The topic of NPLs raises hackles. “European” suggestions for solving the problem apply to every country in theory – but in practice primarily to Italy, Greece and Cyprus.
That’s why a technical package of ‘guidelines’ from the European Central Bank’s bank supervisory arm prompted furious denunciation from a former Italian prime minister, and a swathe of other Italian politicians when they were unveiled. More recently, the European Parliament’s legal service, at the prompting of MEP Antonio Tajani, said that the ECB had “no competence” to issue the guidances on NPLs, with another MEP claiming the central bank was “creating a parallel regime of capital requirements”.
Hitting out at the provisions, though, is just an excuse. Accounting rules, even when imposed by the ECB, do not change reality, only a styled representation of reality.
A provision mechanistically drops to the bottom line – and from there, flows through to capital strength or weakness.
But it has no impact at all on whether an institution actually does recover any cash from a loan. Whether or not a non-performing loan is recognised at 100 or at 0, if there are no payments being made and no collateral that’s worth anything, that’s what really matters in the long run.
If it turns out the ECB is asking for excessive provisions excessively early – then, banks can hold onto their assets, and write them back when they start paying again.
That will produce a mechanistic boost in profits down the line, of equally flimsy substance. Provisions can produce volatility in reported profits, but they can’t make a borrower start or stop paying.
Of course, provisions do have real effects. Representations of reality can feed back into real situations. They affect tax payments, dividends, and, perhaps, overall confidence in an institution. If a regulator uses the accounting balance sheet for stress tests or for regulatory intervention, then provisions will matter.
For investors in a bank, accounting is the best version of reality they have access to. They can’t see management information system – they can only see audited accounts when they decide whether to buy bonds, roll commercial paper, or support a rescue rights issue.
But they can drill down into the nuances. If every potential shareholder in Italian banks knows that the banks are being asked to provision aggressively, then they can choose, if they wish, to strip out these provisions to get to ‘underlying’ numbers (or at least, another version of accounting treatment).
Forcing banks to provision properly against NPLs – or over-provision NPLs – is also widely held to encourage management to dispose of these assets in a timely fashion.
Since that usually means an institution with a 5% cost of capital and 20x leverage selling to private equity firm or hedge fund with 20% cost of capital and 4x leverage, that implies a big discount to the theoretical value which banks might be able to realise holding non-performing assets themselves — a wealth transfer from the shareholders in Italian banks to the likes of Fortress, Apollo, and Elliot Advisors. The greater expertise, or greater vigour with which distressed debt firms will service assets helps bridge the gap, but it’s a very large gap.
For this to be an attractive trade, management needs to value the immediate gain on disposal against the provisioned level more than any possible future recovery.
If any recovery is very far out, if management is focused on the short term, or if management incentives are aligned to accounting, rather than cash, then the trade looks good.
In Italy, these conditions are true. Recoveries are miles away — or might never exist.
When Italian politicians complain about the ECB’s provisioning proposals, they’re not really taking aim at the increased volatility of reported P&L that will be generated, nor the temporary dip in reported capital ratios that will result.
Their aim, really, is to shield Italian banks from recognising their real failures to recover any cash or any collateral from their non-performing assets — not to wade into a fight about accountancy. This failure has many explanations, from poor lending to a dysfunctional legal system.
But it’s important to look beyond the P&L statement to the reality underneath, and fighting about provisions is a distraction. The message to bank management teams needs to be: “Get that money”.