Pandemic fallout reignites discussion over need for entities specialising in bad loans
By Andreas Charalambous and Omiros Pissarides
The establishment of a “bad bank” aims at setting up a specialised institution for the transfer of non-performing loans (NPLs) and the related risks outside the balance sheets of banks. It has been introduced with success in a number of countries (i.e. Ireland and Spain) while consultations are currently underway for its implementation, in a form yet to be decided, both in Cyprus as well as the EU. Evidently, the expected increase of NPLs in the coming months due to the pandemic is fuelling the discussion.
This article aims to contribute to a productive exchange of views, via analysing the positive features and the related challenges, while identifying some of the preconditions for a successful implementation of such a concept in Cyprus.
The primary advantage of a bad bank relates to the improvement in the quality of banks’ assets, thus allowing banking institutions to focus on their traditional activities (accepting deposits and granting loans). Furthermore, it facilitates the effective functioning of entities specialised in NPL management, particularly as concerns pricing, offering of long-term restructuring solutions to borrowers and assimilation of a responsible repayment culture among borrowers.
Even so, a transfer of NPLs outside the banking sector does not on its own resolve the problem. This is due to a number of reasons, including the fact that NPLs remain within the economy. Moreover, the market value of the NPLs is often considerably lower than their balance sheet value. In practical terms, this imposes a cost burden on the already strained banks, which are forced to increase their provisions, thus reducing profits and possibly augmenting their capital requirements.
A possible way forward could be to attract private investors that would provide financing for the bad bank. Considering the profit motive that would incentivise such investments, necessary preconditions include the existence of a transparent and stable legal framework as well as an effectively functioning secondary NPLs market. In the case of Cyprus, with the anachronistic nature of its legal framework, this aspect is of particular importance.
Taking into consideration the magnitude of the problem and the reluctance of private investors to engage in such activities, some form of government intervention is often required. In such a case, there are three major issues to be addressed. First, the fiscal load should be contained, a major challenge for highly indebted countries such as Cyprus. Second, moral hazard issues arise, which could emanate from transferring the NPLs outside the bank at an excessive price to the benefit of the bank and the private investors but at the concurrent expense of the taxpayer. The legal framework governing state aid provides partial defence against such practices, although in reality it can be overcome, as revealed for example in the case of the former Cyprus Co-operative Bank, when state support with a considerable fiscal burden for the taxpayer was ruled to be in line with EU law. Third and extremely important, experience suggests that politically motivated interference typically affects the quality of corporate governance and the performance of a bad bank or other asset management entities.
Consequently, if state intervention is deemed necessary, it has to be based on certain principles: (a) the bad bank should exclusively cover commercial loans, while for housing loans other solutions must be pursued, for example a revised Estia scheme, (b) the transfer price of NPLs has to be as close as possible to their actual market value and be based on independent expert valuations thus reducing the cost to the taxpayer, (c) the participating banks must be mandated to implement a credible restructuring plan, covering capital adequacy, profitability and the necessary adaptation to new technological advancements and upgrading of their customer service ability.
In conclusion, a bad bank can prove to be a useful concept with ambitious but often conflicting objectives. A bad bank implementation plan, therefore, has to rely on an objective legal and institutional framework as well as on modern governance principles aiming at a holistic and long-term sustainable solution of the NPL challenge.
Andreas Charalambous is an economist and former director of the Ministry of Finance. Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services
