This year marks the 10th anniversary of the Vienna Initiative and the 6th anniversary of the NPL Initiative. Since the launch of the NPL Initiative in 2014, important regulatory, supervisory and tax reforms have been implemented to improve the resolution of NPLs, and the conditions for a sound secondary NPL market (although still not perfect) contributed greatly to the ability of banks to deleverage a large part of the stocks. This resulted in a gross NPL ratio in the region, more than halving since its peak of 9.8% in Q1 2014 to 4.4% in Q3 2018. However, work is still not complete. Progress in recent years has in large part been driven by the need to tackle the NPL stock, but more must be done to embed changes within the banks themselves for sustainable long-term NPL prevention and management.

Key Developments in BIS Banks’ External Positions and Domestic Credit and Key Messages from the CESEE Bank Lending Survey

Deleveraging of western banks in Central, Eastern, and Southeastern Europe (CESEE) seems to have come to an end, with their exposure vis-à-vis the region remaining stable in 2017 at about US$630 billion. After a long credit-less recovery, credit growth is picking up on the back of robust economic activity. Domestic deposits remain the main source of bank funding but CESEE banks resumed tapping into foreign founding sources in 2017.

The CESEE Bank Lending Survey, for the period October 2017 to March 2018, shows positive developments in the credit market. Banking groups consider their positioning in the region to be either improving or stabilizing, on the back of brighter profitability performances. Regional supply conditions improved, but still lagged behind very robust demand. Survey-based quality and quantity indicators continue progressing, thus signaling further support to already positive aggregate net credit extensions.

Read the full DCM here.

This report presents the results of the EIB CESEE Bank Lending survey at the regional and at the single country level. The survey is a unique instrument developed in the context of the Vienna Initiative to monitor cross-border banking activities and deleveraging in CESEE, to better understand the determinants / constraints influencing credit growth in CESEE and to gain some forward-looking insights into cross-border banks’ strategies and market expectations regarding local financial conditions. Read the full report here

This NPL Monitor reviews the latest NPLs data consistently available from the IMF (as of 31 December 2016) for the 17 economies of Central, Eastern and South Eastern Europe (CESEE) countries. The monitor also reports on progress with recent structural reforms in the five NPL Initiative “Partner Countries”, on recent NPLs transactions closed in the region, and summarizes regional loan servicing capacities in the CESEE. Read the full report here.

Summary:

The latest NPLs monitor report produced for the Vienna Initiative shows that non-performing loans in CESEE continued to decline in the 12 months to the end of 2016, benefitting from improvements in the regulatory environment for impaired credits and in the secondary market for bad debt. NPLs have been a major burden on CESEE economies and been an impediment to recovery in the region from the global financial crisis.

The report showed a decline regional NPL ratio to the end of 2016 to 6.2 per cent, down 1.5 percentage points from a year earlier. The remaining stock of NPLs in the region had fallen a sharp 18.1 per cent to €46.5 billion, representing around 3.8 per cent of GDP. The report warned that NPL ratios in the region remain persistently high for many countries, exceeding 10 per cent in six of the 17 CESEE countries. However, it said none had a ratio above 20 per cent.

It also pointed to expected further regulatory changes that would improve NPL resolution and the development of a more transparent NPL market. Recent reforms included a new out-of-court restructuring framework in Hungary and the training of judges on insolvency in Croatia.More remained to be done to resolve the remaining regulatory, legal and tax impediments in many of the CESEE countries.

Key developments in BIS Banks’ External Positions and Domestic Credit

Adjusting for one-off factors, the external position of BIS reporting banks in Central, Eastern, and Southern Europe (CESEE) has improved somewhat in the first half of this year. The improvement in the external positions is corroborated by BOP data. Foreign bank funding for the region as a whole has improved, despite reductions in foreign funding for some countries. Outside the Commonwealth of Independent States (CIS), credit accelerated, with the credit to the household sector recovering firmly in almost all the countries. Read the full report here

Collection of papers on how corporate debt distress was addressed in the wake of the Asian financial crisis.

Micro, small, and medium enterprises (MSMEs) are among the largest commercial users of insolvency systems. MSMEs are a significant part of the global economy – and just as there are large numbers of MSMEs, there are large numbers of MSME insolvencies. However, there are a very few specialized legal regimes for MSME insolvency; most jurisdictions treat MSME insolvencies the same as for other corporate entities, or conversely, natural persons, despite MSMEs' unique attributes. This report considers the specific challenges of insolvent MSMEs (including the difficulties of defining MSMEs and distinguishing them from large corporate entities); reviews and analyzes how legislation in different jurisdictions deals with the challenges of MSME insolvency; and considers if existing international standards are sufficient to address MSME insolvency.

