Pavlos Masouros, Assistant Professor of Corporate Law at Leiden University and Managing Partner of Masouros & Partners Attorneys-at-Law in Athens, Greece
If regulators push European banks to set time-bound operation targets for NPL write-downs and disposals, then in all likelihood long-termism in corporate finance shall disappear for a number of bank-dependent European firms
Pavlos Masouros, Assistant Professor of Corporate Law at Leiden University and Managing Partner of Masouros & Partners Attorneys-at-Law in Athens, Greece
20
September
2016
|
13:05
Europe/Amsterdam

NPL portfolio cleanup could open the gates of short-termism

Non-performing Loans (NPL) Management in European banking and the risk of short-termism

Accelerating the NPL portfolio cleanup by banks might seem a reasonable step from a prudential oversight point of view - but it might have the unintended result of opening up the gates of short-termism in European corporate governance. How’s that possible?

On 29 July 2016, the European Banking Authority published the results of the 2016 EU-wide stress tests.[1] One of the takeaways of the results is that EU banks exposed to high non-performing loan (NPL) ratios are more fragile than others. This finding might accelerate the implementation of reforms in European banking regulation that shall encourage: (a) massive NPL portfolio sales by banks; and (b) the concomitant development of distressed securitised asset markets in the EU.

Moving towards the de-leveraging of NPLs

The traditional view of European (continental) corporate finance is that it is largely bank-oriented and characterised by weak securities markets. This in turn affects the corporate governance of European firms; bank capital is by nature more patient than equity capital, enabling managers to tie up assets in long-term investments rather than seek to pump up the share price by using free cash flow to distribute fat dividends and/or launch stock buyback plans. If European banks are encouraged or even forced to set time-bound operation targets for NPL write-downs and disposals, then in all likelihood the corporate governance upside of bank capital, i.e. patience and long-termism, shall disappear for a number of bank-dependent European firms.

There are indeed signs that European banking shall soon move towards the de-leveraging of NPLs, so a shift in the corporate governance effects of bank financing in the EU is likely to start materialising soon too. First of all, the IFRS 9 (an accounting rule to be implemented from 2018) will include a clear definition of write-off that is different from loan cancellation. Under IFRS 9, banks are expected to write off loans earlier, opening the way for possible corporate restructuring or liquidation. There are also calls to move closer to the US system, where banks are obliged to write down loans to the recoverable value of collateral after six months, as well as to suspend interest income on NPLs once the loan is 90 days past due.[2] At the same time tax reforms in separate EMU Member States that shorten the timeline for full loan loss deductibility are hailed (see e.g. the 2015 tax reform in Italy, by which Italian banks were allowed to fully deduct loan loss provision, as well as losses on NPL disposals, in the year they are booked, while under the previous regime these were only deducted over a five-year period). Influential authors working with the IMF (which has assumed an increased role in EMU affairs since 2010) also suggest that the Single Supervisory Mechanism (SSM) should set a time limit on how long banks can carry NPLs on their balance sheet; the SSM is even encouraged to agree with banks on identifying nonviable firms for quick liquidation.[3]

Short-termist pressures

The combined result of the gradual implementation of the above (suggested or agreed) reforms will be the development of a distressed securitised market for NPLs; this would also be in alignment with one of the goals of the EU Capital Markets Union, so things might move this way faster than expected.[4] PE funds have the natural potential to dominate this market and thus take a lead role in the stakeholder structure of a number of European firms reversing the dynamics of corporate governance in the continent. The prospect of a profitable exit by the PE fund within 3-5 years (the average holding period for PE funds) could result in the release of short-termist pressures upon underperforming firms, a situation unknown to many European SMEs, but well-known for decades in the US.

All in all, it seems that taking up the challenge of solving the NPL problem in European banking might come at a cost for the long-term prospects of economic growth. This is because short-termism in corporate governance has been identified as a possible factor of dampening GDP growth[5], a figure that for many remains the ‘holy grail’ in a largely stagnant EMU.

 

[1] The results can be accessed here: http://www.eba.europa.eu/documents/10180/1532819/2016-EU-wide-stress-test-Results.pdf"
[2] European Central Bank - Financial Stability Review, May 2016 – Euro area financial institutions, pg. 73
[3] Shekhar Aiyar et al., A Strategy for Resolving Europe’s Problem Loans, Sept. 2015, IMF Staff Discussion Note
[4] See Action Plan on Building a Capital Markets Union COM(2015) 468 final, pg. 21
[5] see P. Masouros, Corporate Law and Economic Stagnation (2013)

About the author

Pavlos Masouros is Assistant Professor of Corporate Law at Leiden UniversityLaw School in the Netherlands and Managing Partner of Masouros & Partners Attorneys-at-Law in Athens, Greece. In addition to his many international academic positions, Pavlos is the Co-Managing Director of the Centre for European Company Law, an EU-wide business law think-tank. He has been named a Fellow of the ‘40 under 40’ European Young Leaders and is a sought-after commentator on current developments in the field of corporate law and law & economics. His opinions have appeared in high-profile publications, such as The Washington Post, ReutersOpinion, and Slate.