23 January 2017

Bruegel: Will better insolvency standards for banks help Europe’s debt deleveraging?

Insolvency regimes in the euro area are on the whole costly, lengthy, and recover little value. A new directive proposed by the Commission sensibly aims to strengthen preventive restructuring and to give once-failed entrepreneurs a second chance.

The ECB’s new guidelines on the management of non-performing loans (NPLs) will shine a spotlight on the way banks deal with NPLs. Both supervisors and market analysts will be scrutinising banks’ efforts to work out loan delinquency in enterprises and households. The need to address financial distress early will be further reinforced in 2018 when the EU’s new accounting standard (the IFRS 9) will force banks to recognise loan impairments on the basis of expected, rather than actual, credit losses.

Banks’ workout efforts, their attempts to restructure, divest or write off their portfolios of NPLs, will be shaped by the quality of national regimes for insolvency and restructuring. As is well known from the World Bank’s Doing Business indicators, insolvency procedures in several euro area countries are costly, lengthy and result in inadequate value recovery. There have been a number of notable reforms but on the whole regimes are still biased towards liquidation, rather than restructuring.

Early financial restructuring of borrowers in debt distress ahead of a formal insolvency proceeding and liquidation will result in higher value recovery for lenders. It also raises the chance of preserving the business as a going concern. However, debt restructuring occurs “in the shadow of the law”: in anticipation of a court-led process that unfolds unless borrower and lenders come to a timely private agreement. Where legal proceedings are unclear or costly, the borrower’s incentive to seek an early restructuring remains quite weak, and further value loss ensues.

Several EU countries lack a framework for early private debt restructuring (whether entirely ‘out-of-court’ or with light court supervision). However, such provisions can play a crucial role. They can enable coordination between lenders, provide temporary protection from enforcement, secure the ongoing operation of the distressed business, and protect new credit provided on the basis of restructured finances and a new business plan.

Against this backdrop, the Commission in November released its proposal for a Directive on preventive restructuring frameworks and debt discharge. This is somewhat of a milestone in a long process. The Commission had already released a non-binding recommendation two years ago, calling on member states to reform their insolvency frameworks, but this had only mixed success. This directive could now lead to some sensible pan-European practices, such as:

• the availability of a rescue procedure ahead of insolvency;
• a limited stay on enforcement;
• securing the ongoing operation of distressed businesses that are in the process of restructuring through continuity of management (“debtor in possession”);
• rules for majority decisions that bind all lenders (“cram-down”);
• protection of new financing which would be senior to existing funding;
• clarity on the court involvement that will sanction these arrangements, without imposing inordinate delays or costs.

This feeds into at least three of the EU’s current objectives:

• The Commission’s single market strategy underlines the importance of promoting entrepreneurship. According to this policy, there is a need to reduce the stigma of debt and the lengthy discharge periods during which lenders may pursue entrepreneurs – often including their personal estate – which discourages former and would-be entrepreneurs from taking the risk of launching a new firm or start-up.
• Providing some standard in insolvency regimes was a key element in the Commission’s capital market union plan. This is vital, given the related risk premia in loans and bond issuance, and because about one in four insolvency cases have a cross-border dimension.
• This seems doubly relevant within the euro area, where levelling out some of the risks lenders bear in individual banking markets should result in deeper financial integration and uniform transmission of a common monetary policy within the currency bloc. The Council’s roadmap to complete the Banking Union last year indeed pointed out insolvency reform as essential to prevent the re-emergence of NPLs.

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© Bruegel