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### Executive Summary — Restructuring status and urgent priorities
- Restructuring status
  - EU banking system restructuring is under way, but is far from complete.
  - Level Tier 1 capital ratios of EU banks have been substantially increased: "10 percent in June 2012 against 7 percent in December 2008" (EBA, 57 EU banks).
  - System-wide, capital ratios have been met partly by deleveraging or recalibrations of the risk weights on activities.
  - Consolidation in the banking sector has been slow; banks rarely closed; some banks downsized via branch closures, sales/closures of business lines, and staff reductions.
- Key hurdles and urgent priorities
  - NPLs are building up and central bank liquidity dependence remains high, especially in peripheral countries.
  - The EBA recapitalization exercise led to "€200 billion of new capital or reduction of capital needs," but fresh capital is difficult to attract given uncertain profitability prospects.
  - Four priority areas:
    - Strengthen EU bank resolution tools and align with the Financial Stability Board Key Attributes; fast adoption and swift transposition of the EU resolution directive is welcome but enhancements are warranted.
    - Facilitate restructuring of NPLs: remove legal impediments to speed restructuring and maximize asset recovery; in several EU countries (Italy, Greece, and parts of Eastern Europe) bankruptcy reforms lag—e.g., seizure of collateral may not be possible in a reasonable timeframe.
    - Evolve DG COMP practices in systemic cases to ensure consistency with a country’s macro-financial framework and support viability of weak banks, recovery of market access, and credit provision; increase transparency.
    - Significantly enhance and harmonize disclosure by the EBA, especially interpretable metrics on asset quality: NPLs, collateral, PD, and LGD.

### Recent developments — pre-crisis conditions and crisis transmission
- Pre-crisis vulnerabilities
  - Many European financial systems were bank dominated, complex, and very large relative to domestic GDP.
  - Global assets of the five largest banks were typically more than 300 percent of their home country’s GDP.
  - Total bank assets account for "283 percent of GDP in the EU, compared to about 65 percent of GDP in the U.S."
  - From 2000 to 2007, solvency ratios increased by only "0.2 percent" (from "10.7 percent to 10.9 percent" for the largest 90 EU banks in the 2011 EBA stress test, Bloomberg).
  - Return on equity (ROE) was about "17 percent in 2007" for European banks.
- Crisis transmission and feedback loops
  - The U.S. mortgage market triggered the crisis, but adverse feedback loops among sovereigns, banks, and the real economy deepened and spread the crisis.
  - Sovereigns in some cases struggled to backstop weak banks alone; lack of collective mechanisms allowed spillovers across euro area countries.

### Crisis response — scale, composition, and central bank measures
- Scale and composition of support (September 2008–December 2011)
  - Member states committed a total of "nearly €4.5 trillion, i.e., 37 percent of the EU GDP." (Alternative estimate: "€4.9 trillion or 39 percent of EU GDP".)
  - Taxpayer money effectively used (capital injections, state guarantees, etc.) amounted to "€1.7 trillion, or 13 percent of EU GDP".
  - Out of 76 top EU banking groups, 19 currently have a major or 100 percent government stake.
- Public intervention lines and magnitudes (Table 1, figures in billions of Euros)
  - Capital injections: Used "288" (2.4 percent of GDP); Approved "598" (4.9 percent of GDP).
  - Guarantees on bank liabilities: Used "1,112" (9.1 percent of GDP); Approved "3,290" (26.8 percent of GDP).
  - Relief of impaired assets: Used "121" (1.0 percent of GDP); Approved "421" (3.4 percent of GDP).
  - Liquidity and bank funding support: Used "87" (0.7 percent of GDP); Approved "198" (1.6 percent of GDP).
  - Total: Used "1,608" (13.1 percent of GDP); Approved "4,506" (36.7 percent of GDP).
  - Note: Not including LTRO amounts; including LTROs, the amount committed to banks stands at "23 percent of EU GDP."
- Central bank and monetary policy measures
  - ECB measures included broadened eligible collateral, full allotment liquidity facilities, refinancing at fixed low rates, extended LTRO maturities, active asset purchases, and announcement of OMT in September 2012.
  - National central banks granted Emergency Liquidity Assistance (ELA).
  - Bank of England Asset Purchase Facility (APF) cumulative assets purchased net of sales and redemptions: "£360 billion (as of September 2012)."
- State aid and recapitalization exercises
  - DG-COMP: "10-15 percent of the EU banking system is now under the State Aid framework and undergoing some forced restructuring."
  - State-aid restructured banks deleveraged up to "19 percent of their total assets" versus "5 percent" average for non-restructured banks (Morgan Stanley sample).
  - EBA stress testing and recapitalization:
    - 2011 stress test: 90 banks, core Tier 1 threshold "5 percent."
    - EBA recapitalization target: "9 percent by end-June 2012" after sovereign buffer.
    - Aggregate capital shortfall at end–June 2012: "€115 billion"; capital plans led to "€200 billion of new capital or reduction of capital needs."
    - Tier 1 ratios excluding hybrid instruments used as proxy for Core Tier 1; Tier 1 ratios now exceeding "10 percent," against "7 percent in December 2008."
- Independent asset quality reviews
  - Countries under/near financial assistance (Cyprus, Greece, Ireland, Portugal, and Spain) and Slovenia carried out independent asset quality reviews to regain market confidence.

