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NON-PERFORMING LOANS: SOU THERN EUROPE’S NEXT TIPPING POINT 19 July 2017 19 th July 2017

NON-PERFORMING LOANS:

SOUTHERN EUROPE’S NEXT TIPPING POINT

19 July 2017

19

th

July 2017

MINT

The level of Non-Performing Loans held in the Southern European Banking Sector threatens the region’s financial stability.

BILL BLAIN

Strategist, Head of Capital Markets bblain@mintpartners.com +44 (0) 20 7786 3877

BEN STHEEMAN

Associate ben.stheeman@mintpartners.com +44 (0) 20 7786 3877

CONTENTS

PREFACE

2

EUROPE’S TIER II PROBLEM BANKS

4

DEFINITIONS

5

SIFIs

5

NON-PERFORMING LOANS (NPLS)

6

GOOD BANK, BAD BANK

7

RESOLUTIONS: WHAT HAS BEEN DONE SO FAR

8

ITALY

9

UNICREDIT

14

GREECE

15

PORTUGAL

18

CYPRUS

20

SPAIN

21

IRELAND

22

GERMANY

24

THE ECB’S RESPONSE – IT’S A LEARNING THING

25

CONCLUSION

26

PREFACE

PREFACE Above is the Itraxx European Senior Financials CDS Index. It is a generic index showing

Above is the Itraxx European Senior Financials CDS Index. It is a generic index showing the spread of senior bank debt issues by European banks since the Global Financial Crisis - a measure of how risky they are perceived to be.

The European Financials Spread is now at its tightest spread since the crisis.

WHAT DOES THIS TELL US?

Despite uncertainty about new bank regulatory regimes and the ability of regulators to bail-in bond depositors in order to protect taxpayers, investors are sanguine on European financials.

Spreads have tightened in line with the general inflation of all financial assets caused by too much money chasing too few assets - a direct consequence of QE and a negative interest rate policy.

A perception that the European economy is recovering has helped. Stronger European growth will improve bank fundamentals, and rising rates will enable banks to improve margins.

The successful resolution of the failing Banco Popular in Spain and the more problematic solutions to Monte dei Paschi and the Venetian banks in Italy has created an impression that problems around European banks are finally being addressed.

However, while the 30 largest SIFIs (Systemically Important Financial Institutions) in Europe look, on the whole, secure, we are more concerned about two aspects of European banking.

1. Among the Second Tier Financial Institutions there are a large number of undercapitalised European banks still struggling with unsustainably

large volumes of Non-Performing Loans (NPLs). The next European financial crisis is as likely to be triggered from long-term issues in the mid-sized sector as an idiosyncratic event at one of the SIFIs. For this reason, it is worth looking at these mid-sized institutions in detail. Following an analysis of all Eurozone banks with balance sheets greater than €10bn, this report below examines 26 European banks with serious NPL imbalances.

2. There is a clear geographic divide across Europe: in the North banks have NPLs capital levels under control but towards the South this is not the case. Of the 26 banks this report focusses on, 23 are based in Southern Europe, and 3 in Northern Europe. This NPL Divide highlights future difficulties in creating an EU Banking Union with a single set of enforceable regulations due to national self-interest and the propensity of borrowers to honour their debts.

Our analysis suggests there exists a total capital shortfall of €120bn in the Eurozone. With a capital shortfall of this size, Europe’s Tier II banking sector remains in a precarious condition.

The banks which we highlight as particularly at risk of needing to be recapitalised are Banca Carige, Unipol Banca, Banca Popolare di Bari, Banco BPM, Iccrea Banca Impresa, Novo Banco, Bank of Cyprus, Alpha Bank, Piraeus Bank, Eurobank Ergasias, and National Bank of Greece.

Our primary concern for Italy is the lack of a strong banking champion. There is simply no large Italian bank secure enough to take on the responsibility of recapitalising these banks, meaning public funds must be used instead. This is putting pressure on Europe’s attempt to unify rules on resolutions, and protect taxpayers’ money.

Resolving Europe’s NPL problem will require a change in policy. There still remains stark differences between Eurozone-wide resolution rules and the individual actions of member states. In its current form, the ECBs banking regulation will not suitably deal with a European banking crisis.

EUROPE’S TIER II PROBLEM BANKS

Below is a table of the 26 banks this report focusses on. These banks are those facing capital shortfalls or, in UniCredit’s case, are very close to facing a capital shortfall.

In particular, the two key ratios to look at are the NPL ratios and the CET1 Capital ratios, and their difference, as this shows the capital shortfalls faced by these banks.

The table highlights that there remain plenty of Southern European banks with significant NPL ratios, which are not supported by their corresponding CET1 ratios.

 

Total

NPL

CET1

Assets

NPL

Coverage

Capital

Bank

Country

EURbn

Ratio

ratio

Ratio

Alpha Bank

Greece

64.87

53.80%

49.00%

17.30%

Piraeus Bank

Greece

81.50

51.90%

46.10%

16.80%

Bank of Cyprus

Cyprus

22.17

51.80%

42.00%

14.40%

Eurobank Ergasias

Greece

66.39

45.00%

50.80%

17.30%

National Bank of Greece

Greece

78.53

43.60%

56.00%

16.00%

Unipol Banca

Italy

12.35

42.30%

45.80%

13.90%

Novo Banco

Portugal

52.33

39.01%

50.00%

10.80%

Banca Carige

Italy

26.11

34.68%

46.40%

10.90%

Credito Valtellinese

Italy

25.47

30.64%

41.60%

11.60%

Banca Popolare di Bari

Italy

13.57

24.71%

44.90%

9.92%

Banco Bpm SpA

Italy

168.00

23.32%

48.20%

11.66%

Iccrea Banca Impresa S.p.A.

