Tackling the post-COVID European NPL ‘problem’: a State aid perspective

The European Commission has, in recent years, pursued a general policy aim of keeping non-performing loan (NPL) ratios to sustainable levels by seeking to address the legacy stock of NPLs and the risk of accumulating new NPLs. But in spite of gradual improvement, the COVID-19 pandemic seems to have (as they say) ‘thrown a spanner in the works’, with rising NPL ratios already being seen across the EU and concerns of NPL accumulation once liquidity support schemes are withdrawn.

There is, however, an opportunity for banks and NPL investors to proactively manage and engage with the situation. This blog will:

1. set out the Commission’s post-COVID strategy for addressing NPLs;
2. explain how the EU bank resolution framework applies to proposed impaired asset measures (such as State-supported AMCs) in response to the pandemic; and
3. consider some key practical considerations from a State aid perspective when designing impaired asset measures in response to the pandemic.

The Commission’s post-COVID strategy

On 16 December 2020, the Commission published a Communication on ‘Tackling non-performing loans in the aftermath of the COVID-19 pandemic’, which sets out the Commission’s strategy for managing NPLs in the context of the pandemic.

Based on learnings from the 2008 financial crisis, the Commission is focusing on developing an EU-wide strategy to pre-emptively address any potential accumulation of NPLs on banks’ balance sheets as a result of the pandemic whilst also ensuring a high degree of consumer protection.

In particular, this strategy includes:

• Monitoring and early resolution / disposal: incentivising banks to monitor debtor distress and proactively engage with debtors (including restructuring debt where necessary), and engage in early identification, resolution and disposal of NPLs.
• Developing the secondary market for distressed assets while ensuring strengthened protection for debtors: for example, the Commission reiterates its proposal for the adoption of the Credit Servicers Directive and recommends an EU-wide central electronic data hub in order to enhance market transparency.
• Reforming the EU’s corporate insolvency and debt recovery legislation to enable more convergent insolvency procedures and speed up the recovery of value.
• Supporting the establishment and cooperation of national asset management companies (AMCs): the Commission clarifies that while market funding without a State guarantee is preferable and should be explored as part of the design process, it is likely that most cases will require significant public funding (and therefore a State aid assessment).
• Supporting the implementation of precautionary recapitalisation measures (e.g. capital injections, Asset Protection Schemes (APSs)): the Commission emphasises that market-based solutions should remain the first and primary tool, and that any State aid will need to be targeted, limited and not result in a bailout of banks that were experiencing viability problems before the pandemic.

EU bank resolution and COVID-19

Pursuant to the EU bank resolution framework, State aid to a bank by way of an impaired asset measure (i.e. an AMC or APS) would constitute ‘extraordinary public financial support’, thus triggering the ‘failing or likely to fail’ provisions. This means that the bank benefitting from the aid should, in principle, be resolved or liquidated.

This would not, however, be the case for a capital injection, a State-backed APS or transfer of NPLs to a State-supported AMC that come under the ‘necessary to remedy a serious disturbance in the economy’ exception (as set out in Article 32(4)(d) BRRD / Article 18(4)(d) SRMR, i.e. the precautionary recapitalisation exception).

The Commission has confirmed that it considers the COVID-19 pandemic to be a ‘serious disturbance in the economy’. So - provided all the other conditions of the exception are satisfied - State aid by way of a capital injection, a State-backed APS or transfer of NPLs to a State-supported AMC in response to the pandemic would not trigger resolution or liquidation of the beneficiary bank.

Key practical considerations from a State aid perspective 

When looking to design an impaired asset measure in response to the pandemic, it is worth bearing in mind some key practical considerations.

Aid-free solutions may not in practice be preferable.

State-supported AMCs and APSs can be set up without State aid. This would be more straightforward from a procedural standpoint as well as minimise the burden on taxpayers.

But it may not always be feasible to avoid State aid. For example, in a stressed environment, a transfer of NPLs to an AMC at a depressed market value would not provide capital relief to the bank - it would instead crystallise high losses and erode its capital buffers.

To the extent such a measure includes State aid, parties should consider relying on the precautionary recapitalisation exception in order to avoid the unpredictable nature of the ‘resolution or liquidation’ route under the EU bank resolution framework.

It is important to allocate enough time and resources to impaired asset valuation.

Calculating the market value and Real Economic Value (REV) of an NPL portfolio plays an essential role in assessing whether there is State aid and whether the aid is lawful. This exercise is, however, time and resource consuming given the various practical difficulties involved. 

Since impaired assets often do not have an easily observable market price, their market price will need to be estimated. The estimation must be done by independent experts using prudent parameters and generally accepted valuation methods (as set out in the Commission’s Impaired Asset Communication and AMC Blueprint), and is likely to be verified by the Commission with the help of its own experts.

For measures that include State aid, significant advanced planning is necessary to comply with the precautionary recapitalisation exception (if relied on) and restructuring aid requirements. 

In order to come under the precautionary recapitalisation exception, the impaired asset measure must satisfy various conditions such as showing that the measure is temporary and proportionate in nature. This would require, for example, planning a clear exit strategy for the State.

Aid granted via impaired asset measures must comply with additional requirements applicable to restructuring aid (as set out in the Commission's 2013 Banking Communication and 2009 Restructuring Communication). The design of the impaired asset measure will need to include, for example, a restructuring plan which shows how the beneficiary banks’ long-term viability will be restored. However, the Commission’s Temporary Framework (para. 7) indicates that such aid could be granted without the need for bail-in as per paras. 43-45 of the Banking Communication.

This will therefore require significant upfront planning before the aid is notified to the Commission.