### On-going challenges — macro environment, funding, and NPLs
- Monetary policy and forbearance
  - Very low interest rates, quantitative injections, tolerated forbearance, and government backstops avoided abrupt restructuring but underlying pressures remain.
  - Accommodative monetary policies must be combined with strong macro policies and comprehensive restructuring strategies (asset diagnosis, recapitalization, resolution).
- Macroeconomic environment and credit conditions
  - Activity in the euro area was expected to contract by "0.2 percent in 2013" (IMF WEO Update, January 2013).
  - Credit conditions remain tight in some EU countries, especially peripheral and Emerging Economies in the EU (EEE).
- Funding challenges
  - Funding remains a large challenge, especially for banks in peripheral countries.
  - Many peripheral banks are heavily reliant on ECB funding with challenges on asset encumbrance and collateral eligibility due to rating downgrades and valuation effects.
  - Banks in Greece and Ireland have substantially used ELA.
  - Following announcement of OMT, funding conditions eased somewhat; some peripheral banks issued debt in primary markets and CDS spreads eased, but wholesale funding remains prohibitively expensive to support lending sustainably in the current environment.
- Nonperforming loans (NPLs)
  - Since 2007, loans to the economy decreased by "3 percent" while NPLs increased by "almost 150 percent," i.e., "€308 billion" in absolute terms.
  - NPLs jumped from "2.6 percent in December 2007 to 8.4 percent of total loans in June 2012."
  - Country differences:
    - From December 2007 to June 2012, NPL ratio for Italy increased by "2.5 times"; in Spain, the increase was "seven times."
    - Ireland: average NPLs of "around 30 percent," followed by Hungary and Greece.
  - Definitions of NPLs are not harmonized across the EU, impairing comparability.
  - NPLs absorb management capacity, weaken profitability, foster forbearance, and deter new investors by impairing transparency.

### Capital ratios, RWAs, and supervisory opacity
- RWA recalibrations and opacity
  - During the last EBA recapitalization exercise, 30 percent of the shortfall banks were required to make up was met through reduction in RWAs; "€10 billion" came through RWA “recalibrations.”
  - Such recalibrations are expected to continue, contributing to opacity in bank capital computations.
  - Bank of England Financial Stability Report (November 2012): RWAs calculations for the same hypothetical portfolio can be vastly different; the most prudent banks calculate over twice the needed capital as the most aggressive banks.

### Resolution and restructuring framework — needs and proposed reforms
- Overall needs
  - Enhance framework for resolution and restructuring to address resolution on a “gone” or a “going” concern basis, State aid rules, and measures to facilitate private sector market-based adjustment.
  - SSM is only one step; resolution, a deposit guarantee scheme (DGS), and a single rulebook are essential counterparts.
  - Resolution and a DGS will need to be centralized, with a common backstop.
  - ESM prepared to directly recapitalize banks; European Council decision of June 2012 provided ESM the possibility of direct bank recapitalization when an effective SSM is in place.
- Findings and reforms in national regimes
  - National FSAPs showed countries lacked domestic resolution tools.
  - UK created a special resolution regime (SRR); Germany adopted Bank Reorganization Act (January 2011) with asset separation and court-led bail-in of senior unsecured creditors.
  - European Commission issued a draft directive in June 2012 for harmonized crisis management and resolution; transposition deadlines cited: 01/2015 and 01/2018 for bail-ins.
  - FSB Key Attributes (endorsed by G-20 leaders in 2011) aim to make resolution feasible without severe systemic disruption and without exposing taxpayers to loss.
- Box: Proposed Resolution Directive — risks and enhancements (selected)
  - EU-wide funding for resolution is lacking; binding mediation powers for the EBA and mutual borrowing arrangements face constraints.
  - Scope should be widened to include systemic insurance companies and financial market infrastructures; all banks should be subject to the regime without ordinary corporate insolvency proceedings.
  - Triggers for resolution should be flexible to determine non-viability (including liquidity breaches and other serious regulatory failings, not just capital shortfalls); mandatory intervention provision recommended.
  - Directive affords less flexibility than the Key Attributes—e.g., no standalone mandatory recapitalization power or asset separation tool; bail-in safeguards should not prevent departure from pari passu treatment where necessary.
  - Depositor preference should be established for insured depositors, with right of subrogation for the DGS.
- Single Resolution Mechanism (SRM) considerations
  - Desirability of moving quickly to a single resolution mechanism (SRM) with common backstops, at least for countries in the SSM.
  - Rationale: national regimes face difficulty handling larger, cross-border banks; limited incentives for least-cost rapid action; coordination difficulties without common backstops.
  - SRM mandate alongside SSM: develop resolution/recovery plans and intervene before insolvency using quantitative and qualitative triggers.
  - Required powers: bail-in of subordinated and senior unsecured creditors; transfer via “purchase and assumption”; asset separation via AMVs; override shareholder rights; establish bridge banks; closure of insolvent banks.
- Coordination and institutional arrangements
  - SRM must coordinate closely with SSM (e.g., formal meetings with Chair of Supervisory Board of the ECB or representation of ECB Chair on SRM board).
  - Resolution likely subject to state aid rules; SRM needs close coordination with DG COMP.
  - Existing agencies may need operational and legal changes; using ESM as resolution mechanism may be worthwhile short term, but creating a new single resolution agency may be best medium term once common funding and backstops are agreed.

