As the global economy continues to grow, expansion throughout the Eurozone remains subdued by remnants of the global financial crisis. The recovery pace of the Eurozone has far lagged that of its developed counterparts, and despite recent years’ developments, legacies of the crisis remain a threat to financial stability.
The most crucial of these threats are the continent’s high level of non-performing loans (NPLs)1, which amounted to €864.50bn or 4.8% of total gross loans as of March 31, 2017, (Source: EBA Risk Dashboard- Q12017). The buildup of NPLs following the crisis has weighed on the profitability and lending activities of Eurozone banks, tying up capital and further exposing the continent to economic shocks.
Despite differences at the national level, the overall pace of deleveraging in the Eurozone has been slow. Deleveraging efforts have been impeded by a variety of market failures, all of which leading to large bid-ask spreads subsequently forcing banks to maintain legacy NPLs on their balance sheets. Adding to market failures is the slow pace of economic recovery, which has led to the accumulation of new NPLs despite improving economic conditions. Even with the recent downward trend, the ratio of NPLs to total gross loans remains elevated at 4.8%, far above pre-crisis levels of 2.8% and above the average of less than 2% across advanced economies (Source: IMF Financial Soundness Indicators). In the years following the crisis, the effects of legacy NPLs on banks’ balance sheets have materialized, suppressing bank capital and driving down profitability to historical lows.
NPLs have impacted Eurozone bank’s profitability in many ways. Increased loan loss provisions and impairment losses have depressed bank’s operating income, while concerns regarding the quality of banks’ balance sheet have driven up funding costs. The average return on equity (ROE) of Eurozone banks stands at 3%, far below the pre-crisis average of 9%1 and the well below the average cost of equity of 8-10%2. The spread between the cost of capital and the average return of Eurozone banks has further impeded funding dynamics and depressed bank valuations. Persistent weakness in the banking sector has become a key focus of EU regulators as the expectation that weak profitability will persist into the future presents significant obstacles to the resolution of NPLs and the stability of the financial system.
In the near-term, banks profitability faces the risk of further erosion from the onset of new accounting standards governing impairment losses, tightening capital requirements and a fragile economic outlook. Effective January 2018, IFRS 9 will replace IAS 39 accounting standards governing impairment losses. The new standard introduces of a forward-looking impairment model that requires banks to recognize losses in advance of an actual default, offsetting gains from a steepening yield curve.
The potential for tightening capital requirements under Basel IV standards will further constrain bank lending and dampen already fragile economic growth.
Furthermore, the Eurozone remains vulnerable to changes in financial condition and any disruptions to growth could lead to more defaults, further driving up NPLs and threatening the banks position as a going concern.
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The already weakened position of these banks limit their ability to withstand economic shock, and the materialization of these near-term risks could lead to the collapse of the banking sector, with the potential for financial contagion bearing important repercussions for the European economy.
- European Central Bank (ECB) Consolidated Banking Statistics. The average annual ROE for the period 2013-2015 was 3%. The average annual ROE during 2007 was 9.89%.
- European Banking Authority, “EBA Risk Assessment Report”. December 2016. According to the EBA’s risk assessment questionnaire (RAQ) 84% of banks estimate their cost of equity above 8%. Cost of equity was determined using the capital asset pricing model (CAPM). Please refer to page 47 of the report for more detail.
In accordance with European Banking Authority (EBA) guidance, non-performing exposures are defined as material exposures that are more than 90 days’ past-due and or exposures that “…present a risk of not being pack back in full without collateral realization, regardless of the existence of any past-due amount or of the number of days past due” (Source: EBA).