Italy

10.86

22.18%

42.90%

8.60%

BPER Banca

Italy

64.96

21.70%

45.60%

13.33%

Caixa Económica Montepio Geral

Portugal

21.45

20.00%

53.80%

10.20%

Liberbank

Spain

38.32

17.67%

40.00%

12.00%

Millennium BCP

Portugal

72.08

15.93%

100.00%

13.00%

Banca Popolare di Sondrio

Italy

37.20

15.49%

46.91%

10.81%

Caixa Geral de Depositos

Portugal

92.82

15.40%

55.20%

12.30%

Intesa Sanpaolo

Italy

725.10

14.38%

48.72%

12.50%

UBI Banca

Italy

112.38

13.90%

35.83%

11.44%

Banca Sella Group

Italy

13.30

13.80%

52.10%

11.96%

Ibercaja Banco

Spain

58.34

11.77%

45.00%

11.00%

UniCredit S.p.A.

Italy

859.53

11.40%

56.30%

11.71%

Permanent TSB

Ireland

23.60

30.98%

42.00%

15.10%

Allied Irish Banks (AIB)

Ireland

95.62

22.70%

44.00%

16.00%

HSH Nordbank AG

Germany

84.37

16.50%

49.20%

14.90%

 

Total:

Ave:

Ave:

Ave:

€2,921bn

27.10%

49.17%

12.90%

     

.

 

Source: Published Information using EBA definitions

As of 31/12/2016 or later

DEFINITIONS

CET1

Common Equity Tier 1 measures equity capital plus declared reserves. It is the core measure of the financial strength of a bank.

CET1 Ratio

The Common Equity Tier 1 Ratio measures a bank’s capital against its risk-weighted assets.

Non-performing

Defined by the European Banking Authority (EBA) as loans which are:

loans (NPL)

1) 90 days past-due or loans which the debtor is unlikely to repay, or 2) Impaired or defaulted according to the applicable accounting or regulatory frameworks.

NPL Ratio

The amount of gross non-performing loans over a bank’s total gross loans

NPL Coverage

A measure of a bank’s ability to absorb potential losses from its NPLs. It is calculated as provisions set aside for impaired assets divided by NPLs.

Ratio

Total Capital

A second capital measure calculated as the sum of a bank’s tier one and tier two capital expressed as a percentage of its risk-weighted assets.

Ratio

SIFIs

Financial Institutional Investors typically focus on the SIFIs (Systemically Important Financial Institutions). They are important because, according to the Financial Stability Board, their failure would produce widespread shocks to the financial system due to their “size, complexity and systemic connectedness”. Basel III addressed these institutions in particular.

However, as the recent noise around Italian banks highlights, while it is important to monitor SIFIs, there exist plenty other smaller banks whose failure would still have significant consequences on investor confidence in the wider financial system. Greater concern should be expressed on these banks due to the abundance of poor quality loans on their balance sheets, particularly when compared with their levels of capital.

The focus of this report, will therefore not be on the SIFIs, but on the smaller, mid-sized banks based in parts of the Eurozone which are struggling due to the poor quality of many of their loans. This report does discuss one of the SIFIs, UniCredit, as its balance sheet weakness directly affects the scope for private sector recapitalisations of mid-sized Italian banks.

NON-PERFORMING LOANS (NPLs)

The primary weakness of the Southern European banking sector is NPLs.

While the Eurozone’s NPL ratio peaked at 8% in 2013, it has since decreased to 6.17%.

Despite this, there remains a handful of countries in which significant improvements are yet to be made: NPL ratios remain at double-digit levels in six Eurozone countries, and over €900bn of such loans held by banks directly supervised by the ECB remain.

The Eurozone’s NPL coverage ratio amounts to about 46%.

The basis of good banking is sound lending. In contrast, a weak balance sheet propped up by poor quality loans is a sign of a poorly run bank in which far too little care was taken to ensure that only reliable loans were taken on. Due to the large number of NPLs in the Euro Banking Sector, there are a number of banks which are beginning to pay the price for their careless lending. The countries which these banks are concentrated in are Italy, Portugal, Spain, Greece, Cyprus, and, for different reasons, Ireland and Germany.

The comparison of German and Irish high NPL banks with Southern European high NPL banks highlights the differences in state responses to the balance sheets of these institutions.

Despite the EBA’s efforts, there remains a lack of harmonisation in the definition of an NPL. While some banks will report their level of NPLs using the EBA’s definition, many do not.

When using the NPL ratios provided in their annual reports, the average ratio of the 26 banks discussed in this report was just under 22%.

When using the EBA definition for NPLs, the average NPL ratio increases to 27.10%.

As a result, the total capital shortfall for European Banks increased from just over €75bn to over €120bn when using the common EBA definition.

Therefore, in this report, NPLs have been calculated using the EBA’s definition rather than those appearing in the earnings reports of banks. In addition, non- performing loans (NPLs) and non-performing exposures (NPEs) were used interchangeably, as recommended by the ECB Banking Supervision in March.

GOOD BANK, BAD BANK:

In April last year, Italy’s financial sector agreed to contribute €5bn to establish

a rescue fund Atlante helps recapitalise weaker banks struggling to raise capital, and purchase the securities of mezzanine and junior tranches of NPLs.

The creation of Atlante should not be discouraged. Having said that, questions exist over the timing of its creation and its funding.

The rationale behind the creation of this rescue fund is a sound one. There are various examples of successful European rescue funds: Ireland created the National Asset Management Agency in 2009, which functioned as a bad bank aiming to improve credit availability in Ireland, while Spain also created the Fund for Orderly Bank Restructuring in 2009. As a result of these funds, the banks of both these nations do not dominate this report.

However, a common theme with the creation of these successful bad banks is their timing. They were all created at the height of the Financial Crisis, and as a result, since then, Ireland and Spain have made far more progress in cleaning up their banking sectors. Italy, on the other hand, have waited eight years before acting.

