Banks should brace themselves for some bad news on bad loans

The discovery of two seemingly effective vaccines has raised hopes that the world will soon return to normal. For Europe's banking system, however, this may not be an easy transition.

Bankers are bracing themselves for a big increase in non-performing loans after this year's deep recession. From Italy to Greece, the frailest lenders are already under strain. Regulators eased the pressure on bad loans to deal with the pandemic, but there's no sign that this will be anything other than temporary. Lenders might well have to raise more equity, at the cost of diluting existing investors.

So far, Europe's banks have coped well with the Covid-19 shock. For the previous six years, the European Central Bank had applied pressure on the industry to build up regulatory capital and cut the number of non-performing loans. Last March, supervisors decided they could temporarily give banks some breathing space in their capital and liquidity requirements, while also asking for the quid pro quo of a suspension in dividend payments. These efforts have paid off for now; the euro zone hasn't seen any significant banking troubles.

Difficulties could be around the corner, however, as bad loans always take a while to build up. Most banks have applied generous payment holidays for customers, which has clouded the picture on riskier loans. As these end, the real state of banking books will become clearer.

Families and companies have enjoyed strong support from governments, which have extended grants and loan guarantees. The economic recovery — expected after vaccines become widely available — will ease some financial pressure. But the true economic cost of this year's lockdowns will only emerge once governments withdraw emergency fiscal measures to get a grip on their budget deficits.

Two banks are already under severe pressure. In Greece, the ECB won't let Piraeus Bank SA pay a 165 million-euro ($196m) coupon on a convertible bond to the state-owned Hellenic Financial Stability Fund because it wants Piraeus to set aside more capital. This decision paves the way for a conversion of these bonds into equity, which would increase the government's stake in the bank from about 26% to 61%. In Italy, the government is considering yet another recapitalization of Banca Monte dei Paschi di Siena SpA, as the bank fears it may breach its capital requirements this year.

Many bankers — especially in Europe's weakest economies such as Italy — want politicians and regulators to adopt more lenient measures to help them recover from the crisis. Some are listening: Andrea Enria, chair of the ECB's Single Supervisory Mechanism (the euro area's banking watchdog), has dusted off his plans for a regional "bad bank." Failing that, he has another idea for a European network of national asset-management firms to help struggling lenders; a network that would have access to centralized funding from the European Stability Mechanism (the euro area's rescue fund) or a similar institution.

Bankers should shouldn't get their hopes up, though. Brussels is working on an action plan to deal with bad loans, but it's likely to fall short of Enria's hopes. Stretching the ESM's mandate to supporting bad banks would complicate existing negotiations about making it the backstop to the Single Resolution Fund, the fund that's involved in bank failures. Moreover, more prudent countries might demand tougher rules on non-performing loans in exchange for a bad bank. 

There's also the question of whether the European Commission is willing to water down permanently its rules governing state aid, after a temporary relaxation during the crisis. Brussels is set to review its rulebook that deals with bank failures at the end of next year. For now, however, there's little sign that the EU wants to change tone. The priority appears to be closing loopholes that have let governments sidestep rules when winding down smaller and medium banks, such as two lenders in Italy in 2017. If anything, the regime could become tougher.

If bad loans pile up and the situation spirals out of control, politicians may change course. Monte dei Paschi will be a litmus test on allowing state aid. But bankers shouldn't count on much help after the pandemic. Europe's regulatory future appears similar to the recent past.

Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

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