Is This the Silver Bullet for Italy's Bad Loan Problem?

(Bloomberg) -- The answer to cleaning up bad loans still weighing down Italian banks may lie in a controversial proposal that would allow lenders to sell their debt at deep discounts without being forced to hold more capital.

European Parliament lawmaker Peter Simon, who’s leading the assembly’s work on updating prudential rules for the region’s banks, wants to make it easier to sell debt cheaply without having to adjust a calculation known as loss given default, which typically hurts banks’ capital ratios. Opponents of the change say it may let lenders off too easily and penalize the ones that have already reduced much of their bad-debt pile under existing rules.

The main beneficiaries could be second-tier Italian lenders like BPER Banca SpA that haven’t yet wound down or sold as much bad debt as larger competitors UniCredit SpA and Intesa Sanpaolo SpA. BPER may be able to accelerate soured loan sales if the rules are softened, according to Chief Executive Officer Alessandro Vandelli.

European authorities want banks to reduce their levels of bad credit to free up funds to lend to healthy companies and support growth, but they’re split on how to tackle the issue. Even after making deep reductions this year, Italian banks are still weighed down by about 324 billion euros ($384 billion) of non-performing loans, the highest total in Europe.

Relief Needed

“Despite huge efforts, a third of ECB-supervised banks still suffer from high levels of non-performing loans as a legacy of the financial crisis,” Simon said in response to questions from Bloomberg. “We have to deal with this problem in the interest of financial stability and security.”

Daniele Nouy, who heads the European Central Bank’s supervisory arm, says going down the LGD route would punish lenders that have done the heavy lifting and kill the credibility of bank risk models.

LGD waivers have been used before, but sparingly. The ECB gave Banca Monte dei Paschi di Siena SpA a pass in 2016 when it agreed to offload about 28 billion euros in bad loans. Even under Simon’s proposal, waivers should only apply to large-scale disposals that significantly reduce a bank’s exposure to bad loans.

“For very specific circumstances, there is a little bit of margin” to grant a waiver, Nouy said at a hearing in Frankfurt on Nov. 30. A “massive operation of cleaning would get our attention.”

Italian Bankers

The Italian Banking Association considers softening the rules on LGD helpful in tackling Europe’s bad loans, Federico Cornelli, the group’s head of EU regulatory affairs, said at the hearing.

The FTSE Italia All-Share Banks Index fell 0.3 percent as of 10:41 a.m. in Milan, compared with a 0.9 percent decline for the 44-member Bloomberg Europe Banks and Financial Services Index.

“The pitfall that comes up time and again is moral hazard, but that’s a weak argument for me,” said Gregory Turnbull Schwartz, who helps manage 173 billion pounds ($232 billion) at Baillie Gifford in Edinburgh. “That potential cost is dwarfed by the gain of shrinking this problem to a manageable size. The problem needs to be addressed in a non-penal manner for banks.”

Change Welcome

BPER, Italy’s sixth-largest bank by number of branches, plans to cut gross non-performing loans to 13.5 percent of total lending by 2020 from an estimated 20.5 percent at the end of this year, in part through sales.

Any measure that accelerates the process of selling down bad loans should be welcomed, BPER chief Vandelli, said in a reply to questions from Bloomberg.

“We have also planned and begun mass sales of portfolios of bad loans,” he said. “These sales may be intensified if the supervisory authority decides to make corrections to the current mechanism in order to reduce penalties for operators.”

Under current rules, a bank that sells some of its bad debt for less than what it foresaw in its risk models must adjust the model, potentially driving down its regulatory capital levels. Bank of Italy researchers showed that say a 12 percentage point increase in LGD would cut the common equity Tier 1 ratio among a sample of Italian banks by 90 to 190 basis points. A basis point is .01 of a percentage point.

Currently, banks that want an LGD waiver would have to ensure that the remainder of their portfolio is “structurally healthier” than the part being sold, said Sebastian Schneider, a partner at consultant McKinsey & Co.

“If you can show that the rest is significantly healthier and crisis resistant, this incentive makes economic sense,” said Schneider, who advises European banks. “You need to have a control mechanism to make sure you’re not opening the floodgates.”

--With assistance from Chiara Remondini and Boris Groendahl

To contact the reporters on this story: Nicholas Comfort in Frankfurt at ncomfort1@bloomberg.net, Sonia Sirletti in Milan at ssirletti@bloomberg.net, Alexander Weber in Brussels at aweber45@bloomberg.net.

To contact the editors responsible for this story: Patrick Henry at phenry8@bloomberg.net, Ross Larsen, Vernon Wessels

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