European banks face significant credit risks as the SSM focuses its attention on non-performing loans

  • Estimated €826bn of NPLs are currently sitting on the balance sheets of European banks that are supervised by the SSM
  • NPL volumes still remain close to levels revealed at the ECB’s comprehensive assessment in 2014
  • Significant differences between NPLs across different countries with high volumes in place across Italy, Spain, France and Greece
  • Greek, Austrian, Portuguese, Italian and Cypriot banks likely to be challenged further in future stress test

New analysis from Linklaters estimates that since the ECB’s Single Supervisory Mechanism (‘SSM’) was implemented on 4 November 2014, non-performing loan (‘NPL’) volumes across the banks it supervises remain high, reducing marginally from €841bn* to €826bn**. The NPL to Asset Ratio of these banks has also only slightly decreased from 4.13% (end of 2013) to 3.92% (H1 2015).

Banks have been announcing plans to offload NPL portfolios and demand continues to be significant from investors with at least €40bn*** of distressed funds raised to buy these portfolios. But the research suggests that NPLs in certain countries are steadily increasing, causing a drag on banks’ profitabilities and market confidence. Tackling these credit risks will be a key supervisory priority for the SSM in 2016.

“In its first year of operation, the SSM has made good progress in building trust in the European banking system. The comprehensive assessment helped identify problems on balance sheets and provided the market with clarity on the scale of non-performing loans. But these continue to be a significant on-going issue, particularly in Southern European markets,” says Andreas Steck, a regulatory partner at Linklaters.

European banks would require a further €400bn of NPL sales to match US banks

Since 2011, NPLs in the US banking sector have continued to decline. Economic progress has been a crucial driver of this divergence from Europe but Linklaters’ analysis shows that European banks supervised by the SSM would need to reduce NPLs by a further €400bn to achieve present levels seen in the US. Whilst the US has benefited from a number of economic,  institutional and political factors, regulators have also provided detailed regulatory guidance on the treatment of write-offs which have supported NPL reduction.

Steck says “that the ECB is clearly working hard to deal with NPL resolution and with a working group now in place to tackle these loans, we will see them engaging in a much stronger fashion with national competent authorities and banks to ensure that further action is taken ahead of next year’s stress test.”

Greek, Austrian, Portuguese, Italian and Cypriot banks to be challenged further in future stress test

As part of the comprehensive assessment, banks were required under the stress test to maintain a minimum Common Equity Tier 1 (CET1) ratio of 8% under a baseline scenario and a minimum CET1 ratio of 5.5% under the adverse scenario. Linklaters has developed its own stress-test model ****of the European banks that incorporates criteria based on risk weighted assets (RWAs) and impairments. The results suggest that Greek and Austrian banks would currently be most challenged under the adverse scenario with median CET1 ratio under 7%.

The RWA ratios under the adverse scenario for Greek, Austrian, Portuguese, Italian and Cypriot banks also remains high, averaging 66%, suggesting more future deleveraging will be required. Collectively, banks in these five countries have only disposed of €5bn***** non-core assets since the stress test last year.

“Since the stress tests, banks have assessed their needs for capital requirements with recent updated targets from the SSM. As we look toward next year, the SSM will also be looking at the quality of this capital closely and it will be interesting to see how it calculates the treatment of Deferred Tax Assets toward the banks’ capital”, says Edward Chan, a banking partner at Linklaters.