Challenges and recent developments regarding NPLs and the role of EU state aid rules.

More than one trillion euros’ worth of nonperforming loans (NPLs) are concentrated in the periphery of the European Union, with banking regulators and market participants urging the EU and its member states to take immediate action toward alleviating the strain on affected banks.

Market reform is underway with a view to creating liquid secondary markets for NPLs in order to facilitate direct sales of NPL portfolios to outside investors including nonbanks. However, given its magnitude and the urgency involved, the resolution of the NPL problem is expected to necessitate more drastic public intervention, most likely in the form of state-backed asset management companies (AMCs). AMCs would acquire NPL portfolios from affected banks at prices exceeding the current market value of the NPLs, thereby limiting the exposure of banks to losses that in some cases could threaten their viability.

Yet public subsidies for NPL relief, including the state financing of AMCs, qualify as “state aid” under EU law to the extent that they are not provided “on market terms.” EU state aid control rules and the recently introduced EU bank recovery and resolution framework prohibit, in principle, the grant of state aid to banks, resulting in significant uncertainty as to the availability of state-backed NPL relief. In this briefing we examine the EU law aspects of currently proposed tools to tackle NPLs, in particular from an EU state aid control perspective.

At Morgan Lewis we are closely following recent developments relevant to the future of NPLs. We help both owners and prospective investors in NPL portfolios navigate the increasingly complex EU legal and regulatory landscape, and map relevant risks and opportunities as the EU, member states, and affected banks consider available options.

NPLs May Threaten Eurozone’s Positive Economic Outlook

Unsustainable NPL ratios threaten the viability of banks in the EU periphery and pose broader risks to financial stability in Europe.Despite the Eurozone enjoying its best quarter for economic growth since the beginning of the financial crisis, and despite the augmented banking supervisory tools at the EU and national levels, the risk of bank failure and resultant systemic contagion in a deeply interconnected EU banking system remains highly probable. At the same time, significant NPL ratios inhibit credit growth, preventing banks from offering fresh credit to businesses in need, thereby affecting economic growth.

Over the last year, a number of banks have ceased operating as stand-alone entities—including in Italy and Spain—largely owing to a long tail of bad debt. With NPL ratios remaining at record levels, this trend can be expected to continue without immediate action on the part of the affected banks, and most critically, without reform initiatives by the EU and member states.

Banks exposed to significant levels of bad debt struggle to remove them from their balance sheets. Market prices for NPLs have been depleted, and are invariably well below their book value or even the present value of the future cash flows that can be expected from them (that is, their “real economic value”). This is largely attributable to the lack of effective, liquid secondary markets for NPLs. Legal and regulatory impediments, including to transfers of NPLs from banks to nonbanks, result in asymmetry between supply and demand, while increased uncertainty as to the value of NPL portfolios (also due to lack of information on borrowers, collateral, and NPL sales) results in inflated risk premiums, which drive NPL prices further down.

Market Reform Is Underway, but State Financing Remains Likely

Banks are urged to develop detailed action plans to address unsustainable NPL ratios. In tandem, the EU and member states are exploring options to remedy existing market failures. These include facilitating the development of liquid secondary markets for NPLs by lifting legal and regulatory impediments to their transfers, including from banks to nonbanks. The European Commission (“Commission”) has recently launched a public consultation on removing possible constraints on the development of secondary markets for NPLs, and on a potential mechanism to better protect secured creditors from borrower default (that is, the so-called “accelerated loan security” aimed at facilitating effective out-of-court foreclosure of collaterals). This consultation will likely pave the way for new legislative initiatives at the EU level.

The envisaged reform will likely increase investor interest in NPLs, and thereby increase their value. Fresh injections of taxpayer money into banks with unsustainable NPL ratios will remain, however, highly probable. Given the magnitude of the NPL problem and the urgency involved, the permanent removal of bad debt from balance sheets will often necessitate at least some level of public financing.