Read the full report here.

A Toolkit for Out-of-Court Workouts was created to achieve two objectives: (1) to provide policy makers with tools to develop a corporate restructuring framework and culture in their country; and (2) to help stakeholders implement informal corporate restructuring principles to try to rescue failing enterprises. It is accordingly aimed primarily at policy makers, financial institutions, and insolvency representatives, as well as enterprises. The Toolkit generally examines different models for restructuring, in the understanding that there is no such thing as a "one size fits all" approach, and countries have the ability to develop flexible and varied solutions to meet their specific financial sector needs. Specifically, the focus of the Toolkit is on workouts, which for the purposes of this publication is taken to mean two types of restructuring models: (1) those that involve no judicial involvement (i.e., that are purely out-of-court mechanisms [OCWs]); and (2) those that involve some institutional or judicial involvement (hybrid procedures). Focusing on these models is designed to provide stakeholders with a broader understanding of restructuring and the varied models that different countries are implementing. Included in the Toolkit are sample documents typically used in a workout. These are included only to illustrate certain practicalities and considerations in conducting a workout, and should not be used without legal advice in the jurisdiction of their intended use

In March 2018 the European Commission presented its second progress report on the Action Plan to tackle NPLs in Europe, which Finance Ministers agreed on in July 2017. The progress report, which takes the form of a communication and an accompanying staff working document, shows that the decline of NPL stocks is continuing.

Read the full report here.

The EBRD is launching a €300 million framework aimed to mobilise up to EUR 1.5 billion to support efforts aimed at resolving the persisting challenge of high levels of NPLs in many of its countries of operations. The facility will allow the Bank to acquire minority stakes in NPL servicers, invest in NPL portfolios and provide senior debt instruments to co-investors for the purchase of NPL portfolios. The EBRD will invest alongside established partners with a proven track-record in central, eastern and south-eastern Europe, Greece, Cyprus and Turkey.

Previous interventions by the Bank in addressing the challenge of non-performing loans include, among others, investments in Turkey, Greece, Bulgaria and other countries.

Nick Tesseyman, EBRD Managing Director, Financial Institutions, said: “This new framework is a major step as it will allow us to address a continuing challenge in many of our countries in a systematic, coordinated and bespoke manner. The combination of financial intervention and policy engagement will allow us to address one of the key post-crisis legacy issues in the banking sector. It comes at exactly the right point in time to contribute to the return to strong growth in our region.”

In its latest NPL Monitor, published in November 2017, the Vienna Initiative warned that despite a decline in the 12 months to the end of 2016, NPL levels in central, eastern and south-eastern Europe remained persistently high for many countries, exceeding 10 per cent in six of the 17 countries of the region. While the report noted an overall decline in the regional NPL ratio and stock thanks to regulatory reforms and portfolio sales, it urged decision-makers to resolve remaining regulatory, legal and tax impediments in many countries.

The EBRD is also actively involved in these efforts. For example, in Hungary the Bank supports the authorities in implementing out-of-court restructuring. In Croatia, the EBRD is assisting the government to strengthen the relevant legal framework. And in Serbia the Bank is engaged with the authorities through the working group on NPLs to support the environment for concrete solutions.

Read a short KPMG article on the EBRD’s NPL investments gaining momentum here.

Following up on the Action Plan on reducing NPLs agreed y Europe’s finance ministers in July 2017, the European Commission (EC) has published on 14th March 2018 a series of measures and proposals designed to tackle NPLs. This package outlines a comprehensive approach including policy actions that target four key areas for banks:

1. Ensuring sufficient loss coverage by banks for future NPLs

The EC has proposed amending the Capital Requirements Regulation (CRR) with the aim of introducing minimum provisioning levels for newly originated loans that become Non-Performing (“statutory prudential backstop”). This is currently only a proposal and not yet in force, with no explicit planned date of finalisation. This proposal was supported by the outcome of the impact assessment performed by EBA on the use of prudential backstops to prevent the building up of new NPLs,

Since this measure would apply to newly originated loans that become NPLs, it is designed to address the risk of the accumulation of NPLs on the balance sheet, as well as the risk of not having enough funds to cover future NPL losses.