Further questions arise regarding the funding of Atlante. Italy faces a capital shortfall of over €32.6bn, and there are a total of €324bn of NPLs in the nation’s financial sector. €5bn seems a drop in the ocean relative to these figures, particularly when Spain’s bad bank was funded to the tune of €99bn.

It seems as if, in its current state, Atlante will struggle to meaningfully change the banking sector it has been tasked with cleaning up.

RESOLUTIONS: WHAT HAS BEEN DONE SO FAR

In the last several weeks, four Southern European banks have failed, all as a

result of excessive volumes of NPLs on their balance sheets.

Monte dei Paschi di Siena

Following its performance in July last year as the worst performing European bank in stress tests, MPS attempted unsuccessfully to raise €5bn in equity to plug some of its capital shortfall.

As a result, the Italian state was forced to step in and announce a precautionary recapitalisation of up to €8.8bn. Through a five-year restructuring plan, MPS will dispose of €28.6bn of bad loans, priced at about 21% of their gross value, to the government sponsored and privately funded back-up fund Atlante. On 5 th July, the European Commission granted formal approval of this restructuring plan as junior creditors agreed to contribute €4.3bn to the rescue.

The two Venetian banks:

At

the end of June, the ECB confirmed that Veneto Banco and Banco Popolare

di

Vicenza were “failing or likely to fail”. The ECB decided the resolution of the

banks should be dealt with according to national insolvency laws, and so Italy agreed to inject €5bn of taxpayers’ money while handing their good assets to Intesa Sanpaolo. As part of the resolution, the state offered guarantees of up to €12bn to cover losses from the two banks’ bad loans.

Fabrizio Viola, the CEO of one of the Venetian banks, Popolare, was the former chief executive of MPS who left following the results of the EU stress tests. While MPS’ failure was not exclusively due to Viola’s management, Viola oversaw MPS burn through €8bn of fresh capital. His appointment at Popolare

is a clear indication of the revolving door of Italian banking.

The chronic mismanagement of Italy’s financial institutions highlight that many

of their weaknesses are structural.

Banco Popular:

At the beginning of June, a resolution to save Banco Popular took place demonstrating the private sectors potential to help deal with Europes NPL crisis.

Popular’s NPA ratio (its NPLs plus its problematic stock of real estate assets) was 32.2%. This is a very high figure but there still remain eight other Euro Area banks with assets over €10bn that have higher NPL ratios.

Popular had raised €2.5bn in equity in June 2016 in an effort to secure its balance sheet, and had also borrowed €7.2bn from the ECB. This is a clear example that efforts to improve a bank’s balance sheet far from guarantee that bank’s security. In contrast to the Italian government bailing out their failing

banks, the responsibility of Popular’s recapitalisation fell to the private sector

as Santander recapitalised the bank. As a result, Populars resolution was largely considered a success.

ITALY

Italy’s high levels of NPLs are, in part, related to its poor growth levels. The IMF predicts the economy will take a decade to return to pre-crisis levels, presuming there is not another. Italy’s economy has not performed much worse than Spain’s, yet its NPL ratio is over triple that of Spain’s. For this reason, there must be other reasons why Italy’s banks are in trouble such as differences in cultural attitudes towards debt repayments and financial reporting.

Italy punches far above its weight in terms of NPLs:

€324bn of Italian bank loans are non-performing.

This has decreased from a peak of €341bn at the end of 2015.

Despite Italian bank assets accounting for only 13% of the Eurozone total, Italian banks held one-third of all NPLs in the Euro Area.

In total over 17% of Italy’s loans are non-performing.

Our analysis suggests the total capital shortfall for Italian banks is

32.64bn.

It is therefore unsurprising that Italy’s banks are over-represented in the list of bad banks. “High NPL banks”, according to ECB guidelines are those with NPL ratios over 7%. This means that 16 of Italy’s 19 banks with balance sheets greater than €10bn are considered “High NPL banks”!

greater than €10bn are considered “High NPL banks”! Many Italian banks are beginning to offload their

Many Italian banks are beginning to offload their NPLs by selling them on to hedge funds. Caution should be exercised here since this will merely move the problem elsewhere. Furthermore, flooding the market with NPLs will only reduce the price banks receive for their NPLs because of increased supply. For this reason, it should be expected that Italian banks will end up receiving a price at a far greater discount than hoped for.

Unipol Banca: UNIIM Corp, UNI IM Equity

This is a relatively small bank in a very insecure state:

Its NPL ratio of 42.3% is the highest of any Italian bank, even when considering MPS and the two Venetian banks.

Its CET1 ratio of 13.9% is relatively low for a bank with its level of NPLs

The bank is beginning to recognise its precarious situation by creating an internal bad bank to house €3bn of its NPLs. This will cost €780mn in terms of extra provisions paid for by Unipol Group selling two insurance businesses to its main insurance subsidiary. If successful, its NPL ratio will be reduced to 10% which will represent a large step towards confirming the safety of the bank.

It should be noted though that Popular failed even while it was attempting to

offload its NPLs. Unipol aims to implement the entire project by the end of Q1 2018. Until this is completed, the bank remains in trouble, and is one to be watched.

Banca Carige: BANCAR Corp, CRG IM Equity

Following the recapitalisations delivered to the Veneto Banks, Carige is one of the most troubled European Banks out there.

Its NPL ratio is 34.7%

It has a coverage ratio of 46.4%.

Carige’s total capital shortfall of almost €4bn is very large for a bank of its size.

These are very similar figures to Veneto and Popolare di Vicenza before both had to be recapitalised.

The bank is showing some signs of recovery following a €500mn rights issue and a €1.2bn disposal of NPLs but it has some way to go still. Carige has pledged to reduce its portfolio of bad loans by a further €1.8bn.

It requires a greater level of stability if it is to survive - there was a no-confidence motion approved last month in the Bank’s CEO who had only been in charge for just over a year.

