NPL handling is key to banks’ future
Greek banks should be overcapitalized to sustain sizable credit losses from the massive stockpile of nonperforming assets accumulated during the 2008-13 recession. Whether the new capital increases and other corporate actions planned by the four core banks in the aftermath of stress tests conducted by the Bank of Greece will be enough remains to be seen. The outcome will largely depend on the country’s economic performance in 2014 and beyond and the banks’ own ability to manage their loan arrears.
The capital needs of the Greek banking sector stood at about 6.4 billion euros – or 5.8 billion for the four core banks (Alpha, Eurobank, National and Piraeus) – according to the recent stress tests conducted by the Bank of Greece. The tests took into account the diagnostic test on the loan portfolios of all banks performed by BlackRock Solutions and were based on the baseline scenario, reflecting macroeconomic projections in IMF’s fourth review back in July. It should be noted that the capital needs for the four core banks amounted to 8.8 billion euros under the adverse scenario, which forecasts a further sizable GDP contraction.
The International Monetary Fund has made it clear Greek banks need more capital to cope with anticipated credit losses this year and beyond. Also, Standard & Poor’s said last week Alpha and Piraeus will need more capital than planned in the next two years to meet the minimum regulatory capital adequacy ratio defined as Basel III fully loaded core Tier 1, at 8 percent as of year-end 2015. S&P pointed out the two banks will continue to benefit from capital support from the Hellenic Financial Stability Fund and liquidity support from the European Central Bank.
In contrast to the IMF and S&P, most Greek bankers and analysts think local banks will be sufficiently capitalized to address future capital needs, following announced actions to address the 6.4-billion-euro shortfall under the central bank’s stress tests. The latter are also confident the results of the stress tests to be conducted by the ECB later this year will not deviate at all or much from the outcome of the BoG tests. However, at least one senior banker we talked to admitted local credit institutions will need extra capital in coming years if they are to extend sufficient credit to the Greek economy. He said he was confident banks will be able to raise it from private investors if the economy returns to normal.
Whether Greek banks will be able to sustain hits from the expected credit losses from the large stock of nonperforming assets and vulnerable restructured loans, which are neither recognized as nonperforming loans (NPLs) nor provisioned against according to S&P, in coming years will depend on two factors: their profitability, which is tied to the course of the economy, and their own management of NPLs.
It is reasonable to expect Greek banks to boost their profitability before provisions – that is the amount of capital set aside to provide against loans losses – in 2014 and beyond. The main drivers should be improving net interest margins and cost synergies from mergers. Local credit institutions managed to raise their lending rates to better reflect risks during the last few years but also saw their own cost of funding rise sharply and interest income from Greek government bonds almost erased. Although banks may be unable to charge corporations and households higher interest rates, they should continue to benefit from falling funding costs. Interest rates on time deposits will continue to ease as liquidity conditions improve while banks regain access to capital markets – like Piraeus did with the three-year bond – and substitute expensive funding (ELA) from the Greek central bank with ECB or/and market funding.
But the biggest challenge will come in NPL management. Greece did not follow the example of Ireland and Spain to set up a state-run bad bank which in turn would buy troubled assets from commercial banks at a heavy discount. Instead, Greek banks have set up internal “bad bank” units to deal with the large stockpile of NPLs. The challenge is big since loans past due 90 days are seen peaking around 35 percent of total loans or higher at the end of 2014 or 2015 from 6 percent before the crisis. Moreover, the coverage ration – that is, provisions set aside against credit losses – stands around 50 percent in Greece compared to 60 percent or more at the European level. It is encouraging the new arrears are declining but the task is still formidable, especially, if one also takes into account the restructured loans, estimated around 7 to 10 percent of total loans, which are not recorded as NPLs.
Banks will be much better positioned to manage NPLs if the economy recovers, benefiting from write-backs as income and asset prices rise. They will also be able to reduce their high NPL ratio further once they start providing more loans. An improvement in the NPL ratio, defined as nonperforming to total outstanding loans, could come from dealing with strategic defaulters – that is, people who can but do not pay. Perhaps selling some loans to distressed funds could ease the pressure further but that may have to wait for the economy to recover.
It looks, however, like the most drastic solution to dealing with the legacy of NPLs will be a combination of write-offs and the restructuring of loans. This seems to be the approach banks favor, but entails execution and other risks. No doubt the restructuring process will be complex and lengthy. However, this process along with operational profitability will determine whether banks are sufficiently capitalized to satisfy the capital adequacy ratio and also provide credit to their financially healthy customers.