### Borrower restructuring, asset recovery, and Asset Management Companies (AMCs)
- Legal and operational impediments
  - Legal frameworks should facilitate restructuring of NPLs and maximize asset recovery.
  - IMF involvement in bankruptcy/insolvency reform aims to introduce fast track restructuring tools and out-of-court processes in several EU countries (including Italy, Greece and Portugal).
  - Example: repossession of collateral for a retail mortgage may take several years in Italy versus few months in Scandinavia and the United Kingdom.
  - Implementation frictions can heavily reduce collateral value and leave NPLs on bank balance sheets.
- Options for handling NPLs
  - (i) retention and management by banks at appropriately written-down values with government recapitalization assistance;
  - (ii) relocation or sale to decentralized “bad banks,” loan recovery companies, or AMCs;
  - (iii) sale to a centralized AMC set up for public policy purposes (possibly when NPLs reach systemic proportions).
- Experience with AMCs
  - AMCs used in Belgium, Denmark, Ireland, Spain, Switzerland, and the United Kingdom; discussions in Cyprus and Slovenia; considered but ruled out in Iceland.
  - Costs and benefits:
    - Advantages: consolidation of workout skills; securitization facilitation; greater leverage over debtors; prevent fire sales; allow good banks to focus on core business.
    - Disadvantages: asset purchases by AMCs do not raise banks’ net worth unless done above-market; asset purchases do not solve lack of capital; overall cost may be higher than expected depending on legal/operational environment and political pressure.
  - Key design features:
    - Operational independence; structured incentives to avoid becoming a warehouse of NPLs; commercial orientation to purchase at fair market value; adequate funding with separate operating budget; using an entity without a banking license avoids regulatory capital/liquidity requirements.
  - EU examples:
    - Ireland: NAMA set up December 2009 to acquire bad loans from five participating banks and receive government-backed securities as collateral against ECB funding.
    - Spain: August 2012 legislation established Sareb; mid–December 2012, Sareb increased its capital to allow main private participants (banks) to become shareholders.
  - Historical note: Malaysian Danaharta purchased impaired loans at average discount of 55 percent; selling banks retained right to receive 80 percent of recoveries in excess of acquisition costs.

### Supervisory transparency, EBA role, and asset quality reviews
- EBA dissemination and supervisory convergence
  - The EBA must promote better dissemination of supervisory micro-data and enhance transparency in disclosure of banks’ risk-related data.
  - 2011 stress test showed value of detailed disclosure.
  - EBA should:
    - enhance quality assurance processes;
    - promote disclosure of granular asset quality information;
    - expand depth and coverage of audits;
    - issue guidelines for supervisors on best practices for asset quality reviews and push for enhanced comparability and completeness of Pillar 3 reports.
  - EBA should coordinate technical expertise with national authorities.
- Supervisory convergence and RWAs
  - EBA work on consistency of RWAs is a priority.
  - Initial work found divergences in application of IRB models, differences in interpretation/implementation of regulatory framework, and dispersion across banks in the gap between expected losses on defaulted and non-defaulted assets.
  - Work should be harmonized with BCBS Level 3 exercises and followed by guidelines (and perhaps Regulatory Technical Standards) to ensure consistency.
- Asset Quality Reviews — country cases (selected)
  - Ireland: BlackRock Solutions loan diagnosis over "€275 billion" across five largest Irish banks (Jan–Mar 2011); five building blocks including AQR, distressed credit operations review, data integrity validation, loan loss forecast (LLF) through end-2013, and public communication.
  - Greece: BlackRock engaged Aug–Dec 2011; individual results communicated to banks but not disclosed publicly.
  - Portugal: Special Inspection Program Jul–Nov 2011 for eight largest groups (accounting for more than 80 percent of system assets); W1 and W2 results public in December 2011; W3 not disclosed.
  - Cyprus: AQR Sept–Dec 2012, Pimco and Deloitte appointed for on 22 institutions accounting for 73 percent of Cyprus banking system; stress test horizon mid-2012 to mid-2015.
  - Spain: Olivier and Wyman and Roland Berger May–Jun 2012 for 14 main groups (88 percent market asset share); cumulative credit losses in adverse scenario "€250-270 billion" and "€170-190 billion" in base scenario; estimated capital needs range "€51-62 billion" (adverse) and "€16-25 billion" (base); capital buffer requirement "€37 billion" for core Tier 1 threshold of "7 percent."
  - Note: Slovenia almost conducted an independent assessment.

### Enhancing DG COMP practices and disclosure
- DG COMP and State Aid
  - DG COMP has been the main coordinating mechanism for bank restructuring during the crisis; interventions imposed restructuring but sometimes heightened macro-financial concerns (decision speed, transparency, impact of compensatory measures).
  - DG COMP exclusive mandate: ensure State aid is compatible and accept State aid in exchange for strict conditionality.
  - Under State aid regime: 60 EU banks—accounting for "10–15 percent of the EU banking assets"—underwent deep restructuring; 20 banks were resolved.
  - Procedures accelerated; ESM support to bank recapitalization conditional upon Commission approval of restructuring plans (example: less than six months to approve restructuring plans of eight Spanish banks).
- Enhancements recommended
  - DG COMP practices in systemic cases should ensure consistency with macro-financial frameworks and enhance transparency.
  - Phasing and composition of restructuring should mitigate adverse macroeconomic effects.
  - Re-examination (with IMF and ECB) of policy for determining remuneration of instruments used for capital support and the methodology for determining required degree of bank deleveraging would be appropriate.
  - A permanent coordination mechanism between DG COMP and financial stability authorities could help reconcile competition and resolution objectives.
- Disclosure gaps
  - Despite EBA stress test disclosure (over 3,000 data points), data gaps impede market discipline: funding side (collateral encumbrance, ECB funding, LCR ratios), derivatives and off-balance sheet activities, RWAs, PDs.
  - NPL definitions not harmonized; write-off practices under IFRS are flexible and inconsistent across banks.
  - Collateral disclosure is not mandatory under IFRS; when disclosed, values and valuation approaches vary (Fair value, nominal value, nominal realizable value, stressed value); periodicity and governance of revaluation differ.

