Authored by Don Quijones via WolfStreet.com, 

If the ECB scales back stimulus, banks face even greater risk of collapse. But now there’s a new solution

Events are moving so fast in Europe these days, it’s almost impossible to keep up. While much of the attention is being hogged by political developments, including the election in the Netherlands, Reuters published a report warning that the European banking sector may face even higher bad loan risks if the ECB begins to scale back its monetary stimulus programs, something it has already begun, albeit extremely tentatively.

The total stock of non-performing loans (NPL) in the EU is estimated at over €1 trillion, or 5.4% of total loans, a ratio three times higher than in other major regions of the world.

On a country-by-country basis, things look even scarier. Currently 10 (out of 28) EU countries have an NPL ratio above 10% (orders of magnitude higher than what is generally considered safe). And among Eurozone countries, where the ECB’s monetary policies have direct impact, there are these NPL stalwarts:

• Ireland: 15.8%
• Italy: 16.6%
• Portugal: 19.2%
• Slovenia: 19.7%
• Greece: 46.6%
• Cyprus: 49%

That bears repeating: in Greece and Cyprus, two of the Eurozone’s most bailed out economies, virtually half of all the bank loans are toxic.

Then there’s Italy, whose €350 billion of NPLs account for roughly a third of Europe’s entire bad debt stock. Italy’s government and financial sector have spent the last year and a half failing spectacularly to come up with a solution to the problem. The two “bad bank” funds they created to help clean up the banks’ toxic balance sheets, Atlante I and Atlante II, are the financial equivalent of bringing a butter knife to a machete fight. So underfunded are they, they even strugggled to hold aloft smaller, regional Italian banks like Veneto Banca and Popolare di Vicenza, which are now pleading for a bailout from Rome, which in turn is pleading for clemency from Brussels.

What little funds Atlante I and Atlante II have left are hemorrhaging value as the “assets” they’ve been used to buy up, invariably at prices that were way too high (often at over 40 cents on the euro), continue to deteriorate. The recent decision of Italy’s two biggest banks, Unicredit and Intesa Sao Paolo, to significantly write down their investment in Atlante is almost certain to discourage the private sector from pumping fresh funds into bailing out weaker banks.

Which means someone else must step in, and soon. And that someone is almost certain to be the European taxpayer.

In February ECB Vice President Vitor Constancio called for the creation of a whole new class of government-backed “bad banks” to help buy some of the €1 trillion of bad loans putrefying on bank balance sheets. Constancio’s idea bore a striking resemblance to a formal proposal put forward by the European Banking Authority (EBA) for the creation of a massive EU-wide bad bank that, in the words of EBA president Andrea Enria, would “make it much easier to achieve critical mass and to create a well functioning market for (impaired) assets.”

Here’s how it would work, according to Enria (emphasis added):

The banks would sell their non-performing loans to the asset management company at a price reflecting the real economic value of the loans, which is likely to be below the book value, but above the market price currently prevailing in illiquid markets. So the banks will likely have to take additional losses.

The asset manager would then have three years to sell those assets to private investors. There would be a guarantee from the member state of each bank transferring assets to the asset management company, underpinned by warrants on each bank’s equity. This would protect the asset management company from future losses if the final sale price is below the initial transfer price.

One of the biggest advantages of launching an EU-wide bad bank is that it would avoid the sort of public “resistance” that would occur if it was done at a national level, says Enria. Italian lenders would presumably be able to continuing pricing bad loans at or around 40 cents on the euro on average, even though their real value — i.e. the current value priced by the market — is often much lower. The difference between the market price, if any, and the price the banks end up receiving for their bad debt will be covered by Europe’s taxpayers.

If given the green light, the scheme would pave the way to the biggest one-off bail out of European banks in history. It would be Euro-TARP on angel dust, with even fewer checks and balances and much less likelihood of ever recovering taxpayer funds. According to a banker source cited by Reuters, while Germany has not yet endorsed the EBA plan, the EU documents describe the development of a secondary market for NPLs as a priority. According to Enria, the EBA hopes to finalize matters “at the European level” in the Spring.

The documents also include proposals for a wider “restructuring of banking sectors” as states address the NPLs problem. This “could lead to mergers among EU banks after they offload their bad loans,” a banking industry official said.

In other words, EU taxpayers would have to spend potentially hundreds of billions of euros saving yet more banks from the consequences of their own acts and bail out their bondholders and potentially their stockholders too, with funds desperately needed in other areas. Those banks, once saved and their balance sheets cleansed, would then be handed on a platter to much bigger banks. In return, taxpayers would end up with an even more concentrated, consolidated, interconnected financial system that is even more prone to abuse, corruption, and excess.

The ECB’s policy isn’t about creating inflation but about keeping a financial system and a currency union from collapsing upon each other. Read…  ECB Trapped in its Own “Doom Loop” as Inflation Surges