Euro Financials: A eurozone ‘bad bank’ edges closer towards reality – The ECB has set tales wagging that a eurozone-wide ‘bad bank’ could be the solution for future non-performing loans (NPLs) that arise due to the coronavirus crisis.

Andrea Enria – chairman of the supervisory board of the European Central Bank – has twice detailed in newspapers recently the justifications for creating a ‘bad bank’ to address future NPLs that may arise from the coronavirus crisis.

A previous solution to fix a future problem – The setup of a ‘bad bank’ is not new, failed loans would be removed from bank balance sheets and placed in a vehicle to be serviced and sold. In fact, the removal of NPLs from banks balance sheets would be similar to the initiatives that were rolled out at a national level in countries such as Spain and Ireland in the wake of the global financial crisis.

The difference this time is that the process would be at the eurozone level. Enria notes that, ‘we need an integrated European response rather than a plethora of uncoordinated national initiatives’.

The ECB touts the benefits of a ‘bad bank’; to free-up the banking sector to lend, promote consolidation, promote greener lending and to advance technology.

Furthermore, ‘in the unlikely case that such a scheme ends up making losses, we could limit or even prevent any mutualisation of them across the EU. Instead, losses could be allocated by the nationality of the originating banks and each corresponding national scheme’. It would be a truly eurozone solution to a eurozone problem.

A tsunami of failed loans on the horizon? The ECB is taking a very proactive approach at this stage of the crisis. Thus far, NPLs have remained actually rather low in the banking sector as there is often a delay of a number of years to reach peak NPLs following a crisis.

The ECB however, expects an incoming torrent of NPLS to arise. It estimates that in a severe but plausible scenario, non-performing loans at euro area banks could reach a colossal EUR 1.4tn, well above the levels seen following the 2008 financial and 2011 EU sovereign debt crises.

Sentiment supports the scheme and the willingness to change laws signals the green light – Up until recently, the idea that private banks should be allowed to offload NPLs in such a scheme was frowned upon. Authorities had believed that the ability of private banks to benefit from the schemes was something of the past.

However, regulatory sentiment has clearly shifted. For instance, they recently gave the green light to Monte dei Paschi to off-load NPLs from its balance sheet. Crucially, Enria goes on to mention that the ECB could ‘make legislative adjustments, if necessary’ to address a future NPL mountain. In essence, this gives the green light to the creation of the scheme regardless of the previous state aid rules.

Good for banks and the speed of the economic recovery – A creation of a eurozone-wide ‘bad bank’ would be positive for the banking sector and could be a potential game-changer for periphery banks, which are expected to suffer greatly due to the coronavirus.

It would also be positive in terms of helping the speed of the eurozone recovery from a post-coronavirus era. The solution would help the supply of credit in the economy – a crucial failure in the 2008 crisis. This would mean governments and regulators have one less thing to worry about so they could focus on how to promote the demand of credit in the economy to generate economic growth.

The benefit the scheme would supply to a European economy recovery would likely be a fundamental driver that garners political support for the scheme. If the ECB, governments and banks are on board, there should not be too many hurdles to stop the creation of the first eurozone ‘bad bank’.

A crucial time for European banks – Finally, the timing of the ECB discussion on a ‘bad bank’ comes at a crucial time. European bank Q3 earnings that have been released this week have shown good earnings that have largely beaten expectations.

There is a huge focus on whether the ECB will allow shareholder distributions – dividends and buybacks – to be permitted at the start of next year. At present the ECB has prevented banks from paying dividends until the end of this year to keep capital within banks as they position to deal with the coronavirus crisis.

The ECB is caught in a tough place – the strong earnings will add fuel to the fire that dividends should be resumed. However, a second and critical rise in coronavirus cases in Europe this week has led to a sudden uncertainty as to whether a ‘second wave of bank provisions’ may be needed for the European banking sector. If the ECB can convince some banks that an NPL backstop could be on the cards, then this could help them to placate some banks in their eagerness to pay-out shareholders fully.