_Italic: Source — content unit from the provided IMF PDF._

### 2013. The views expressed in this document are those of the staff team and do not necessarily reflect

### FINANCIAL SECTOR ASSESSMENT PROGRAM — EUROPEAN UNION: PROGRESS WITH BANK RESTRUCTURING AND RESOLUTION IN EUROPE (TECHNICAL NOTE, MARCH 2013)

### Executive Summary
- Restructuring status
  - The EU banking system restructuring is under way, but is far from complete.
  - Level Tier 1 capital ratios of EU banks have been substantially increased: "10 percent in June 2012 against 7 percent in December 2008" (EBA, 57 EU banks).
  - System-wide, capital ratios have been met partly by deleveraging or recalibrations of the risk weights on activities.
  - Consolidation in the banking sector has been slow, with banks rarely closed; some banks have downsized via branch closures, sales/closures of business lines, and staff reductions.

- Key hurdles and urgent priorities
  - Nonperforming loans (NPLs) are building up and central bank liquidity dependence remains high, especially in peripheral countries.
  - Despite the EBA recapitalization exercise leading to "€200 billion of new capital or reduction of capital needs," fresh capital is difficult to attract given uncertain profitability prospects.
  - Four priority areas for urgent progress:
    - Strengthen EU bank resolution tools and align them with the Financial Stability Board Key Attributes for Effective Resolution; fast adoption and swift transposition of the EU resolution directive is welcome but enhancements are warranted.
    - Facilitate restructuring of NPLs: remove legal impediments that slow restructuring and maximize asset recovery; in several EU countries (Italy, Greece, and parts of Eastern Europe) bankruptcy reforms lag—for example, current practice may not allow seizure of collateral in a reasonable timeframe. Encourage active bank management of NPLs and permit a market for distressed assets to emerge in Europe.
    - Evolve DG COMP practices in systemic cases to ensure consistency with a country’s macro-financial framework and support viability of weak banks, recovery of market access, and credit provision; increase transparency for credibility and accountability.
    - Significantly enhance and harmonize disclosure by the EBA, especially interpretable metrics on asset quality: NPLs, collateral, PD, and LGD.

### I. Introduction
- Scope and purpose
  - The note reviews experience with bank restructuring in Europe in recent years, pressures to restructure, impediments slowing the process, and helpful policy actions.
  - Discussion includes, but goes beyond, government-led resolution of problem banks.

### II. Recent Developments
- Pre-crisis conditions and vulnerabilities
  - Many European financial systems were bank dominated, complex, and very large relative to domestic GDP.
  - Global assets of the five largest banks were typically more than 300 percent of their home country’s GDP.
  - Total bank assets account for "283 percent of GDP in the EU, compared to about 65 percent of GDP in the U.S."
  - From 2000 to 2007, solvency ratios increased by only "0.2 percent" (from "10.7 percent to 10.9 percent" for the largest 90 EU banks in the 2011 EBA stress test, Bloomberg).
  - Return on equity (ROE) was about "17 percent in 2007" for European banks.
  - Leverage increased, with reliance on short-term wholesale funding.

- Crisis transmission and feedback loops
  - The U.S. mortgage market triggered the crisis, but adverse feedback loops among sovereigns, banks, and the real economy deepened and spread the crisis.
  - Sovereigns in some cases struggle to backstop weak banks alone; lack of collective mechanisms has allowed spillovers across euro area countries.

A. Crisis Response
- Scale and composition of support
  - Over the September 2008–December 2011 period, member states committed a total of "nearly €4.5 trillion, i.e., 37 percent of the EU GDP." (DG-COMP figures and notes: estimated at "€4.9 trillion or 39 percent of EU GDP" in October 2012 in an alternative estimate.)
  - The amount of taxpayer money effectively used (capital injections, state guarantees, etc.) amounted to "€1.7 trillion, or 13 percent of EU GDP" (Table 1).
  - Out of 76 top EU banking groups, 19 currently have a major or 100 percent government stake.

- Public intervention lines and magnitudes (2008–2011)
  - Table 1: Public Interventions in the EU Banking Sector: 2008–2011 (figures in billions of Euros)
    - Capital injections: Used "288" (2.4 percent of GDP); Approved "598" (4.9 percent of GDP).
    - Guarantees on bank liabilities: Used "1,112" (9.1 percent of GDP); Approved "3,290" (26.8 percent of GDP).
    - Relief of impaired assets: Used "121" (1.0 percent of GDP); Approved "421" (3.4 percent of GDP).
    - Liquidity and bank funding support: Used "87" (0.7 percent of GDP); Approved "198" (1.6 percent of GDP).
    - Total: Used "1,608" (13.1 percent of GDP); Approved "4,506" (36.7 percent of GDP).
  - Note: These figures do not include LTRO amounts; including LTROs, the amount committed to banks stands at "23 percent of EU GDP."

- Central bank and monetary policy measures
  - In the euro area, the ECB provided enhanced support by:
    - Broadening the scope of eligible assets for central bank funding and setting up full allotment liquidity facilities;
    - Undertaking refinancing operations at a fixed and historically low rates;
    - Extending the maturity of central bank funding via Long-Term Refinancing Operations (LTROs);
    - Actively purchasing assets; and
    - Announcing a program of Outright Monetary Transactions (OMT) in September 2012.
  - National central banks granted Emergency Liquidity Assistance (ELA) in crisis situations.
  - Bank of England set up an Asset Purchase Facility (APF) with cumulative assets purchased net of sales and redemptions totaling "£360 billion (as of September 2012)."
  - Figure 2 (ECB monetary financing operations vis à vis euro area banks) shows the scale of Main Refinancing Operations (MRO) and LTROs (data from Bloomberg).