This provisioning schedule is in line with expectations of non-linearity (i.e. provisions would get steadily larger as time progresses), thereby allowing banks to look for other options to solve the NPL issue, such as via secondary markets, or out of court settlements. Noncompliance would dictate deductions from banks’ own funds (de facto a Pillar 1 measure). This provisioning backstop accompanies the publication of the Addendum to the ECB guidance to banks on NPLs (discussed below).

2. Developing secondary market for NPLs and facilitating out-of-court collateral enforcement

The EC has published a proposal for a directive which is designed to:

a.      Fostering the development of a secondary markets for NPLs, introducing;

• a common set of new rules for credit servicers to operate cross-border within the Union (”EU passporting”),
• specific market entry conditions for loan servicers, and
•  conditions for borrower rights protection.

b.     Enabling accelerated out-of-court enforcement of loans secured by collateral, introducing for secured creditors a more efficient method of value recovery from secured loans through an accelerated extrajudicial collateral enforcement (out-of-court).

This is currently only a legislative proposal to the Council and European Parliament for approval, with no immediate implications for banks and no indication of when this would take effect.

3. A technical blueprint for how to set up a national Asset Management Companies (AMCs)

The Action Plan agreed in July 2017 invited the EC to propose a guidance (“blueprint”) for member states to set up an AMC in their market, in order to better address the ongoing NPL issue. The EC has now published its final AMC blueprint which is non-binding and contains a number of suggestions for common principles on all aspects of such a company, including the setup, governance and operations, drawing on best practices within the network. The blueprint is heavily inspired by the lessons learned from SAREB and NAMA.

The ECB published the final Addendum to the ECB Guidance to banks on NPLs on the 15 March 2018.

During the consultation period on the draft Addendum (October to December 2017), the ECB received 35 responses with over 500 individual comments. The EC and EU Parliament also raised fundamentals questions to the essence of the text and the risk of overreaching ECB’s mandate. Key clarifications have been made to the final addendum since our previous alert, which we outline below. Overall, the text is clearer that these are supervisory expectations with no legal effects and the provisioning calendar is slightly less constraining (i.e. longer period before first provisioning).

Read the full ECB Guidance to banks on NPLs

In line with the NPL action plan of the EC, the European Banking Authority (EBA) issued on Thursday 8 March 2018 a consultation paper on its draft guidelines for credit institutions on how to effectively manage non-performing exposures (NPEs) and forborne exposures (FBEs). Some of the key elements are highlighted below.

The EBA guidelines has a legal basis (thus compulsory) and where developed on the basis of EBA's Pillar 2 mandates in the CRD IV. They closely mirror the content of the ECB Guidance to Banks on NPL Management, published in March 2017 and cover expectations in terms of NPL strategy, governance and operations, control and monitoring, early warning and collateral valuation (although valuation is expected to also cover immovable).

The main differences the EBA Guidelines introduce are:

• Applicable to all regulated European credit institutions, while the ECB Guidance is only to Significant Institutions supervised by the SSM.
• Catered for consumer conducts requirements due to EBA’s consumer mandate.
• Doesn’t have the ECB concept of “High NPL” banks but instead sets a threshold NPL ratio of 5% from which credit institutions should establish a NPE strategy and related governance and operational arrangements.
• Defines the concept of proportionality for the application of the text, according to the size and complexity of the credit institutions (this is however not precisely defined and leaves for interpretation by supervisors).
• Sets out requirements for competent authorities' assessment of application as part of the Supervisory Review and Evaluation Process (SREP)

The public consultation period will end 8 June 2018, with a public hearing to be held on 25 April 2018 from 11:00 to 12:30 GMT at the EBA premises. Final publication is expected for summer 2018, with monitoring of implementation as of 1 January 2019.