Its CET1 ratio lags behind the ECB’s recommendation of 11.25%. It is expected its CET1 level will fall to 10.3% at the end of this year. While it will remain above the ECB’s regulatory requirement of 9%.if such a trend continues, Cariges shortfall will only increase.

Carige is in the unfortunate position of having an extremely high level of NPLs while lacking the capital needed to offset the winding down of these NPLs - not

a good mix.

Credito Valtellinese (Creval): CRVALD Corp, CVAL IM Equity

Creval’s NPL ratio of 30.6% is high and has only been marginally reduced in recent years.

Its coverage ratio of 41.6% is low.

Its CET1 ratio of 11.6% is low.

Reducing Creval’s stock of NPLs will require increased provisioning which will hamper its profitability.

On 14 th July, it announced that it had completed the securitisation of a €1.4bn portfolio of NPLs. Through securitisation, loans are packaged together and transformed into bonds of varying levels of risk.

This is a significant move but more will need to be done to confirm the safety of this bank. It is worth noting that many retail investors have money tied up in Creval, increasing the chances of a State recapitalisation if it fails.

Banca Popolare di Bari: BPBARI CORP, BPB HM Equity

Bari’s CET1 ratio is less than 10%.

This is low for a bank with an NPL ratio of almost 25%.

Its coverage ratio is less than 45%.

To provide the bank with the capability of winding down its NPL stock, it will need to boost its capital reserves in the coming months.

It is being investigated by Italy’s finance police for alleged obstruction of regulators, something both Venetian banks were being investigated for before their failure. Having said this, being investigated by the authorities is not a rarity for an Italian bank.

Banco BPM: BBPMSPA Corp, BAMI IM Equity

This is a relatively new bank created on 1 st January this year by the merger of Banco Popolare and Banco Popolare de Milano.

It faces a capital shortfall of over €9bn, the largest in Italy.

Its NPL ratio of 23.3% is large given it is the third largest bank in Italy, while its core equity ratio of 11.7% is low.

It is attempting to reduce its NPLs by selling €693mn of bad loans in June at a valuation well above what it hoped to receive. However, for a bank that has over €29bn of NPLs on its balance sheet, BPM has a lot more work to do. Juggling the complications of integrating two large banks while trying to reduce its large stock of NPLs represents a big challenge in the coming months for this bank, and one it might not be able to overcome.

Iccrea Banca Impresa: BNAGRI Corp, 1273Z IM Equity

This is another typical weak Italian bank.

It holds the lowest Euro Area core equity ratio of 8.6% following MPS’ failure.

Its coverage ratio of 42.9% is low considering it has very little capital to fall back on.

For a bank with a balance sheet of just over €10bn, its capital shortfall of over €1bn is significant.

Iccrea has made very little progress so far in attempting to improve the quality of its assets and more needs to be done.

BPER Banca: BPEIM Corp, BPE IM Equity

BPER has an NPL ratio of 21.7%

This is large considering its CET1 ratio is 13.3%.

In Q1, its CET1 and total capital ratios decreased by 47bps and 55bps respectively, at a time when its peers’ capital ratios have been improving.

At the end of June, BPER completed the acquisition of Nuova Carife, one of the banks bailed out in 2015 by the Bank of Italy, for €1 in a deal that would marginally improve its NPL ratio as it receives Carife’s good assets.

Despite this, we are worried about BPER’s lethargic response to its high NPL ratio. Little has been announced regarding a significant move to reduce its non- performing loans and while this bank has had little negative media regarding its NPLs, they remain at a troubling level.

Banca Popolare di Sondrio: BPSOIM Corp, BPSO IM Equity

Sondrio’s NPL ratio of 15.5% is high.

Gross impaired loans increased by 8% during 2016 and a further 2% during Q1 2017.

While this does represent a slower growth than previous years, the fact that its NPLs are increasing at a time when its peers’ are decreasing is a cause for concern.

Credit Rating Agency Fitch is sceptical of Sondrio’s 2017-2021 strategic plan to manage its impaired loans arguing it will “fail to reduce the stock of impaired loans in a meaningful manner.” Sondrios present failure to reduce its NPL volumes supports this opinion.

Furthermore, Sondrio’s profits have been volatile in recent years falling 22% in 2016. This volatility is set to continue unless Sondrio makes genuinely meaningful steps towards reducing its NPLs.

Intesa Sanpaolo: ISPIM Corp, ISP IM Equity

Intesa, the second-largest Italian bank, is a typical example of Italy’s large banks being no more secure than their smaller counterparts.

It faces a capital shortfall of almost €5.3bn due to its €57bn stock of NPLs.

Its NPL ratio is 14.4%.

The intervention by the Italian government following the failure of the two Venetian banks involved state support for Intesa to pay €1 for their good assets, worth €5.2bn, without harming its capital ratios in the process, on top of a guarantee of up to €12bn for potential losses incurred from their NPLs.

In May, Intesa announced a change of strategy which would involve a reduction of its non-performing loans by a third by 2020 as well as closing hundreds of branches to reduce its costs by hundreds of millions of euros. Such a move is necessary to guarantee the security of Intesa, but is long overdue and not a particularly radical shift when compared with some of its peers.

Intesa may not be in imminent danger of failing but it is certainly not in great shape. The lack of Italy’s big banks’ financial security is the primary reason why Italy’s banking failures are not being dealt in the private sector. There are no large reliable banks which can cover for the weakness of the smaller banks in the same way as Santander was able to with Banco Popular.

UBI Banca, UBIIM Corp, UBI IM Equity

UBI’s NPL ratio is 13.9%.

UBI has been making progress towards reducing its poor quality loans, but still faces a capital shortfall of almost €1.5bn.

UBI’s weakest aspect is its coverage ratio of less than 36%, which exposes it to financial shocks.

At the beginning of the year, UBI bought, for €1, the good assets of three lenders rescued by the state in 2015. UBI recently completed a €400mn rights issue to ensure its CET1 ratio remains above 11% in the wake of this purchase.