- State aid and restructuring
  - DG-COMP: "10-15 percent of the EU banking system is now under the State Aid framework and undergoing some forced restructuring."
  - Based on a restricted sample of 30 large institutions, banks under State Aid rules have been deleveraging up to "19 percent of their total assets" (Morgan Stanley), versus "5 percent" average for non-restructured banks.
  - Led by the EBA, stress testing and recapitalization exercises increased quantity and quality of capital:
    - The second EBA stress test (2011) included 90 banks and used a core Tier 1 threshold of "5 percent."
    - The EBA recapitalization exercise recommended a higher core Tier 1 capital (CT1) target of "9 percent by end-June 2012" after establishing a sovereign buffer.
    - Capital plans submitted by banks led to "€200 billion of new capital or reduction of capital needs," for an aggregate capital shortfall of "€115 billion" at end–June 2012.
    - Tier 1 ratios excluding hybrid instruments are used as a proxy for Core Tier 1; Tier 1 ratios are now exceeding "10 percent," against "7 percent in December 2008."

- Independent third party diagnostics
  - Countries under or near financial assistance (Cyprus, Greece, Ireland, Portugal, and Spain) and Slovenia (three largest banks) carried out independent asset quality reviews to regain market confidence.

B. On-Going Challenges
- Monetary policy and forbearance
  - Very low interest rates, quantitative monetary injections, tolerated forbearance, and government backstops have avoided abrupt restructuring and intense credit crunches, but underlying pressures remain.
  - Accommodative monetary policies provide breathing space but must be combined with strong macro policies and comprehensive restructuring strategies (asset diagnosis, recapitalization, resolution).

- Macroeconomic environment and credit conditions
  - The economic environment in much of the EU remains weak; recession in the periphery has been spilling into other EU economies.
  - Activity in the euro area was expected to contract by "0.2 percent in 2013" (IMF WEO Update, January 2013).
  - Credit conditions remain tight in some EU countries, especially peripheral and Emerging Economies in the EU (EEE), threatening recovery.

- Market perceptions
  - Recent policy actions, notably the OMT program (August 2012), have eased investor fears, but perceived risks to financial stability remain elevated.
  - Tail-risk perceptions led to retrenchment of private financial exposures to the euro area periphery.

- Nonperforming loans (NPLs)
  - Since 2007, loans to the economy decreased by "3 percent" while NPLs increased by "almost 150 percent," i.e., "€308 billion" in absolute terms.
  - NPLs have jumped from "2.6 percent in December 2007 to 8.4 percent of total loans in June 2012."
  - NPLs absorb management capacity, weaken profitability through continued losses, foster forbearance, and deter new investors by impairing transparency.
  - NPLs differ widely across countries:
    - From December 2007 to June 2012, the NPL ratio for Italy increased by "2.5 times"; in Spain, the increase was "seven times."
    - Ireland stands out with average NPLs of "around 30 percent," followed by Hungary and Greece.
  - Definitions of NPLs are not harmonized across the EU, impairing comparability.
  - Independent asset quality reviews and stress tests have supported diagnosis of asset quality and prospects for private recapitalization in stressed countries.

- Figures and evidence
  - Figure 1: Assets of EU and U.S. Banking Groups (2011, percent of GDP) — total assets data from SNL Financial, GDP from Eurostat, EU Commission.
  - Figure 3: Deleveraging/Restructuring Plans (percent of total assets) — state aid restructuring banks' average "19 percent" vs. non-restructured banks' average "5 percent" (Morgan Stanley).
  - Figure 4: Tier 1 Ratio of EU Banks 2008–2012 (EBA sample of 57 banks).
  - Figure 5 and Figure 6: NPLs to Total Loans (EBA 90 SIFI bank sample and country comparisons, June 2012 vs. December 2007).

*Source: International Monetary Fund, Monetary and Capital Markets Department, Financial Sector Assessment Program, March 2013.*

### 15.      Capital ratios have increased, but concerns have been expressed about the

### 15.      Capital ratios have increased, but concerns have been expressed about the

### Capital ratios and risk-weighted assets (RWAs)
- During the last EBA recapitalization exercise, 30 percent of the shortfall that banks were required to make up was met through reduction in RWAs, of which €10 billion came through RWA “recalibrations” (validation, roll out or changes to parameters of internal models).
- Such recalibrations of RWAs are expected to continue, contributing to opacity in bank capital computations.
- The Bank of England Financial Stability Report (November 2012) showed that banks’ RWAs calculations for the same hypothetical portfolio can be vastly different, with the most prudent banks calculating over twice the needed capital as the most aggressive banks.

### Funding challenges
- Funding remains a large challenge, especially for banks in the peripheral countries.
- Many peripheral banks are heavily reliant on ECB funding with challenges on asset encumbrance and collateral eligibility due to rating downgrades, valuation effects on their collateral and overall loss of market confidence.
- Banks in Greece and Ireland have substantially used ELA.
- Following the announcement of the OMT program by the ECB, funding conditions have somewhat eased for peripheral banks; some have been able to issue debt in primary markets and peripheral bank CDS spreads have been easing.
- Wholesale funding remains prohibitively expensive for the euro area periphery banks to sustainably support lending in the current environment.