Read the full EBA Draft Guidelines on management of non-performing and forborne exposures

This briefing gives a short introduction into NPLs, takes stock of the current situation in the euro area, touches on the impact of NPLs on credit supply, and summarises the activities taken at European level to address the problem

Read the full briefing here

The EBA released a video to help all interested stakeholders get familiar with the key features of the two sets of EBA templates on NPLs published on 14 December 2017. The EBA designed the templates to help restart the secondary markets for NPLs in Europe, thus contributing to the European Council’s action plan to tackle NPLs in Europe, released in July 2017: watch the video here

The European Securities and Markets Authority (ESMA) has published three consultation papers on draft technical standards implementing the Securitisation Regulation (SR). The Regulation establishes a general framework for securitisation and creates a specific framework for simple, transparent and standardised (STS) securitisation. Securitisations are transactions that enable a credit institution or a corporation to refinance assets, such as loans, by transforming them into tradable securities.
The Regulation requires certain information to be reported about securitisations to repositories, including details of their underlying exposures, details of the securitisation structure itself, and information on the securitisation cash flows. The securitisation repositories will be registered and supervised by ESMA. In addition, securitisations seeking to be designated as STS must fulfil additional criteria and notify ESMA of their fulfilment of these criteria. Finally, third party entities may seek to be authorised by a national competent authority to assess the compliance of securitisations with the STS criteria.

The Securitisation Regulation includes a number of mandates for ESMA to draft technical standards on these provisions. Accordingly, ESMA’s just-published consultation papers seek stakeholder views on:

The contents and format of underlying exposures and investor report templates, which aim to meet the Securitisation Regulation’s reporting requirements;
The operational standards for providing these reports to securitisation repositories, and the operational standards for accessing this information from securitisation repositories. Moreover, the specific conditions for the entities specified in the Regulation to access information from securitisation repositories; The contents and format of the notification to ESMA of a securitisation’s STS status; and
The application requirements for third party entities seeking to be authorised as providers of STS verification services.

Next steps: ESMA, in order to facilitate the provision of feedback, has made available flexible-format versions of the proposed reporting templates on its website. The consultation is open for feedback until 19 March 2018. ESMA will use the feedback received to help finalise its draft technical standards, and expects to publish a final report in July 2018 (for the STS notification and third party application requirements) and by the end of 2018 (for the reporting requirements and operational standards/access conditions).

The Joint Committee of the European Supervisory Authorities (EBA, EIOPA and ESMA - ESAs) has published its spring 2017 Report on risks and vulnerabilities in the European Union’s financial system.

The Report highlights the risks to the stability of the European financial sector in an environment subject to political and economic uncertainties. In particular, the protracted period of low profitability of banks and the difficulties faced by insurers to generate adequate returns to meet long-term liabilities in a low growth and low-yield environment remains a major challenge. In addition, the steepening of the yield curve may benefit earnings across all sectors but it also raises valuation concerns and, in the short term, may not be sufficient to alleviate the low profitability concerns. The Report also highlights the high valuation risk linked to search for yield strategies and repricing of risk premia. Rising operational risks related to information and communication technologies are increasingly requiring supervisory attention.

Low profitability of financial institutions

High levels of non-performing loans (NPLs), continuously high litigation costs, overcapacity, and lack of focus in strategies to return to sustained profitability affect the banking sector, notwithstanding a further steady strengthening of the capital ratios. Addressing NPL challenges requires a comprehensive and coordinated European response, including stepping up supervisory action, making progress in structural reforms, and improving the efficiency of secondary markets. Insurers face substantial challenges arising from prolonged low interest rates, especially those with material exposures to life insurance contracts with interest rate guarantees. In the European Union's fund industry, rates of returns are subdued and remained mostly negative.

In its First Progress Report since the Finance Ministers agreed an Action Plan on reducing non-performing loans (NPLs), the Commission highlights the further improvement in NPL ratios and forthcoming measures to bring NPL stocks down further.

Key findings

The First Progress Report highlights recent developments of NPLs both in the EU as a whole and within individual Member States. It shows that the positive trend of falling NPL ratios and growing coverage ratios has solidified and continued into the second half of 2017.

Furthermore:

NPL ratios have been falling in nearly all Member States, although the situation differs significantly across Member States. The overall NPL ratio in the EU declined to 4.6% (Q2 2017), down by roughly one percentage point year-on-year, and by a third since Q4 2014.
The data demonstrates that risk reduction is taking hold in the European banking system, and will support progress towards completing Banking Union, which should occur by risk reduction and risk sharing in parallel.
The report also shows that the EU is on track with implementing the Council's Action Plan.
In spring, the Commission will propose a comprehensive package of measures to reduce the level of existing NPLs and to prevent the build-up of NPLs in the future. The package will focus on four areas: (i) supervisory actions, (ii) reform of restructuring, insolvency and debt recovery frameworks, (iii) development of secondary markets for distressed assets, and (iv) fostering restructuring of the banking system. Action in these areas should be at national level and at Union level where appropriate.