As offloading NPLs from balance sheets at present market prices would result in significant losses and imperil the capital adequacy of the affected banks, and thereby their viability, most solutions to the NPL problem involve the use of state funds, with the alternative being a bail-in or a bank’s winding down (or, where appropriate, its resolution by the Single Resolution Board). In the event of bail-in or liquidation, the burden will typically be borne first by shareholders and creditors. Governments tend to mitigate against such outcomes. The potential political and local economic damage caused by allowing a bank’s shareholders and creditors to take the financial hit means that governments prefer to rescue an affected bank even if that involves spreading the risk among all taxpayers.

Solutions involving the use of state resources (state aid) are thus considered inevitable. These typically revolve around the establishment of state-owned, -funded, or -guaranteed AMCs, which may operate at the national or EU level. AMCs or “bad banks” would acquire NPLs at prices above their market value, thereby limiting the exposure of the relevant bank to losses and the corresponding need for recapitalization. That said, while a bail-in or bank liquidation aims at lessening the burden of rescue packages for troubled banks, it may still require significant amounts of state aid to enable the market exit of the relevant bank (see, in this regard, the cash injections and state guarantees that the Italian State provided to two credit institutions to enable their market exit in summer 2017).

An alternative to transferring NPLs to state-backed AMCs consists in the provision of “precautionary recapitalization” by a member state to an affected bank to facilitate the disposal of NPLs on market terms.

Other proposed solutions include subsidizing borrowers (instead of creditors) in order to facilitate loan repayment, or the use of tax incentives to accelerate recognition of losses resulting from NPL disposals. Potential solutions not involving state aid are also being considered. These mainly consist of internal workouts by the bank in question (including various restructuring options) and direct sales of NPL portfolios to outside investors (which, however, presuppose the implementation of the abovementioned market reform).

State-backed NPL relief: Main Themes and the Role of EU State Aid Control

Any NPL solution involving state intervention must comply with EU state aid rules.

The use of state resources in favor of an individual or a defined group of banks is classified as “state aid” under EU law and is, in principle, prohibited to the extent that it distorts competition in the level playing field for market participants envisaged by the EU Treaties. Exemptions apply, including where the relevant measure seeks to “remedy a serious disturbance in the economy of a Member State.” A measure entailing state aid must be notified to, and authorized by, the Commission’s Directorate-General for Competition (“DG COMP”) before the measure is implemented.

Public NPL relief measures (including, but not limited to, NPL transfers to public AMCs) constitute state aid to the extent they free the affected bank from, or compensate it for, the need to register either a loss or a reserve for a possible loss on NPLs. Such state aid would be “compatible with the internal market” (in other words, lawful) insofar as the relevant measures aim at safeguarding financial stability.

Any aid for NPL relief measures would need to comply with the general principles of necessity, proportionality, and minimization of competition distortions. These principles, among others, require burden sharing among the state, the bank, shareholders, and creditors (i.e., junior debt holders).

In the context of public NPL relief measures, AMCs would typically purchase NPLs at their real economic value. This transfer involves state aid, as the real economic value normally exceeds market value. At the same time, aligning the transfer price to the NPLs’ real economic value can help limit the use of public funds as far as possible by enabling member states to recover the capital used for the transfer in the long run. If NPLs are transferred to AMCs at prices above their real economic value, the public intervention is considered more intense—and the resulting distortion of competition more severe. DG COMP would only approve such solutions in exceptional circumstances and on the basis of a restructuring plan focused on restoring the bank’s long-term viability and limiting the distortion of competition as far as possible.

Interplay with the new EU recovery and resolution framework adds complexity.

While state aid remains technically (albeit exceptionally) available for the purposes of tackling NPLs, the recently introduced EU bank recovery and resolution framework materially restricts the powers of member states to use public resources in support of failing banks. That framework’s main instrument, the EU Bank Recovery and Resolution Directive (BRRD), has as its primary goal the prevention of the use of public funds for bank rescues and, to this end, it favors the use of bail-in tools whereby the failing bank’s shareholders and creditors would be the first to incur losses.

