Debt Hangover: Nonperforming Loans in Europe’s Emerging Economies

IMF Blog, March 29, 2012

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It has been three years since the global economic crisis ended emerging Europe’s credit boom, leaving many loans “sour.”
Nonperforming loans (many of them household mortgages) have risen sharply, creating problems for banks, credit supply, economic growth, and households.
The situation is compared to Japan’s lost decade, where a credit boom reversal led to a credit squeeze, declining asset and collateral values, and economic paralysis.

Share of loans classified as nonperforming rose from 3 percent before the crisis to 13 percent at the peak.
Levels in some parts of the Baltics and Balkans are already comparable with previous financial crises elsewhere.

Nonperforming loans are a serious drag on credit supply and economic growth.
Effects on banks:
- Drive up banks’ funding costs and interest margins.
- Drain banks’ profits and capital.
Effects on borrowers and demand:
- Over-extended households and businesses are reluctant to consume and invest.
Resolution considerations:
- Even if NPL resolution brings new losses to the fore, financial stability would not be undermined.
- Despite the credit boom, the private sector’s debt-to-GDP ratio is still low in most countries, so a resumption of credit growth would not be a problem.

Collective action problem:
- Individual banks neglect positive spillovers (for example on collateral values) from resolving loans.
- Banks are reluctant to book additional losses while facing regulatory and liquidity challenges elsewhere in Europe.
- “Extend and pretend” behavior: rolling over debt service in hope loans will become performing.
Structural and institutional constraints:
- Legal, judicial, tax, and regulatory systems are often poorly equipped to deal with insolvency and to facilitate efficient restructuring.
- Moving bad loans off banks’ balance sheets, foreclosing, or seizing and selling collateral is difficult in many emerging European countries.

Collective, country-level push by policymakers, bankers, financial regulators, and supervisors is the preferred approach.
Banks:
- Step up the work-out of nonperforming loans, often with help from more experienced Western parent institutions.
- Writing down unrecoverable loans should not be a taboo.
- Local banking associations can help overcome first-mover disadvantages.
Policymakers (country-specific priorities):
- Create regimes for insolvency and out-of-court restructuring, often from scratch.
- Design tax regimes that do not punish debt writedowns and loan-loss provisioning.
- Ensure bankruptcy courts have sufficient resources.
- Avoid heavy-handed interventions such as extended foreclosure moratoria or mandated debt writedowns, which can undermine payment culture and contractual environment and deter new lending.
Financial supervisors and regulators:
- Step up pressure to accelerate resolution of bad loans.
- Prohibit ever-greening, overvaluation of collateral, and underreporting.
- Ensure adequate capitalization and provisioning.
- Remove regulatory obstacles that constrain banks from owning real estate or establishing special vehicles to manage NPLs.
- Coordinate actions closely between banks’ home and host country regulators.
International institutions:
- The IMF, World Bank, the European Bank for Reconstruction and Development, and the European Union can provide international coordination (such as under the Vienna Initiative) and technical assistance.

Emerging Europe’s debt hangover will not be cured by a good night’s sleep.
If policymakers, bankers, supervisors, and international institutions work together, the recovery will be shorter and less painful.

Source: Debt Hangover: Nonperforming Loans in Europe’s Emerging Economies (Christoph Rosenberg, Christoph Klingen, March 29, 2012).