The Commission also calls on Member States and the European Parliament to rapidly agree on the Commission's proposal on business insolvency. Proposed in November 2016, this measure would help companies in financial difficulty to restructure early on so as to prevent bankruptcy, leading to more efficient insolvency procedures in the EU. Read the Staff working document here, the MEMO here and the Factsheet here.

This note provides an updated picture on NPLs in the European Union, showing that – although the NPL ratio has been steadily decreasing, significant differences remain across Member States. It then discusses the two main factors driving NPLs in the long term: the macroeconomic cycle and the banks’ lending practices, arguing that policy makers should continue to encourage the development of sound internal credit ratings. Finally, four main levers are discussed, that can be used to curb high NPL stocks. Internal recovery processes, which should be improved by investing in better IT architectures... and specialised professional skills. NPL sales, which may prove attractive (and reduce the supervisors’ own reputational risks), but also to destroy value for bank shareholders, debtholders and the public purse. Asset management companies (AMCs), which may prevent banks from disorderly liquidating NPLs, force badly-managed banks to feel the pain of past mistakes and gradually recover loans while being funded at an acceptable cost. Calendar provisioning regimes like the one recently proposed by the SSM, which may force banks to quickly write down non performing exposures, but may suffer from several drawbacks and should be enacted through a fully-fledged, accountable political process. In designing ways to tackle non-performing exposures, one should never forget that NPLs, while being associated with modest profits and poor loan supply, do not cause them but, like them, follow from poor real growth, ineffective management and faulty governance schemes.

Special features section from the Financial Stability Review (November 2017) includes a chapter on overcoming NPL market failures with transaction platforms.

Executive summary: When banks judge that more value can be extracted by offering non-performing loans (NPLs) for sale rather than working them out themselves, potential investors cannot be sure that the credit quality of the assets is as good as the banks portray it to be. Such information asymmetries in the NPL market drive a wedge between the prices that investors are prepared to pay for NPLs and the prices that banks are prepared to sell them for. While information asymmetries can be overcome through investor due diligence, this requires specialist expertise and the costs of valuing NPL portfolios can be very high. As few investors have the resources to absorb such costs, barriers to entering the market are compounded. This appears to explain why the euro area NPL markets display the features of an oligopsony, a situation where there is a concentration of market power among a limited number of investors, which pushes traded prices even lower. At the same time, potential NPL investors can face coordination challenges when debtors have multiple loans with different banks. In such situations, investors must face the prospect of competing with other creditors for the debtor’s resources. While coordination between banks for common exposures may alleviate this problem, this too can be costly, weighing further on market prices. By offering the prospect of greater transparency in NPL markets, fostering wider investor participation and addressing coordination issues, NPL transaction platforms could help in overcoming all three of these market failures. The attendant improvement in market liquidity would allow banks to achieve better prices for NPL sales, preserve their capital and mitigate financial stability risks. This special feature outlines the desirable features of NPL transaction platforms and discusses their operational implementation.

Access the chapter on "overcoming NPL loan market failures with transaction platforms".

Access the full Financial Stability Report, November 2017.

The European Banking Authority (EBA) published today data templates that will create the foundation for NPL transactions across the EU. The templates will provide a common EU data set for the screening, financial due diligence and valuation during NPL transactions. An extended use of the templates is expected to widen the investor base, lower entry barriers to potential investors, improve data quality and availability, support price discovery and facilitate the development of the NPL secondary market.

The EBA, along with other EU bodies and institutions, had been invited by the Council to contribute to its action plan to tackle non-performing loans in Europe with a number of initiatives. The EBA NPL templates and accompanying documents can be found here .

Chapter 3 of the Regional Economic Outlook discusses the specific banking challenges facing the Western Balkan economies. In many ways, banks in this region are still reeling from the effects of a boom and bust credit cycle. This legacy is constraining credit growth at a time when it is most needed. In most countries in the region, credit-to-GDP ratios are still below their potential and show little sign of improvement. Policymakers should act on several fronts. Nonperforming loans can be reduced and profitability increased through asset quality reviews and supervisory action plans. Funding bases can be enhanced through better communication with parent banks and home supervisors and by diversifying funding sources. Addressing weak bankruptcy and insolvency regimes, improving cadastral systems, and speeding up slow court procedures should help ease the structural impediments to credit growth.

