that the banks’ CET1 ratios become very favourable, because the figure for RWAs is substantially reduced by these four accounting actions. Static capital, divided into a much lower RWAs figure, delivers a much better CET1 ratio. The CET1 ratio goes into surplus compared to the level required by compliance.
This surplus produces an entirely contrived ability to make new loans, in a broad proportion of EUR20 of new loans for EUR1 of capital surplus. This in turn injects liquidity into the economy to replace the Eurosystem APP which is tapering off, as long as the banks can raise the deposits to make the new loans in a proportion of EUR19 new deposits to EUR20 of new loans.
This is the potential inhibitor, and it has to be overcome via each private bank’s Eurozone central bank, through the creation of asset-baced securities that the central bank views as eligible for refinancing. This does not have to be done on the back of TARGET2, and it is not repo funding, but is achieved through a standing facility between the central bank and the private bank. This is the pinchpoint in the scheme, though, because we have an implication that the Eurosystem central banks will individually take up all the slack that is left by the tapering off of the Eurosystem-wide APP.