### Resolution and restructuring framework — overall needs
- The EU needs to enhance the framework for bank resolution and restructuring to address:
  - resolution on a “gone” or on a “going” concern basis;
  - rules on State aid;
  - measures to facilitate private sector, market-based adjustment.
- The Single Supervisory Mechanism (SSM) is only one step; resolution, a deposit guarantee scheme (DGS), and a single rulebook are essential counterparts.
- Resolution and a DGS will need to be centralized, with a common backstop.
- The European Stability Mechanism (ESM) is being prepared to directly recapitalize banks as well as providing fiscal support; the European Council decision of June 2012 provided the ESM the possibility of direct bank recapitalization when an effective SSM is in place.

### A. Resolution Framework for Problem Banks — findings and reforms
- National FSAPs showed countries lacked domestic resolution tools.
- In reaction to the crisis:
  - The United Kingdom created a special resolution regime (SRR).
  - Germany adopted a restructuring law (Bank Reorganization Act, January 2011) with tools including asset separation and court-led bail-in of senior unsecured creditors.
- The European Commission issued a draft directive in June 2012 for a harmonized crisis management and resolution framework in all EU countries; the Irish Presidency planned to make adoption a top priority and to adopt it during the first part of 2013.
- Transposition deadlines cited: 01/2015, and 01/2018 for bail-ins.
- The FSB Key Attributes (endorsed by G-20 leaders in 2011) specify features for resolution frameworks for G-SIFIs; the objective is to make resolution feasible without severe systemic disruption and without exposing taxpayers to loss.

Box 1. Proposed Resolution Directive––Risks and Areas for Enhancements (selected points)
- Resolution of banks is undermined by the absence of a more effective EU-wide framework to fund resolution; binding mediation powers for the EBA and mutual borrowing arrangements between national funds face inherent constraints.
- Passage of the directive will substantially enhance the range of tools available to resolution agencies in the EU; the scope should be widened to include systemic insurance companies and financial market infrastructures. All banks should be subject to the regime, without the possibility of ordinary corporate insolvency proceedings.
- The breadth and timing of the triggers for resolution should be enhanced by providing the authority with sufficient flexibility to determine non-viability (including breaches of liquidity requirements and other serious regulatory failings, not just capital/asset shortfalls). Provision for mandatory intervention in the event a specified solvency trigger is crossed is recommended.
- The directive affords less flexibility for certain resolution powers than the Key Attributes—for instance, it does not permit exercising the mandatory recapitalization power and the asset separation tool on a standalone basis. Bail-in safeguards should not prevent departure from pari passu treatment where necessary on grounds of financial stability or to maximize value for creditors as a whole.
- Depositor preference should be established for insured depositors, with the right of subrogation for the DGS.

### Single Resolution Mechanism (SRM) considerations
- It is desirable to move quickly beyond harmonized national regimes and set up a single resolution mechanism (SRM), ideally with common backstops and safety nets, at least for countries participating in the SSM.
- Rationale:
  - National resolution regimes face difficulty handling larger, cross-border banks.
  - Limited incentives among national authorities for least-cost and rapid action could impede resolution.
  - Coordination difficulties without common backstops may undermine effectiveness.
- The resolution authority should seek to achieve least cost resolution without disrupting financial stability, protect insured depositors, and ensure shareholders and unsecured, uninsured creditors absorb losses.
- The SRM will need a mandate, alongside the SSM, to develop resolution and recovery plans and intervene before insolvency using well-defined quantitative and qualitative triggers.
- Required powers and tools include: bail-in of subordinated and senior unsecured creditors; transfer of assets and liabilities via “purchase and assumption”; asset separation through asset management vehicles; override of shareholder rights; establishment of bridge banks; closure of insolvent banks.

### Coordination and institutional arrangements
- The SRM will need to coordinate closely with the SSM (e.g., regular formal meetings with the Chair of the supervisory Board of the ECB or representation of the ECB Chair on the SRM board).
- Resolution will likely be subject to state aid rules, so the SRM will need close coordination with DG COMP.
- Existing agencies may require operational and legal changes to carry out a resolution role; using the ESM as the resolution mechanism may be worthwhile in the short term, but creating a new single resolution agency may be best in the medium term once common resolution funding and backstops are agreed.

### Borrower restructuring and asset recovery
- Legal frameworks should facilitate restructuring of NPLs and maximize asset recovery.
- IMF involvement in bankruptcy/insolvency law reform in several EU countries (including Italy, Greece and Portugal) aims to introduce fast track restructuring tools and out-of-court restructuring processes.
- Example of legal-enforcement frictions: repossession of collateral backing a retail mortgage may take several years in Italy versus few months in Scandinavia and the United Kingdom.
- Active management of NPLs is needed; options include:
  - (i) retention and management by banks at appropriately written-down values with government recapitalization assistance;
  - (ii) relocation or sale to one or more decentralized “bad banks,” loan recovery companies, or Asset Management Companies (AMCs);
  - (iii) sale to a centralized AMC set up for public policy purposes (possibly when the size of NPLs reaches systemic proportions).
- Implementation issues (e.g., inability to enforce collateral) can heavily reduce collateral value and leave NPLs on bank balance sheets.
- An efficient framework for handling NPLs is key to rehabilitate viable borrowers and provide exit for non-viable borrowers.

### Experience with Asset Management Companies (AMCs)
- EU experience with AMCs is at an early stage; AMCs have been used in Belgium, Denmark, Ireland, Spain, Switzerland, and the United Kingdom.
- Discussions on possible AMCs were underway in Cyprus and Slovenia; AMCs were considered but ruled out in Iceland.
- It is early to fully assess recent experience; comparing features with AMCs elsewhere and drawing preliminary conclusions is useful.