The interplay between EU state aid rules and the BRRD remains largely unexplored, and available precedents shed only limited light on the application of the current framework for the purposes of public NPL relief. The Commission has recently authorized, following extensive negotiations with the Italian authorities, the grant of state support to an Italian bank with an unsustainable NPL ratio by employing what is considered by many to be the “fine print” in the BRRD regime. The latter provides for the possibility of granting a “precautionary recapitalization” to a bank in need under certain circumstances without triggering the bank’s resolution and burden sharing under the BRRD. The bank’s recapitalization enabled the divestment of its NPL portfolio “on market terms by transferring it to a privately-funded special vehicle.” This has been a heavily politicized decision, and is criticized for sidestepping the new BRRD framework or at least undermining its objectives. Whether the precautionary recapitalization tool will be used again remains to be seen.

While the Italy precedent confirms the availability of the precautionary recapitalization tool, it remains unclear whether aid granted through AMCs specifically for the purpose of tackling NPLs could be consistent with the BRRD and whether such aid could fall into the precautionary recapitalization exemption.

Outdated guidance and practical difficulties lead to uncertainty.

Over the years, the Commission has developed detailed rules for assessing state aid to ailing banks. A specific set of rules is dedicated to impaired asset relief measures that technically apply to distressed assets such as NPLs. Existing guidance includes the Commission’s Communication on the Treatment of Impaired Assets in the Community Banking Sector (“Impaired Assets Communication”), issued in 2009. However, the Impaired Assets Communication, forged in the wake of the financial crisis, aimed to clarify the application of state aid rules to state relief measures in respect of distressed US subprime mortgage-backed securities. While the Impaired Assets Communication technically covers NPLs, updated, clearer guidance addressing the particularities of NPLs’ treatment is required. New guidance will need to establish a coordinated approach in relation to the relevant asset and participation perimeters, asset-size thresholds, valuation rules, capital structures, governance, and organization of AMCs. It should additionally set forth the conditions under which state-backed NPL relief would not trigger a bank’s resolution under the BRRD (e.g., on the basis of the “precautionary recapitalization” exemption or otherwise).

Clearer guidance on the application of EU state aid and BRRD rules to NPL transfers, together with market reform, will likely present opportunities for institutional investors, including private equity and credit firms, in relation to NPL portfolios.

Case-by-case assessment will continue.

A coordinated approach toward state-backed NPL relief by the EU and member states will not result in a “one-size-fits-all” solution. State support will become available to some banks, but not others. Banks with high NPL ratios may benefit from disposal to AMCs on favorable terms, or precautionary recapitalizations in accordance with the BRRD, coupled with disposal of their NPLs at market prices. Banks that would likely fall short of solvency requirements notwithstanding any NPL relief will instead be placed into liquidation or resolution. Those able to sell their NPLs at market prices without imperilling their capital adequacy and viability would probably not be eligible for state support. Where public NPL relief measures are required, the authorization of state aid by DG COMP will presuppose, among other factors, the clear identification of the affected bank’s NPL problem, its intrinsic viability prior to the NPL relief, and its prospects for a return to viability. Fresh guidance by DG COMP on the treatment of NPLs will be key to a coordinated and consistent approach to the NPL relief problem, and to ensuring that any measures will not produce spillover effects that threaten competition in the banking sector.

Risk of financial protectionism.

Decisions as to how to deal with failing banks will continue to be highly politicized. While the BRRD is the law of the land, and its adoption has been agreed to by the member states, governments will still exert significant pressure on the Commission to avoid politically costly bail-in situations, and will favor supporting ailing banks using public resources. Solutions in this context will follow exhaustive negotiations among the Commission, the member state concerned, and banking regulators, with compromises being made between financial protectionism and the need to respect the current recovery and resolution framework. Member states and the Commission will need to weigh the risks of undermining the BRRD objectives and the reemergence of increased moral hazard that state support to ailing banks would create.

The Commission will remain the “final arbiter.”

Any NPL relief measure will require the Commission’s “blessing.” Even if a privately funded, free-from-aid solution were to be found, the relevant member state would likely notify the DG COMP of any requisite measures (e.g., relevant administrative acts, legislation) for the purposes of legal certainty. The disposal of an NPL portfolio “on market terms,” which technically does not constitute aid, may form part of a broader package of support measures often consisting of the recapitalization and restructuring of the affected bank. In this scenario, an NPL solution, albeit aid free, would still be subject to exhaustive negotiations among the member state, DG COMP, and banking regulators; would be included in the bank’s restructuring plan; and would ultimately require clearance from DG COMP.