21 March 2017

European Parliament: Carving out legacy assets: a successful tool for bank restructuring?

This paper assesses the effectiveness of the various resolution tools to deal with legacy assets such as NPLs under the resolution framework. On the one hand, the on-balance sheet tools and on the other hand, the tools that carve out the assets from the banks’ balances are assessed.

In the aftermath of the 2007-2009 great financial crisis, banks have accumulated a large pool of non-performing loans (NPLs). In total EU banks have more than €1 trillion in NPLs on their balance sheets. High NPLs are putting pressure on the performance of banks in euro-area countries such as Cyprus, Greece, Italy, Portugal, and Slovenia, where the banks have NPL-levels above 15%. Some of the banks in these and other countries may fail and need to be resolved in the near future, which would test the new resolution framework.

This paper assesses the effectiveness of the different tools and approaches that can be used to resolve legacy assets such as NPLs. Since there are no cases to draw lessons from under the resolution framework, the older cases that inspired the design of the framework are analysed. The sample covers the 79 euro-area banks that received capital support in the period from 2007 to 2016. The large majority of these banks failed due to losses on legacy assets (NPLs and securities). Moreover, the applied resolution tools to deal with these legacy assets were fairly similar to the tools available under the resolution framework.

In total, six different resolution tools/approaches to deal with legacy assets have been assessed. There are three options to deal with the assets on balance sheets (no tools, sale of entire bank and asset guarantees) and three options to carve out the assets (sale of part of business, bridge bank and asset separation).

The effectiveness is measured based on the main objectives of the resolution framework: long-term bank viability, financial and economic stability and minimisation of the costs for taxpayers. The latter is best served by minimising the losses that need to be wound-down on creditors through bail-in. The NPLs have certain characteristics that determine whether the resolution tools can contribute to lowering the losses. The market values of NPLs are in most countries well below the economic and book value of the assets. The difference is likely to widen during crises and is explained by higher required returns and accounting of management costs by investors. The resolution tools can be used to maximise the values.

In order to maximise the value of the NPLs, it would be best to avoid direct sales. This makes the sale of a part of the business or the entire business ineffective. In turn, the other four tools might be effective to resolve legacy assets. Not applying any resolution tools would be an option when the portfolio of legacy assets is relatively small and the created capital buffers sufficiently high, which seems to barely put a strain on the bank’s viability and loan growth. The latter is particularly important for banks that have a large market share.

For banks with substantial portfolios of NPLs it would, however, be better to clean up the balances for the viability in the longer term and stability. The bank could receive a guarantee on the legacy assets, the assets could be carved out and transferred to an asset management company (AMC), or the ‘good’ business could be transferred to a bridge bank. An important distinction factor is the management of the assets (i.e. recovery rates and focus on core activities). The research on whether it would be better to let the legacy assets be managed by the bank internally or externally is inconclusive. Larger pools of NPLs, however, seem to create economies of scale that might contribute to higher recovery rates, which would be an argument in favour of an AMC. Each tool has some specific disadvantages, which make the application more difficult. The guarantee has moral hazard issues, bridge banks require capital and the AMC requires liquidity.

Whereas the resolution authorities have the power to create a bridge bank, these might prove insufficient for both guarantees and AMCs. In order to make the AMCs really effective, the Single Resolution Board (SRB) should have more flexibility to use the Single Resolution Fund (SRF) for providing liquidity to the resolution tools. In addition, given the limited size of the SRF and the large amount of funds, a credit line or other liquidity facility from, for example, the ECB or the ESM is recommended.

Full paper

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