Banca Sella Group: BNSELL Corp, BSEL HM Equity

Its NPL ratio is relatively high at 13.8%.

It faces a capital shortfall of around €138mn.

Sella is not in as deep financial stress as some of its peers, evident from its more modest capital shortfall. For this reason, it should not encounter significant troubles, relative to its Italian counterparts, even though its NPL ratio would still be considered high by most countries’ standards.

UNICREDIT, UCGIM Corp, UCG IM Equity

Italy’s biggest bank is far from the safest.

UniCredit holds over €55bn of NPLs.

Its NPL ratio of 11.4% is marginally smaller than its CET1 ratio of 11.7%.

Its capital ratios were extremely poor at the end of 2016 falling to 7.54%, below the ECB’s regulatory requirements. This was as a result of a one-off charge of €12.2bn in Q4 2016 incurred by UniCredit as it increased its NPL coverage. The lender warned that its capital position was not stable. Last summer, UniCredit was the sixth-weakest institution of the Eurozone’s biggest lenders in ECB stress tests.

In order to combat this, investors approved a €13bn rights issue at a 38% discount at the beginning of the year. As a result of this, it does not currently face a capital shortfall. Nevertheless, due to UniCredit’s size, any small increase in NPLs or decrease in capital would lead to a significant shortfall.

UniCredit announced at the end of last year that it had agreed on the sale of €17.7bn of NPLs, in a move dubbed as Project Fino. On 17 th July, UniCredit signed this deal off, and expects a resulting 10bps increase in its CET1 capital ratio. The loans were sold at an average price of about 20 cents each. This is a promising start to reducing its NPL volumes, but much still remains to be dealt with.

Similar to Intesa, UniCredit is not in imminent danger of failure, but it is not in a strong state. In instances of other Italian bank failures, UniCredit is not in a great position to aid these banks in the same way as Santander did with Banco Popular in June. This means that failures will more than likely be dealt with by the public sector in the same way as the other Italian banking failures in recent weeks have been. This would harm a nation whose government debt stands at 133% of GDP, the highest in the Eurozone after Greece.

GREECE

Greece’s banks have long been endangered, being the primary focus of the third Greek bailout package of over €80bn. This package included a €25bn recapitalisation for the Greek banks and €7.7bn of cash buffers for liquidity in the system to protect them from the flood of withdrawals they were facing at the time. The bailout programme expires at the end of August next year.

During the Greek debt crisis of 2015, Greece’s Central Bank provided up to €89bn in Emergency Liquidity Assistance (ELA), an expensive form of bank lending, to the nation’s banks with the permission of the ECB.

The current cap on ELA to Greek banks has since fallen to around €41bn per month.

Deposits in these banks have decreased by over 50% from a peak reached in 2009 to less than €120bn in January, which has weighed down Greek banks’ balance sheets.

which has weighed down Greek banks’ balance sheets. Despite the assistance provided to Greek banks, they

Despite the assistance provided to Greek banks, they are by no means secure.

Greece’s NPL ratio has increased from less than 5% in 2008 to 46% in 2016, a figure which continues to increase.

Of loans to SMEs and freelance workers, 60% and 70% respectively are non-performing.

Greece’s largest four banks cumulatively hold a capital shortfall of over

€59bn.

Greece also suffers from an industry-wide problem of poor management. Greece’s rescue vehicle, the Hellenic Financial Stability Fund (HFSF) found in 2016 that about 20 of the 55 board members of Greece’s four major banks failed their “fit and proper” test.

Greek Banks are aiming to reduce system-wide NPEs to 34% in 2019 driven primarily by the curing of loans and write-offs. Considering that Greece, since the GFC, is yet to have a year in which it decreased its NPLs, this is a very high target. Some small co-op banks have NPL ratios of over 80%, a figure which must suggest a different cultural attitude towards the repayment of debt. If such an attitude exists, Greece will struggle to meaningfully reduce its NPLs in the short- term.

Alpha Bank, ALPHA Corp, ALPHA GA Equity

Over half of Alpha Bank’s exposures are non-performing, providing Alpha with a capital shortfall of €18.36bn.

The bank’s ELA in March 2017 stood at €12.2bn, down from €19.6bn in December 2015, comprising 19% of its total assets.

Alpha’s ELA covers its capital shortfall to some extent, but it does not cover it entirely, particularly as its ELA will likely decrease in the coming months and years.

There has been a lack of comprehensive action towards reducing its NPLs as it missed its target for Q1 2017. Alpha Bank’s relatively high level of core equity capital does mean that it can afford to hasten its reduction of its non-performing exposures for a short time at least.

Piraeus Bank, TPEIR Corp, TPEIR GA Equity

Piraeus, now the largest Greek bank by assets, has an NPL ratio of almost 52%.

It holds the largest capital shortfall in the Euro Area of €18.65bn.

After three rounds of recapitalisations undertaken in recent years, Piraeus has been forced to issue billions of new shares in an attempt to boost its equity capital. In the wake of Greece’s sovereign debt crisis, Piraeus has seen over 99% of its market capitalisation wiped out.

It remains 26.2% owned by Greece’s bank rescue fund HFSF and is planning to sell its Bulgarian, Romanian, Serbian, Albanian and Ukrainian subsidiaries as a part of its ‘Agenda 2020’ plan to reduce its foreign exposures and bad loan portfolio. It aims to increase new funding to €5bn annually by 2020, up from €2bn in 2016 and divest stakes in the shipping company Hellenic Seaways and the fish farms Nireus Aquaculture and Selonda.

Piraeus will then create a separate division known as “Piraeus Legacy Unit” to clean up its balance sheet and leave €28bn in risk-weighted assets (a reduction of almost 50%) and a 2% NPL ratio. These targets are ambitious but, if successful, would secure Piraues’ safety.

