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No bad banks, or other vehicles. The bad debts will stay with the banks, but its management will be shared.

9 June 2017

The plan for combating credit risk has already been communicated to the banks. There are no bad banks, or vehicles. Bad debts will remain on balance sheets, but its management is becoming integrated.

No bad bank or autonomous vehicle can currently absorb the banks’ problematic assets. A solution for the bad debt problem in Portugal is taking shape, very conditioned by what can be done within the tight framework of European competition and banking rules. The Portuguese government, Banco de Portugal and the main banks are working on the creation of an integrated platform for managing bad debts, especially in the corporate segment.

In this model, bad loans will remain on the banks’ balance sheets, and while there may be an accounting separation, there will not be a legal one, so that institutions will not have to recognize impairment losses, freeing banks from the need for injections of private capital, or public support that would very unlikely pass the European Commission’s “market tests”.

This Thursday, during the biweekly debate held in the Assembly of the Republic, the Portuguese prime minister revealed that there was a high-level meeting between the Ministry of Finance, Banco de Portugal and the three main banks in the country earlier this week, with the intent of “presenting a proposed solution to the matter for institutions to study and comment on”.

This is not really a solution, but several solutions or a multi-track solution. The objective is to clean up the legacy of problematic credits that are on the Portuguese banks’ balance sheets and that continue to generate losses in several financial institutions. It won’t happen all at once, nor will there be an equal response to all situations. This week, the project took a further step with the formal presentation to the three banks – Caixa, BCP and Novo Banco – where the bulk of the problems are concentrated, which will now have to respond.

The proposals are to move forward as quickly as possible, without prejudice to more radical or costly solutions, which could only proceed if exceptions were granted to The European Commission’s banking union and state aid rules.

It is not the first time that Prime Minister António Costa has spoken out about it in recent times. Last week, the prime minister went even further in describing the possible solution, when asked how Portugal will solve the problem of bad debts. In an interview with the German newspaper Handelsblatt, António Costa discarded the need for a bad bank, stating that banks currently have the capital needed to deal gradually with the problem of bad loans. But when asked if there was any plan to stabilize the financial sector, the prime minister said there was.

“We are working with Banco de Portugal on a shared platform for banks to coordinate debt recovery. Many companies have loans from multiple banks. The recovery of bad debts will be facilitated if lenders are able to coordinate more effectively with each other, but the situation is much better today than it was a year ago. Today it is more of a statistical issue than an economic problem.”

A few days later, in an interview with RTP, the deputy governor of the Banco de Portugal also rejected the notion of creating an autonomous vehicle to carry out the early release of NPLs (non-performing loans), arguing that European legislation does not permit it. Elisa Ferreira said that there is no silver bullet, but while the European Union does not change banking resolution and state aid rules, the Portuguese authorities are not standing still. Elisa Ferreira highlights the three tracks that are being worked on between Banco de Portugal, the Portuguese government and the Portuguese banks:

  • Capitalization program: streamlining legal proceedings involving credits and companies in default;
  • Presentation by banks, at the request of the supervisor, of plans to release their NPL balance sheets in an organized manner;
  • Integrated credit management. Many banks are creditors of the same companies and there are advantages to interacting with an integrated stakeholder who represents all the banks to enable a more effective and coordinated approach.

Before March, each bank had to present a plan to reduce credit at risk to five years for approval by the European Central Bank. This was an important departure for the work that has been done in recent months. In addition to shared management, there is also a solution for facilitating the sale of bad debt, be it individual or in portfolio.

This integrated bad debt management platform is primarily aimed at corporate debt, the debt that is weighing the most on the banks’ balance sheets. It is already being discussed with the main Portuguese banks exposed to the problem, the Observador confirmed together with sources in the banking sector. Participation in the platform is voluntary, and the solution should be of interest to the four banks, Caixa Geral de Depósitos, BCP, Novo Banco and Montepio, that face the most problems with bad debt – and which have already suffered related losses.

One of the issues that is still under discussion, according to information gathered by the Observador, is whether the management of these debts and the banks’ relationship with these large clients should be delivered to an outside entity or be kept in house.

In a recent speech at a conference in Lisbon, Pedro Machado, a partner at PwC, defended this model as a response to the problem of bad debt, arguing in favor of management being handed over to third parties. The objective would be to not only maximize value recovery but also to prevent each of the banks from continuing to renew or even increase the financing of non-viable companies, thereby postponing the recognition of losses on those loans, to the detriment of lending to healthy companies.

Even if it took longer to solve the problem of the non-performing loans, this solution would avoid the need for more capital and would remove the specter of state aid, a restriction of the European Commission that makes it almost impossible in the current legal framework to enable the creation of a bad bank or an autonomous vehicle that would manage such problematic claims. These European limitations, which result from the rules of resolution and competition, have been highlighted by the governor of the Bank of Portugal.

