ECB Rates Allow Zombie Loans to Stymie Credit, BIS Says

Loose monetary policy makes it easy for euro-area banks to keep bad debt on their books, potentially delaying the flushing out of sour loans, the Bank for International Settlements said in its annual report.

The European Central Bank’s record low interest rates and ample liquidity have boosted banks’ lending margins, allowing them to gloss over losses in their business, the Basel, Switzerland-based BIS said in the report, released today. That’s what makes it so crucial to find other means to fix banks’ balance sheets, such as the ECB’s asset-quality review, it said.

“Enforcing balance-sheet repair is an important policy challenge in the euro area,” said the BIS, the record-keeper of the world’s central banks. “Low rates reduce the cost of -- and thus encourage -- forbearance, keeping effectively insolvent borrowers afloat in order to postpone the recognition of losses.”

Non-performing loans have kept growing in the years since 2010 in euro-area countries such as Spain or Italy, where they exceed 10 percent of all loans as the downturn exposed the indebtedness of retail and corporate borrowers. Meanwhile, they dropped to less than 4 percent in the U.S. last year, down from a peak of about 7.5 percent reached after the 2008 collapse of Lehman Brothers Holdings Inc.

In its assessment of the euro area’s 128 largest lenders, the ECB will seek to determine whether firms are giving borrowers easier terms to avoid showing loans as defaulted.

Japanese Experience

“The experience of Japan in the 1990s showed that protracted forbearance not only destabilizes the banking sector directly but also acts as a drag on the supply of credit,” the BIS said. “This underscores the value of the ECB’s asset-quality review, which aims to expedite balance-sheet repair.”

The bad loans on banks’ books are running counter to their strengthening of capital ratios, the BIS said.

“The capacity of capital to absorb future losses is severely undermined by unrecognized losses on legacy assets,” it said. “Unrecognized losses distort banks’ incentives, diverting resources toward keeping troubled borrowers afloat and away from new projects.”

ECB President Mario Draghi is combining different tools as he tries to simultaneously heighten banks’ risk awareness and prompt them to lend in countries just coming out of recession.

Reviving Lending

While the ECB’s scrutiny of balance sheets puts pressure on banks to clean their books, Draghi is also offering as much as 400 billion euros ($545 billion) of cheap funding to jump-start lending that is still lackluster a year after the 18-nation euro area emerged from its longest recession.

The BIS also warned of risks lingering for banks in countries where credit is sound and growing and the earnings outlook is bright, citing some emerging markets along with Switzerland and the Nordic countries.

“In countries with recent financial booms, banks may be weaker than they appear,” it said. “Perceptions of a benign credit outlook and strong earnings potential have ridden on an unstable leverage-based expansion.”