Eurobank Ergasisas, EUROB Corp, EUROB GA Equity

Eurobank has an NPL ratio of 45% with a coverage ratio of 50.8%.

It faces a capital shortfall of €10.7bn.

Eurobank is in the process of selling €2.8bn of NPLs in an attempt to reduce its bad loans by 40% by the end of 2019 but they are struggling with offers which are reportedly only around 5% of the original value of these loans.

While its CET1 ratio of 17.3% will help them absorb some of these losses, they will struggle to reduce their NPLs to the extent they plan to. This is because 75% of its CET1 capital is made up of eligible deferred tax assets, leaving it with a poor level of loss-absorbing tangible capital available.

National Bank of Greece, ETEGA Corp, ETEGA Equity

NBG has an NPL ratio of 43.6%, the lowest of the four major Greek banks.

It has a coverage ratio of 56%, the highest of the four major Greek banks.

It faces a capital shortfall of €11.4bn.

NBG is trying to restructure, having sold 75% of its insurance subsidiary which represents a part of its non-core assets, which tend to be the worst quality assets in a bank. This is a welcome move but far more progress remains to be done.

It also announced the sale of many of its Balkan operations as it focusses on banking at home, while using the proceeds to boost capital ratios and liquidity.

NBG remains 40% owned by HFSF but it hopes to eliminate ELA funding in 2018. This is the most secure bank in Greece but everything is relative.

PORTUGAL

Portugal’s NPL ratio currently stands at 19.5%.

Due to its high levels of NPLs, Portugals banks with assets over €10bn face a capital shortfall of €12.6bn, 6% of its GDP.

Portugal exited its three-year bailout programme in 2014 but is yet to meaningfully address its stock of NPLs, which is widely considered to be its primary obstacle to growth in the medium-term. The weakness in asset quality is particularly concentrated in the corporate sector and drags on the banks’ profit margins, as they averaged a decrease in profits by 7% in 2016.

Portugal’s NPL ratio has not seen any meaningful decrease as it only decreased by 30bps in 2016. If this is to change, Portugal’s banks will first need to increase capital levels to offset the loss incurred through write-offs, and the restructuring and discounted sales of its poor quality loans. Portugal’s CET1 ratio of 12.3% is the second-lowest in the EU, Portugal currently lacks leeway with which it can effectively reduce its stock of NPLs.

As Portugal’s debt to GDP ratio is at 130%, the government’s ability to recapitalise and bail-out banks, as it did with Caixa Geral de Depositos at the end of last year, is limited. There is also little finance available for the state provision of a “bad bank” to take on the NPLs held by the nation’s banks.

Novo Banco, NOVBNC Corp, 1045860D PL Equity

Novo Banco has been widely discussed in the press as the poster-child of Europe’s bad banks.

Its NPL ratio of 39% is very large.

Its CET1 ratio is very small at 10.8%, meaning that Novo Banco faces a capital shortfall of over €10.2bn, which represents over 20% of its total assets.

This ratio has been decreasing, falling 150bps in the space of a year, while its NPL ratio increased by 250bps in the same period.

It is unsurprising that Novo is fraught with difficulties considering it was initially intended as a transition bank following the bailout of Banco Espirito Santo in 2014. If all goes to plan, this period of transition will be completed by November, when it will be sold to US Private Equity firm Lone Star.

Having said this, the completion of this deal is not entirely guaranteed. It is deeply unpopular in the public eye as the Portuguese government, rather than Lone Star, will remain exposed to Novo’s NPLs. Furthermore, a group of bondholders led by BlackRock have sought an injunction to block the sale fearing it would damage their claim to be compensated for €1.5bn in losses suffered on Novo’s bonds. Despite this, the completion of a sale of some sort is most likely a question of when rather than if. Once this is completed, losses on its NPLs will no longer be incurred by Novo and its new parent company, so the bank should survive.

Caixa Económica Montepio Geral (Montepio), MONTPI Corp, MPIO PL Equity

Montepio’s CET1 ratio of 10.2% is poor for a bank with an NPL ratio of

20%.

This CET1 ratio has been increasing but from a very low base at the end of 2015 it was only 8.8%.

Its non-core capital ratio was only 0.3%, meaning it cannot not rely on other capital reserves.

The bank’s profitability is extremely volatile, in part due to its high NPL ratio, as the company recorded a loss of €86.5mn in 2016, and a €243.4mn loss the year before. It has not been profitable since 2013. Having said this, the CEO does expect Montepio to post a profit this year, and stated that the bank did not need to raise additional capital.

Montepio does seem to have improved from its position of technical bankruptcy whereby Montepio held €107mn of negative equity. Nevertheless, it has not made virtually no progress in reducing its NPL stock. For this reason, it certainly remains a bank to watch.

Millennium BCP, BCPPL Corp, BCP PL Equity

The largest private bank in the country, BCP had to be rescued in 2012 by a state bailout of €3bn as a period of severe financial stress caused its CET1 ratio to fall below regulatory requirements.

The bank now has a CET1 ratio of 13% and a NPL ratio of almost 16%.

However, its coverage ratio of 100% is reassuring.

It is also increasing its capital, most notably through a €1.33bn rights issue at the beginning of the year, which included the Chinese Conglomerate Fosun increasing its stake in BCP to 24%. Following the issue, BCP repaid €700mn of the €3bn bailout package.

BCP does now look well capitalised, but it must continue to reduce its NPLs. BCP plans to reduce its total NPLs by €1bn annually over the coming years, which should be manageable considering the progress it has made thus far. For this reason, despite its capital shortfall of over €1.1bn, BCP should recover.

Caixa Geral de Depositos (CGD), CXGD Corp, CXGD PL Equity

CGD has a relatively high NPL ratio of 15.4%.

Its capital position has been improved as the government injected €2.5bn of capital into CGD earlier this year in state aid.

It is beginning to correct its weak balance sheet through the sale of €476mn of NPLs to Bain Capital.