### Government support and State Aid rules
- Competition and State Aid policy has served de facto as the main coordinating mechanism in bank restructuring during the crisis.
- DG COMP interventions have been instrumental in imposing restructuring but have at times heightened macro-financial concerns (speed of decision making, insufficient transparency, impact of compensatory measures).
- DG COMP has the exclusive mandate to ensure State aid is compatible with the treaty and to accept State aid in exchange for strict conditionality.
- Member states provided aid through capital injections, guarantees and asset purchases. Compensatory measures required by DG COMP have included divestments, penalty interest rates, management removals, dividend suspensions and burden sharing (shareholder dilutions, and bail in of subordinated debt).
- According to DG COMP, 60 EU banks—accounting for 10–15 percent of the EU banking assets—underwent a deep restructuring. Under the State aid regime, 20 banks were resolved.
- Procedures have been accelerated and sector-wide implications have been taken into account; ESM support to bank recapitalization is conditional upon the Commission's approval of banks' restructuring plans.
- Example: It took less than six months to approve the restructuring plans of eight Spanish banks, consistent with timelines of the European program of assistance to Spain.

### Enhancing DG COMP practices
- DG COMP’s practices in systemic cases can be further enhanced to ensure consistency with a country’s macro-financial framework; transparency should be enhanced.
- Phasing and composition of bank restructuring is critical to mitigate adverse macroeconomic effects.
- A pricing policy based on ECB recommendations seeks to limit moral hazard by ensuring a sufficient degree of burden sharing, albeit below market remuneration in absence of State aid.
- Increased transparency in pricing and proposed deleveraging would give added credibility; re-examination (with IMF and ECB) of policy for determining remuneration of instruments used for capital support and the methodology for determining required degree of bank deleveraging would be appropriate.
- DG COMP’s role will change as a dedicated resolution framework for the BU is developed; a permanent coordination mechanism between DG COMP and financial stability authorities could help reconcile competition and resolution objectives.

### B. Disclosure — transparency gaps
- Publication of EBA stress test results enhanced transparency, with over 3,000 data points disclosed by EU banks, but remaining data gaps impede market discipline.
- Missing consistent public data across banks include the funding side (collateral encumbrance, ECB funding, LCR ratios), derivatives portfolio and other off-balance sheet activities, RWAs, PDs.
- NPL definitions are not harmonized across Europe, creating large differences in asset quality assessment across countries and banks.
  - In December 2012, ESMA stressed the need for transparency and consistent application of impairments (Treatment of Forbearance practices in IFRS Financial Statements of Financial institutions), recognizing judgment in classification and suggesting examples of trigger events.
  - Practices in terms of write-offs under IFRS are relatively flexible, making comparison across banks difficult.
- Disclosure of collateral is not mandatory under IFRS; when banks disclose collateral values, there is no consistency: practices differ in using Fair value, nominal value, nominal realizable value (capped to the 'gross' value of the loan) or stressed value. Periodicity of revaluation and governance of the process also vary across banks.

*Excerpt from IMF staff report chapter on EU bank resolution and restructuring framework.*

### 36.      The EBA must continue to promote better dissemination of supervisory micro-

### _cr1367 - 36.      The EBA must continue to promote better dissemination of supervisory micro-

### EBA: dissemination, transparency, and asset quality reviews
- The EBA must continue to promote better dissemination of supervisory micro-data across the EU and to enhance transparency in the disclosure of banks’ risk–related data.
- The 2011 stress test exercised showed the value brought by disclosure of detailed information.
- As quality assurance is key, the EBA should strive to:
  - (i) enhance the quality assurance process;
  - (ii) promote the disclosure of granular asset quality information; and
  - (iii) expand depth, and coverage of audits.
- The EBA should raise the awareness of supervisors on asset quality issues by:
  - issuing guidelines for supervisors on best practices for the conduction of asset quality reviews, addressing some specific sectors;
  - urgently pushing for enhancing comparability and completeness of Pillar 3 reports.
- The EBA should work with national authorities and coordinate the provision of technical expertise where needed (cf. TN on EBA).

### Supervisory convergence and consistency of RWAs
- The EBA should enhance its work on supervisory convergence.
- Current work on the consistency of RWAs should be a priority.
- Initial work identified:
  - divergences in the application of Internal Ratings Based (IRB) models;
  - differences of interpretation/implementation of the regulatory framework;
  - dispersion across banks in the gap between expected losses on defaulted and non-defaulted assets.
- This work is of great relevance for supervisory convergence and the level playing field in the single market.
- It should be kept in harmony with Basel Committee on Banking Supervision (BCBS) Level 3 exercises, and followed up with the issuance of guidelines (and perhaps Regulatory Technical Standards) to ensure consistency.

### Appendix I — Experience with Asset Quality Reviews: overview and country cases
- Independent Asset Quality Reviews have been conducted in most of the distressed EU countries.
- Countries under/near financial assistance (Cyprus, Greece, Ireland, Portugal, and Spain) have carried out independent Asset Quality Reviews to regain market confidence.
- Self assessments are usually difficult in a crisis environment because supervisors may be under political pressures to hide losses.

