A eurozone bad bank could help Europe manage an uptick in soured loans amid the coronavirus crisis, but getting consensus will be tough because such a project raises questions about risk-sharing, pricing and the role of the government in the region's banking systems, according to analysts.

As the COVID-19 pandemic is expected to trigger a deep recession in the eurozone and a new wave of nonperforming loans, the European Central Bank has resurrected the idea of putting legacy toxic debt on banks' balance sheets in a bad bank as a way to help lenders cope with new NPLs.

According to an April 19 report in the Financial Times, senior EU officials rebuffed the idea, saying there are more suitable ways of handling bad loans.

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North-south divide

Previous debates about other mutual projects that would spread risk across the eurozone — such as a common deposit insurance scheme and mutual "coronabonds" — have stumbled. The wide gap in indebtedness between the north and south of Europe has meant more frugal countries like Germany, Finland, and the Netherlands have refused to share risk with NPL-laden southern states like Italy and Greece.

NPL ratios have come down in the so-called peripheral European countries, but Italy's banks — those included in a recent monitoring exercise by the European Banking Authority — still had a total volume of more than €110 billion at the end of 2019, and Greece's banks about €70 billion.

The debate about a eurozone bad bank is set to encounter similar problems, with Germany already said to be leading a group of countries opposing the proposal, Bloomberg News reported April 20, citing sources.

An agreement on providing relief for all of the banking systems across the eurozone may be hard given historical differences between member states on what constitutes an acceptable form of relief and the fact that NPL levels in the coronavirus crisis will again differ between countries, according to Elisabeth Rudman, head of European Financial Institutions at DBRS Morningstar.

Up until now it has never been possible to form a pan-European solution for bad loans, she said in an interview, but added that, even without it, a lot of progress has been made.

Alternatives

A proposal for a cross-border bad bank was previously made in 2017 by Andrea Enria, who then chaired the European Banking Authority. It was met with skepticism not only because of variations in NPL levels, but also due to the absence of a pan-European insolvency regime.

Even without the formation of a bad bank, the NPL stock in the eurozone had dropped to €580 billion by June 2019 from about €1 trillion in 2014, according to ECB data. In a speech in June 2019, Enria, now chair of the ECB supervisory board, said a series of ECB measures, including guidance on provisioning for new and existing NPLs, had helped the reduction.

Furthermore, government-backed schemes like GACS, or Garanzia sulla Cartolarizzazione delle Sofferenze, in Italy have contributed to the toxic debt reduction by making NPL securitization deals easier. Greece recently launched a similar scheme, dubbed Project Hercules.

Over the three years before the pandemic, "a pretty active" market for bad loans emerged in all of the affected countries including Italy and Greece, Nicolas Véron, a senior fellow at Brussels-based think tank Bruegel said in an interview.

"If there is a market that allows buyers to buy and sellers to sell under conditions both sides find acceptable, then it is not clear that a bad bank is necessary," he said.

Timing

The news about talks of a bad bank now is surprising as generally, this is a tool best used not in the peak of a crisis but in the recovery phase when things are "getting back to normal," Véron said.

After the global financial crisis in 2008, 15 bad banks were set up in 12 EU countries and managed assets of at least 37 failing banks. Four of the large vehicles — UKAR in the U.K., NAMA in Ireland, FMS in Germany and Sareb in Spain — held assets at a total book value of nearly €490 billion at the time of their creation.

At the current early stage of the coronavirus crisis, there is a high level of uncertainty, which makes it very hard to put a fair price on assets, he said. Therefore, a bad bank debate will not be difficult only for political reasons like the mutualization of debt, but also for practical reasons, such as being able to sell at the right price, he added.

Another question to consider apart from risk-sharing and pricing of assets is what a bad bank will represent in terms of the role of the state in the banking system, Peter Hahn, former dean of the London Institute of Banking and Finance, said in an interview.

The problem with such an approach is that it raises questions about ownership and control, he said. Depending on how much bank risk the EU takes on, six months or a year from now it might need to answer the question "Have we decided now that our banking system is quasi-governmental?"