CGD has, over the past few years, been in a position of financial stress and is one to keep an eye on. Although, with the latest capital injection, and sales of its NPLs beginning to take place, one would expect that CGD should be relatively well protected.

CYPRUS

Cyprus’ NPL ratio of almost 45% is the second highest in the Eurozone.

Its coverage ratio is only 40%.

The Cypriot Central Bank stated that at current growth rates, it will take up to 10 years for the nation’s NPLs to drop to manageable levels.

Cyprus experienced a financial crisis in 2012-13 largely due to Cypriot banks’ exposure to local overleveraged property companies and the financial turbulence Greece was experiencing at the time. As a result of this crisis, Cyprus received a €10bn bailout from the ECB.

Bank of Cyprus, BOCYCY Corp, BOCH LN Equity

In 2013 BoC was forced, under the terms of Cyprus’ bailout, to seize cash from its savers, the first example of a bail-in in action. The bank relied on €11.4bn of ELA, equal to 60% of Cyprus’ GDP at the time.

At the beginning of this year, BoC finished repaying this, allowing it to resume its dividend for the first time since the crisis. At the same time, it returned to the debt markets with a €250mn issuance of Tier 2 securities. €500mn of senior debt is expected to follow. Its debt is expected to improve to investment grade in the not too distant future.

It is clear that there has been some large improvements in BoC’s fortunes but much more needs to be done in regard to its NPLs.

Its stock of NPLs is €10.37bn (over 52% of the nation’s GDP), providing an NPL ratio of 51.8%.

This has been reduced from 62.9% in 2014, and the last eight quarters have seen continuous reductions in its stock of NPLs.

Its CET1 ratio is 14.4%, and so it faces a capital shortfall of almost €7bn, over 35% of Cyprus’ GDP in 2016 - a phenomenal figure for a single bank. The reasons behind its high NPL ratio are, at least in part, structural and this ratio is unlikely to ever return to a figure deemed reasonable by most countries.

It has been making progress in reducing this but it is clear that in the medium term at least, BoC remains extremely vulnerable to any shocks.

SPAIN

Spain’s NPL ratio on the whole is not too troubling.

At 5.7% it is marginally greater than the EU average.

It has been decreasing at some pace in recent years from 9.4% in 2013.

It faces a relatively modest capital shortfall of €1.23bn for an economy of its size.

capital shortfall of €1.23bn for an economy of its size. Liberbank, LBKSM Corp, LBK SM Equity

Liberbank, LBKSM Corp, LBK SM Equity

Following the resolution of Popular, Liberbank is now the most troublesome Spanish bank. It is a relatively small retail bank created in 2011 from the merger of three regional savings banks.

Its NPL ratio of around 17.7% is high

It has a low coverage ratio of 40%.

Liberbank’s faces a capital shortfall of over 1bn

Investors became worried about this bank in the wake of Popular’s failure, as Liberbank’s share price decreased by over 40% in a week. This caused Spain’s stock market regulator to impose a ban on shorting Liberbank’s shares until 12 th July. However, most agree that Liberbank is not in the same position as Popular, and investor reactions were exaggerated, even though its high NPLs and low provisions expose it to economic and financial shocks.

Ibercaja Banco, CAZAR Corp, 1091Z SM Equity

Ibercaja is the other mid-sized Spanish bank with relatively high NPLs.

Its NPL ratio stands at 11.77% and its coverage ratio at 45%.

Due to the bank’s low CET1 ratio of 11%, it faces a capital shortfall of

€178mn.

Ibercaja has been trying to reduce its stock of NPLs, selling €489mn of real estate loans to Bain Capital on 11 th July. This is reassuring and if more of this is done, Ibercaja should not encounter too many problems. However, its scope for selling further NPLs will be tested due to its relatively low CET1 ratio.

IRELAND

Ireland suffered a large financial crisis between 2008 and 2011, during which it had to nationalise its third largest bank, Anglo Irish Bank, before winding down its operations. The net cost of bailing out Anglo Irish amounted to a predicted value of around €40bn. During the crisis, Ireland received a bailout package from the EU and IMF.

While Ireland has been the fastest growing country in the EU for three consecutive years, its banks remain weak as a result of the GFC.

Ireland’s NPL ratio was around 14% at the end of 2016, significantly reduced from the peak level of 27.1% at the end of 2013.

Its NPL coverage ratio is only 35%. This figure leaves the nation’s banking extremely vulnerable to any shocks which might occur.

In total, there is a total capital shortfall of over €5.3bn for Ireland’s banks which have total assets greater than €10bn.

While Ireland’s NPLs remain at a high level, their near 50% reduction illustrates the differences between Northern and Southern Europe’s commitment to reducing their NPLs.

Permanent TSB (PTSB), IPMID Corp, ILOA ID Equity

PTSB, formerly Irish Life & Permanent, was recapitalised in 2011.

It has a high NPL ratio of almost 31%

Its coverage ratio of 42% is relatively low.

Its CET1 ratio is 15.1% is reasonably strong and should provide PTSB with enough leeway to absorb some losses incurred from reducing its NPL load.

It faces a capital shortfall of around €1.68bn, a high figure for a bank of its size

PTSB, 75% owned by the taxpayer, has engaged in a number of NPL disposals over the last couple of years, reducing its stock of NPLs by 11% in 2016, and 40% since 2013. Providing such progress continues, PTSB should recover.

Allied Irish Banks (AIB), AIB Corp, ALBK ID Equity

AIB has a high NPL ratio of 22.7%

Its coverage ratio of 44% is relatively low.

The bank does have a strong CET1 ratio of 16% which will allow it to absorb losses from disposing its NPLs.

Due to the large amount of RWAs that it holds, the bank still faces a capital shortfall of over €3.6bn.

AIB predicts its CET1 ratio will fall to 13% as it reduces its stock of NPLs.

