Friday, June 30, 2017 2:35 PM / Fitch Ratings

Eurozone banks are under increasing pressure to reduce high stocks of non-performing loans (NPLs) after Italy's Veneto Banca and Banca Popolare di Vicenza were put into liquidation this week and Spain's Banco Popular Espanol was put into resolution this month, Fitch Ratings says. These banks have among the worst NPL/gross loans ratios in Europe.

In March 2017, the ECB issued guidance requiring banks with high NPLs to devise strategies to reduce them, including work-out, servicing and portfolio sales. The regulator will then be able monitor adherence to strategy and take appropriate action. NPL ratios are highest at the largest Greek and Cypriot banks while Italy had 12 banks with end-2016 ratios of more than twice the 5.1% weighted average reported by the European Banking Authority.

In Italy, problem loans have built up during a long recessionary period and it is only recently that the economy has started to give banks breathing space to start to tackle this legacy. If large NPL securitisations planned by UniCredit, supported by its recent capital increase, and by Banca Monte dei Paschi di Siena as part of its precautionary recapitalisation, are launched successfully in the next month or so, we expect to see other banks taking the securitisation route to reduce NPL stock. But large NPL sales and securitisations are difficult to achieve and none of the large announced transactions has yet been closed.

The contrasting treatment of Banco Popular Espanol, which was put into resolution, and Veneto Banca and Banca Popolare di Vicenza, which were liquidated, raises questions about the application of the EU's Bank Recovery and Resolution Directive (BRRD). The BRRD is intended to shield taxpayers from the costs of bank failures by forcing banks' creditors to bear costs. However, Italy's decision to transfer senior bondholders to Intesa Sanpaolo along with the two Veneto banks' performing assets and only keep subordinated debt and equity, along with NPLs, in Veneto Banca and Banca Popolare di Vicenza, shields senior bondholders from losses, while the Italian state is paying EUR5.2 billion in cash and providing up to EUR12 billion in guarantees to Intesa Sanpaolo.

The decision was driven by Italy's reluctance for the banks' senior debt to be bailed in, given partly that many retail investors hold this debt, but also that it ranks pari passu with other senior obligations, so would be difficult to segregate for bail-in without endangering the smooth functioning of critical financial services carried out by the banks. Senior bondholders would have been vulnerable to losses had the banks been put into resolution, given their thin junior debt buffers.

We believe the treatment of troubled banks will be clearer once the EU's minimum requirement for own funds and eligible liabilities (MREL) is in place. MREL, combined with a likely EU-wide new class of non-preferred senior debt, will provide loss-absorbing debt eligible for bail-in that shields preferred senior obligations from losses triggered by resolution. This should substantially reduce the need to use state resources.

MREL is due to be implemented by 2022, with insolvency regimes across Europe being updated in the meantime to enable banks to issue non-preferred senior debt. This month the Council of the EU agreed its stance on a package of proposals aimed at reducing risk in the banking industry, including a draft directive requiring member states to create a new class of non-preferred senior debt, eligible to meet the subordination requirement in an insolvency. This should facilitate the cross-border application of bail-in rules.

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