EU banks and state-backed loans: bad news with a long fuse

The European Central Bank’s recent Financial Stability Review paints a bleak picture of eurozone lenders. Profitability is down, loan-loss provisions are up, and exposures to rickety corporates and sovereigns are soaring.

One curious finding, though, was that capital levels have stayed remarkably stable. Core solvency ratios haven’t sunk. Between March and June, they actually increased. This good news may not last. European banks may be sitting on dangerous time bombs, in the form of loans covered by public guarantee schemes (PGSs), that are primed to go off in the next few years.

At the outset of the pandemic, many European Union governments promised to backstop loans made by commercial banks to certain customers. As of end-June, €181 billion ($219 billion) of loans held by EU banks were covered by these PGSs, with French, Spanish, Italian and Portuguese lenders carrying especially large amounts of them on their balance sheets.

With their sovereign guarantee, most of these loans get a heavy discount on their regulatory capital requirements. The European Banking Authority (EBA) calculated the risk-weighted asset (RWA) relief across 78 banks to be around €58 billion. RWAs are used to compute capital charges.

There’s a catch, though. Most of the PGSs are time-limited. But not all the loans they cover will mature before the guarantees expire. The EBA warned that such maturity mismatches would result in the sudden materialisation of credit risks at banks, saddling them with higher RWAs months or maybe years in the future.

Around a third of PGSs are due to expire in the first half of 2021. It’s possible, then, that  banks could see government guarantees cease around the same time a host of loan repayment holidays come to an end. Their solvency ratios would then be hit with a double-whammy: an increase in RWAs because of maturity mismatches; and a reduction in capital as retained earnings are diverted to cover losses on loans previously under moratoria.

Banks will want to get a good number of these loans off their books – and fast. This is especially true of guaranteed loans that are already non-performing. EBA data showed some €1.1 billion of assets have already soured. At five banks, over 10% of PGS loans are currently non-performing.

The question is, who will buy them? Investors and non-traditional lenders bought up huge portfolios of loans debt post-financial crisis, and continue to do so. Italian giant UniCredit sold €1.5 billion of non-performing exposures in July to a number of entities, including a securitisation vehicle sponsored by the UK’s Barclays and digital bank Guber Banca.

However, state guarantees for traditional banks are one thing. Extending the same protections to small challenger banks and non-bank institutions is quite another. The EBA was already concerned about the sovereign-bank nexus created by loan moratoria and PGSs. Enlarging this relationship to encompass unregulated or less regulated entities could further complicate the already tenuous relationship between banks and governments.