In June, AIB returned to the stock market; its IPO was well-received, with shares over four times oversubscribed. AIB was nationalised during the Irish banking crisis, and this offering represented the government selling a quarter of the

bank. The government has appeared willing to potentially sell more of its ownership.

Last month, AIB sold €400mn NPLs to Goldman’s at a 50% discount showing an intention to reduce their exposures to poor quality loans. The fact that it is predicting reductions in its CET1 ratio show that it has plans to continue this in the future. Similarly to PTSB, AIB is trying to reduce its NPLs. The same cannot be said of many Southern European banks.

GERMANY

Germany’s NPL ratio is low at 2.5%.

While its coverage ratio is also low at 37%, its banks tend to be well capitalised, with an average CET1 ratio of around 15%.

Therefore, the majority of German banks should be able to convert sufficient capital into provisions if need be.

Due to these impressive figures, there is a perception of German banks being among the securest on the continent. This is largely true, but there are a couple banks whose assets are of a far poorer quality, and should not be overlooked.

The most notorious example was Bremer Landesbank.

Bremer’s CET1 ratio of 5.29% was extremely weak and fell well below the ECB’s regulatory requirement.

Its NPL ratio of over 17% was extremely high and its coverage ratio of 36.2% far too low.

This was primarily due to the bank’s exposure to shipping loans which have performed very poorly in recent years.

Due to its high level of NPLs and weak capital position, NORD/LB took full control of Bremer.

HSH Nordbank

Another German banking facing NPL issues is HSH Nordbank.

HSH currently has €7bn in shipping loans so is unsurprisingly weak.

Its NPL ratio of 16.5% is high.

Its CET1 ratio of 14.9% is relatively strong which means its task of reducing its capital shortfall of €432mn is not too daunting.

Despite its weakness, HSH’s risks are concentrated in the short-term. This is because the bank, 85% owned by the states of Hamburg and Schleswig-Holstein, must be privatised under European state-aid rules by the end of February 2018. It is currently receiving binding offers for Nordbanks sale, and described indicative offers as a good basis for its subsequent sale.

Once HSH Nordbank has been sold, no German bank with assets greater than €10bn will have an NPL ratio of more than 5.3%. Germany would have dealt with financial weaknesses across its entire banking sector. In contrast, Southern European nations tend to be either addressing the weaknesses of only a handful of banks, or in many cases, no banks at all.

THE ECB’S RESPONSE - IT’S A LEARNING THING

There were stark differences in the ways the Single Resolution Board (SRB) dealt with the failure of Popular and the failure of the Italian banks, highlighting the work that still needs to be done if a single European banking rulebook is to be achieved.

Following Banco Popular’s troubles, the SRB, the Eurozone agency responsible for dealing with bank crises, enacted a resolution scheme forcing Popular’s sale of €1 to Santander. Because the private sector took full responsibility for the resolution of Popular and business was able to continue, it was seen as a success for the SRB.

In contrast, the SRB decided that putting the Venetian banks into resolution was not in the “public interest of the bloc” due to their relatively small size. This paved the way for Italy’s government to recapitalise the banks using taxpayer’s money. The SRB justified this decision by claiming that these banks did not hold systemic risks to the rest of the Eurozone but held regional risks and so should be dealt with on a national level.

However, by allowing these bailouts to take place, the SRB disregarded its own rule book. The ECB’s bank resolution framework, made up of three separate pieces of legislation, was created with the purpose of preventing taxpayer bailouts yet the Italian government is contributing up to €17bn for the re- capitalisation of two banks. As this report shows, more may yet follow.

The data on the larger Italian banks suggest that this intervention was permitted because there are simply no large Italian banks in a secure enough position themselves to actually take on the responsibility of recapitalising these banks, a concerning outlook for a nation whose bad loan problem is far from solved.

Further scrutiny of the SRB’s response to Popular’s failure is not reassuring. The Board’s head described the resolution as “lucky” due to there being a willing buyer. This raises the question of whether the SRB is effective only if luck aligns itself in an advantageous way.

Additionally, on 18 th July, Brusselslawmakers negotiated a new draft regulation banning the securitisation of mortgages where borrowers certify their own income. This move will restrict the European securitisation industrys ability to create a market for the NPLs held by banks. This is because buyers of these loans rely on securitisation markets to fund their acquisitions.

Other EU leaders, including Schäuble, have criticised Italy’s response highlighting the differences which remain between EU-wide resolution rules and national insolvency laws. The viability of a banking union abiding by a set of common rules comes under questions when such great financial divisions separate Northern and Southern Europe.

Nicolas Véron from the Brussels think-tank, Bruegel, put it eloquently: “The single resolution mechanism is not really single as long as you have different insolvency regimes for banks.”

CONCLUSION

In the same way as the European Financials Spread has been tightening in recent weeks, Italian bank stocks have been rising following the rescue of Monte dei Paschi and the two Venetian banks.

the rescue of Monte dei Paschi and the two Venetian banks. There is a growing sense

There is a growing sense that the worst is behind us, as Italy’s Finance Minister declared we have reached a “Turning point in the progressive elimination of non-performing loans”.

Despite these bold claims, Italy, and the rest of Southern Europe, have some way to go before such a turning point is achieved. With a total capital shortfall of €120bn, the lack of a strong banking champion in Italy, and disparities in national resolution regulations, Southern Europe’s banking industry remains in a precarious state.

The transfer of NPLs from banks’ balance sheets to Hedge Funds and state-run “bad banks” should be welcomed, albeit cautiously. Action needs to be taken to reduce the load of NPLs weighing down banks, but it would be wrong to believe this would signal the end of Southern Europe’s NPL problem. These NPLs will not be eliminated, only relocated. Such a strategy risks failing to account for these loans remaining in the financial sector.

For this reason, Southern Europe’s second-tier banks and their level of non- performing loans are worth keeping on your threat-board.

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