European Banks, the future resolution framework and transatlantic finance

European assets disposal to US shadow banks and the emergence of a new resolution framework

I wrote recently about the scope for corporate debt relief in Europe in general and France in particular. This is deeply connected to progress and pressure on the banking sector and concerns surrounding European Banks’ balance sheets.

During the COVID crisis, the European supervisor (SSM) has greatly helped with supervisory relief and capital conservation measures (dividend restrictions…). This helped to avert the sharp tightening of credit standards and accelerate NPLs and corporate default.

These measures were greatly augmented by fiscal and liquidity support measures that shielded a large part of the European corporate sector. It will be key to assess what will happen to the European corporate sector when both sets of measures are withdrawn and the consequences it will have on banks’ balance sheets.

European supervisors are expecting a significant surge in NPLs, despite the relatively buoyant recovery (which seems somewhat at odds with expectations of a rapid and sustained economic rebound). This is the reason why a template for accelerating NPL recognition and disposal is being put in motion. This has important consequences for the European banking system and transatlantic shadow finance, but it also says a lot about the discrete but ongoing rewiring of European bank resolution framework.

It is useful to recall that over the last 5 years, European banks have gotten rid of almost EUR 700bn worth of Non-Performing Assets, snapped almost entirely by US Non-bank actors. This great European deleveraging has been enabled by a great demand from US shadow banks for European high yielding assets. This is only the beginning of a trend that started with disposal of US dollar assets following the 2011 dollar liquidity crisis in the European banking system and is being accelerated by a disposal of Euro denominated High Yielding assets. European banks are deleveraging both their Dollar assets as well as their Euro assets.

This is being accelerated by an NPL Action Plan endorsed by the European Commission, the Eurogroup and actively pushed by the ECB. It relies on the following four building blocks:

1.     Further develop secondary markets for distressed assets, which will facilitate banks to move NPLs off their balance sheets

2.     Reform the EU’s corporate insolvency and debt recovery legislation, which will help converge the various insolvency frameworks across the EU and facilitate the collection of claims of creditors

3.     Support the establishment and cooperation of national asset management companies (AMCs) at EU level, which will have profound consequences on the operation of the European bank resolution framework

4.     Implementation of precautionary public support measures, where needed, to slowly rewire the resolution arrangements established under the EU’s Bank Recovery and Resolution Directive and State aid frameworks of 2013.

What is striking in these proposals is that the first two are institutionalising a legal and financial ecosystem to facilitate securitisation and asset disposal from banks, and that the last two are effectively rewiring the European Resolution Framework by complementing it with instruments that did not exist when the BRRD was launched, or the Single Resolution Board established.

Indeed, a large part of the challenges from 2015 until today, in particular in Europe’s periphery, lie with a banking union framework that didn’t allow widespread bank restructuring, resolution and recapitalisation.

In reality, an alternative framework came to emerge over the last 5 years “by touching the stones at the bottom of the river” and is being solidified today. This owes a lot to both Italy and Greece’s peculiar experiences with bank clean-ups, asset disposals and restructuring and with the permanent state of exception to the arcane rules of the BRRD that are effectively being institutionalised.

§  GACS After several attempts at forming a bad bank, the Italian government was able to convince European authorities to allow a framework of credit enhancement that would facilitate the disposal of assets. This framework is heavily reliant on the European Commission’s assessment of state guarantee not constituting a State Aid because the Italian government receives an insurance premium paid for by the banks. This framework, along with other M&A operations allowed both asset clean-up and restructuring, recapitalisation.

§  Hercules:  The Greek government developed a very similar scheme that also allowed a considerable and rapid sale of NPLs across the banking system. It has reduced the stock of NPLs on banks’ balance sheets by half and is now being extended.

These experiences which required long negotiations and some creativity on the part of DG comp are now becoming an integral part of the European bank resolution/restructuring toolkit. But it remains an imperfect and incomplete toolkit, whose development is hampered by the notion that Member States only need to complete the banking union, while in reality, they have to rethink it altogether.

One area of potential incremental progress is that of Asset Management Companies (AMCs, ie. Bad banks), which after repeated failures is slowly becoming part of the policy debate. The action plan of the commission no longer rules them out, and agrees that they can be partially publicly funded to the extent that the Government behaves as an investor would. This is an important departure from previous positions rooted in a narrow view of what banking system repair needs. The big question is the extent to which these AMCs should be national, European or organised in a network of national AMCs. Andrea Enria has long pleaded for a European bad bank, with modest support from his peers but the debate might be growing again as COVID seems to open some rather fundamental rifts in the current European resolution framework.

Indeed, it is important to note that the Commission considers that the COVID crisis can be considered a disturbance that would fall under the exception in Article 32(4)(d)(iii), which could pave the way for public sector support in the form of precautionary recapitalisation but not only. The objective of this provision is to allow Member States to provide institutions with a temporary capital buffer to deal with severe adverse conditions in order to boost confidence in the banking sector and strengthen financial stability. In its Temporary Framework for State aid measures to support the real economy during COVID, the Commission already recognised this possibility. The central question now is whether the build-up in bad assets during COVID will be considered down the line as something that warrants public sector support for the creation of bad banks for example, thereby creating an important precedent.

In any case, the experience of the last 5 years combined with the COVID crisis are proving to move quite substantially the banking resolution/recovery framework that emerged after the Euro Crisis. This opens important avenues for reforming the framework profoundly but in the meantime, we will see more transfers of risks (but also assets and revenues) from European banks’ balance sheets to American shadow banks, an ongoing feature of transatlantic finance since 2011.