Europe's Central Bank Is Right to Get Tough on Bad Loans

Politicians should support the supervisors' efforts, not oppose them.

A reminder why rules need strengthening.

Photographer: Marc Hill/Bloomberg

A power struggle has set three of Europe’s most important institutions against each other. The European Central Bank, the European Parliament and the Council of the European Union (also known as the EU Council) are fighting over how banks should treat bad loans. The ECB has taken the toughest stance, but also the most appropriate one to the problem. If politicians want to limit the risk of a new banking crisis, they should let supervisors have their way.

The ECB’s supervisory arm has launched a public consultation over its new guidance on non-performing loans. The supervisors are seeking the power to demand that, from the introduction of the rules, lenders set aside 100 percent of the value of loans that go sour in the future. This sounds like a lot, but banks would have seven years to provision for secured loans and two years for unsecured debt. The new guidance would not apply to the current stock of NPLs, which would continue to be handled according to the existing framework.

Euro zone banks have been grappling with bad loans since the global financial crisis and the ensuing sovereign debt crisis. NPLs have now fallen to 830 billion euros ($981 billion) from a peak of 1.06 trillion euros, but they remain a destabilizing force: Investors are unsure about the quality of the loan books of European lenders, which helps to explain why their valuations are lower than their U.S. competitors.

The central bank wants to ensure that banks are on a sound footing when the next crisis hits. That might not seem a matter of urgency now, but the timing could not be better: the euro zone economy is recovering and banks are in a strong position to start preparing for a future recession. True, some businesses and families may be denied credit as a result of the new approach. But there is nothing wrong in a supervisor demanding better underwriting standards, particularly when the economy is on a roll. A safer lending system is also a precondition to ensure that member States are willing to move towards a greater sharing of banking risks, for example creating a joint deposit insurance scheme.

The European Parliament and the EU Council are critical of the proposal, ostensibly for legal reasons. They believe the ECB is overstepping its mandate, writing rules as opposed to simply applying them. Italian officials are especially concerned, given Italy's high NPL ratio and the political sensitivity of the issue.  Meanwhile,  the European Commission has recently launched a consultation over some of the areas the ECB has addressed in its new guidance.

The ECB has acknowledged the need to address the objections, but it is right not to back down. While often dressed in concern over technicalities, at heart the objections are political and institutional. They fail to appreciate the spirit of the ECB’s guidance or the importance of timing.

The supervisors will only use the new guidelines as a regulatory backstop, to force the hand of lenders that are reluctant to take action with regard to new NPLs. Banks that choose not to comply with the rules will need to explain why they chose otherwise. Only if these explanations are insufficient will supervisors take action.

The ECB's rules would ensure that supervisors are fair and transparent about what they expect from banks. The ECB could stand accused of being arbitrary if it were not open about its prudential standards. This is particularly important in the euro zone, where citizens must know that supervisors are not favouring lenders of a given country over another. 

The European Commission should press ahead with its consultation, of course, which will give the ECB’s action the full power of a law. Any differences between the two plans can be addressed over time. However, in the meantime, supervisors must be able to put in place their new guidance rapidly: It may take months to agree on a new body of rules. The risk is that the economy slows down before this happens, forcing the ECB to tighten the regulatory screw when banks are much weaker.

The euro zone has made significant progress in handling its pile of bad loans, but it will still take time to solve this issue fully. The ECB is right to find ways to prevent this problem from happening again. Politicians should support its efforts, not oppose them.

(Corrects reference in the first and fifth paragraph to make clear that it is the Council of the European Union, not the similarly named European Council, that raised objections to the ECB measure.)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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