- Appendix Table 1: EU: Asset Quality Reviews Conducted in EU Countries: 2008–2012 (selected entries)
  - Ireland: Jan–Mar 2011
    - In December 2010, as part of the EU/IMF program, BlackRock Solutions was engaged to perform a loan diagnosis of over €275 billion across the five largest Irish banks.
    - The diagnosis had five building blocks:
      - an asset quality review to assess the quality of aggregate and individual loan portfolios and the monitoring processes employed;
      - a distressed credit operations review to assess the operational capability and effectiveness of distressed loan portfolio management in the banks including arrears management and workout practices in curing NPLs and reducing loan losses;
      - a data integrity validation exercise to assess the reliability of banks' data;
      - a loan loss forecast (LLF) under base and stress scenarios;
      - a public communication.
    - Under the Loan Loss Forecast, BlackRock estimated future losses with forecasted financial statements through end-2013 (three- year horizon) as well as baseline losses.
  - Greece: Aug–Dec 2011
    - As part of the 2nd Memorandum of Economic and Financial Policies, BlackRock was engaged to perform a loan diagnosis over all Greek banks.
    - Individual results were communicated to banks but no disclosure has been made to the public.
  - Portugal: Jul–Nov 2011
    - Under the EU/IMF program, the supervisor led detailed asset quality reviews of the eight largest national banking groups’ loan portfolios and regulatory capital (RWA) calculations.
    - Those eight largest banking groups account for more than 80 percent of the banking system’s total assets.
    - This “Special Inspection Program” (SIP) was carried out with support from external parties, Ernst & Young, PWC and Oliver Wyman.
    - The SIP had three different work streams (WS):
      - the valuation of the credit portfolio,
      - a credit risk capital requirements calculation, and
      - a stress test conducted (by Olivier and Wyman).
    - The results of the W1 and W2 were made public in December 2011. The results of the W3 were not disclosed.
    - The second part of the assessment with four domestic auditors was completed at the end of September.
  - Cyprus: Sept–Dec 2012
    - An asset quality review of the Cypriot banks will be conducted, including a stress test exercise.
    - The Central Bank of Cyprus appointed the investment companies Pimco and Deloitte to conduct the asset quality review of on 22 institutions, which is a mix of EU subsidiaries, co-operative credit institutions, and domestic banks.
    - The participating banks account for 73 percent of the Cyprus banking system.
    - The stress test will have a three-year horizon from mid-2012 to mid-2015.
  - Spain: May–Jun 2012
    - Olivier and Wyman and Roland Berger were assigned to assess the resilience of the main Spanish banking groups (14 which hold 88 percent of the market asset share).
    - Cumulative credit losses for the top-down stress test with a three- year horizon are €250-270 billion in the adverse scenario and €170-190 billion in the base scenario.
    - The estimated capital needs range from €51-62 billion and €16-25 billion in the adverse and base scenario, respectively, and the capital buffer requirement of €37 billion for a core Tier 1 threshold of 7 percent.

- Note: Slovenia has almost conducted an independent assessment.

### Appendix II — Experience with Asset Management Companies (AMCs) in crisis countries
- AMCs have been extensively used in past crises (Sweden, Indonesia, Malaysia, Korea, and Thailand) as a way of facilitating bank restructuring.
- While there is no single optimal solution, operational independence, appropriately structured incentives and commercial orientation are key design features.

- Costs and benefits of AMCs:
  - AMCs allow consolidation of scarce workout skills and resources in one agency, and the application of uniform workout procedures:
    - help securitization because of the larger pool of assets;
    - provide greater leverage over debtors (especially if AMCs are granted special powers of loan recovery);
    - prevent fire sales or destabilizing spillover effects, as banks deleverage;
    - allow the good banks to focus on their core business.
  - However:
    - asset purchases by an AMC do not raise banks’ net worth unless the operation is done at above-market prices, which should be avoided;
    - asset purchases do not solve a problem of lack of capital in the banking sector;
    - the overall cost may be higher than expected, depending on the legal and operational environment for loan recovery and the likelihood of being subject to political pressure.

- Key design features:
  - Governance: operational independence is necessary to assure the effective operation of an AMC.
  - Structured incentives: the AMC should not become a “warehouse” of NPLs and have incentives to ensure effective and efficient asset management and asset disposals.
  - Commercial orientation: assets should be purchased at a price as close to a fair market value as possible to minimize losses (possibly considering some form of profit-sharing arrangement).
  - Funding shall be adequate. the AMC must have sufficient funds to perform its intended functions, with the operating budget separate from funding for asset takeover.
  - A key advantage of using a company without a banking license (an AMC) instead of a “bad bank” is that AMCs do not need to meet regulatory capital and liquidity requirements, thereby reducing their overall costs.

- EU crisis country examples:
  - Ireland: the National Asset Management Agency (NAMA) was set up in December 2009 to help Irish banks divest of bad loans (Irish commercial property) and in turn receive government-backed securities as collateral against ECB funding. NAMA aimed to:
    - acquire bad loans from the five participating banks;
    - work pro-actively on a business plan for acquiring and disposing bad loans; and
    - protect and enhance to the maximum possible level, value of these assets.
  - Spain: legislation enacted in August 2012 established the Asset Management Company for assets arising from bank restructuring (Sareb) and empowers the Fund for the Orderly Restructuring of the Banking Sector (FROB) to instruct distressed banks to transfer problematic assets to it.
    - Mid–December 2012, Sareb increased its capital to allow its main private participants (banks) to become shareholders.

- Historical design note:
  - The Malaysian Danaharta, for example, purchased impaired loans at an average discount of 55 percent, while banks that sold assets retained the right to receive 80 percent of any recoveries in excess of acquisition costs that the AMC was able to realize.

_Italic: Source — content unit from the provided IMF PDF._

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1367.pdf_