On the other hand, sources contacted by the Observador agreed with the prime minister’s diagnosis, saying that the pressure to resolve the problems on a timely basis is lower than it was a year ago. “Banks are not desperate,” Elisa Ferreira stressed. After all, several institutions have recently undergone capital infusions, such as Caixa Geral de Depósitos and BCP, raising ratios to more comfortable levels. Novo Banco is in the process of recapitalizing, provided that the tenets of the agreement made with Lone Star Funds are fulfilled.

But this week’s collapse of the Banco Popular in Spain, with bad debts of more than 30 billion euros, shows that the problem is far from having been solved.

Even if Portuguese banks have managed to attract principally foreign investment, there is no scope for new operations, as the chairman of BCP made clear during the presentation of results for the first quarter of 2017. Nuno Amado said that BCP was willing to analyze a government solution to clean up bad debts, but rejected any solution that might be “destructive to capital, because it is the most expensive asset we have.”

What amounts ​​are we talking about? At the end of last year, non-performing debt was 17.2% of total debt, corresponding to around 42 billion euros. Of this, 45% is covered by impairment, where the banks have already recognized the losses on those debts in their balance sheets. 23 billion euros remain.

Discounting the value of collateral and provisions, we will be talking about something like 10 to 13 billion euros of net unsecured non-performing loans, essentially concentrated in the four institutions with the highest credit losses: Caixa Geral de Depósitos, BCP, Novo Banco and Montepio. Corporate lending accounts for more than half of the value of loans at risk.

Who are the debtors?

Paulo Macedo already stated it during his first press conference as president of Caixa Geral de Depósitos. Caixa’s large impairments, which largely accounted for the capital increase this year, had its origin in something known to all Portuguese banks. It will be the same 200 companies that have caused, and continue to cause, losses in Caixa and its competitors. There are well-known names, such as those companies in the Espirito Santo group or part of Ongoing, the majority of which are in insolvency, builders in PER (Special Revitalization Process), such as Soares da Costa and MSF, and motorway concessionaires in default, such as Douro Litoral and Brisal.

An external platform, which could be shared among several banks, would have as its mission the definition what is feasible and what is not, thereby adopting the most appropriate management response to optimize those assets. This platform will also serve to facilitate the eventual sale of non-performing loans to third parties. These assets are very difficult to evaluate, given the absence of a large market, and because of the uncertainty generated by multiple lenders with mismatched strategies.

In addition to the concerted management of debts and their respective debtors, a joint operation on restructuring and judicial reorganization plans is also under analysis – in the case of companies that are already a participating in the Special Revitalization Process (PER). A recent history of divergence between creditor banks can be found in the case of Soares da Costa. Caixa, the largest lender, voted against the recovery plan, contrary to the second largest lender, BCP. In the most recent case of MSF, another construction company, Novo Banco and BCP, the two largest creditors are acting in a coordinated manner in seeking judicial recovery.

For this coordinated management of credit recovery to work, the legal framework for corporate recoveries and the enforcement of guarantees and mortgages will need to be streamlined. Steps have already been taken in this direction with the Capitalization Program, which creates a set of measures aimed at facilitating and accelerating the processes of credit restructuring, the recovery of viable companies and insolvency proceedings for those companies which are not.

The Observador is aware that on the government’s side the main task is to ensure a legal framework allowing banks to solve the problem in-house. There is no possibility of giving public financial support, which would be necessary in a more radical solution to cleanse these assets (or liabilities), which would necessarily require their exit from the banks’ balance sheets to a vehicle with legal autonomy, even if some tax incentives could be created or some specific guarantees given to reach a solution.

Beyond the additional capital requirements that would be needed at the banks undergoing this cleaning, where current shareholders would be unable regardless to meet such demands, the transfer of the assets to an autonomous vehicle would also require financing those assets in the financial markets, necessitating public guarantees to convince private investors. This would be one of the tracks proposed by the former Goldman Sachs partner, António Esteves, in the proposal he presented in the beginning of 2017 to the Bank of Portugal, which involved private investment to finance the purchase of such problematic assets from banks.

A similar model was followed in Italy, albeit on a relatively small scale given the size of bad debt problem on the country’s banks’ portfolios. In this case, public guarantees were only granted to financial products composed of better quality assets. But the bulk of the bad credit in the country is still unresolved, with the Italian government trying to get around European constraints to inject public money into Monte del Paschi outside the framework of a bail-in resolution, which would involve an imputation of losses to creditors, namely depositors and holders of subordinated debt.

Original Story: Observador (written by Ana Suspiro)

Translation: Richard Turner