In September 2016, the European Central Bank (ECB) published its first stocktake on national supervisory practices and legal frameworks related to Non-Performing Loans (NPLs). The decision to publish was taken in order to support the ECB’s consultation on the then draft guidance to banks on NPLs, as well as to generally promote further dialogue among the parties with a role to play in finding sustainable solutions to the elevated levels of NPLs within the EU. The first stocktake was completed in close collaboration with eight National Competent Authorities (NCAs) focussing in particular (but not exclusively) on the emerging best practices in jurisdictions with relatively high levels of NPLs.

It was subsequently decided to extend the stocktake to the remaining 11 countries participating in the Single Supervisory Mechanism (SSM) so that ECB Banking Supervision would have a full picture of the practices in the euro area as at 31 December 2016, and in order to continue the ECB’s contribution to the European dialogue on NPLs. Given that the new countries in the second stocktake do not have high levels of NPLs, the policies and practices in their jurisdictions are not expected to be as prescriptive or coordinated as those in jurisdictions currently reacting to high levels of NPLs.

Progress has been made within the SSM to address the NPL issue from a supervisory perspective and the overall value of the NPL stock has decreased since the publication of the first stocktake. Nevertheless, one of the key lessons to be taken from the financial crisis and the experience of many jurisdictions with high NPL levels is the need for all stakeholders to be proactive and prepared before NPL levels become elevated. Current legal backlogs relating to insolvency and debt restructuring in a number of jurisdictions with high NPL levels can, for example, be traced back to a failure to establish out-of-court settlement frameworks in quieter times. As a result, banks in some jurisdictions cannot resolve NPL issues efficiently, and their NPLs have a negative impact on their performance. Crucially, banks themselves should ensure that their second and third lines of defence guarantee compliance with various regulatory standards and good practices so that NPLs are promptly identified and managed and that, more broadly, they are prepared insofar as possible to identify and manage NPLs in the event of future downturns.

With regard to supervisory regimes and practices, the first stocktake noted that many jurisdictions with high NPL levels had implemented strategies and taken actions to address the issue, for example through on-site inspections and the publication of additional guidance and requirements. The ECB’s recently published NPL guidance addressed to SIs builds on the good practices in these jurisdictions to some extent, and the implementation of this guidance within SIs will be an important part of supervisory assessment in future.

A number of low NPL jurisdictions currently have little in terms of specific guidance or requirements applicable to LSIs that (with due regard to proportionality) can be considered equivalent to the guidance addressed to those institutions directlysupervised by the ECB. A number of these jurisdictions have indicated, however, that they are in the process of considering whether to apply the ECB’s guidance to banks on NPLs to their respective Less Significant Institutions.

Finally, tools such as dedicated or specifically focussed on-site inspections of arrears/NPLs play a material role in detecting emerging issues at an early stage. They can be used to assess compliance with the EBA ITS on NPE/forbearance, which is essential to ensuring that banks are properly classifying and provisioning their exposures. The ECB and NCAs recognise the importance of such tools and are committed to making any necessary enhancements to their supervisory frameworks on the basis of experience and emerging good practice.

With regard to the legal, judicial and extra-judicial frameworks, to the extent that there have been changes in high-NPL jurisdictions since the first stocktake, these have been (with some exceptions) incremental in nature and it is too early to assess their effectiveness. In any case, changes to judicial systems (including the recruitment of insolvency experts) are not keeping pace with legislative developments.

The pressure to implement frameworks for better-functioning NPL markets or to create AMC solutions is greater in countries with high NPL levels. Out-of-court mechanisms to, for example, enforce collateral or process corporate and household insolvency claims feature in only a minority of jurisdictions with low NPL levels. Many jurisdictions are therefore not as prepared as they could be to manage the legal aspects of any future escalation in NPL levels in a timely and efficient manner.

With regard to information frameworks, the second stocktake has identified little that is new. The majority of participating countries have central credit registers (CCRs) in place, usually managed by national central banks. Such registers are generally considered to be a valuable supervisory tool for on-site and off-site analyses as well as for the sharing of information between banks. However, not all NCAs refer to CCRs when conducting their supervisory activities. Other public registers are also an important source of information, although in some countries the availability of such sources of data remains limited. Finally, delays in the implementation of a CCR in one country included in the first stocktake were noted.

On 11 July, the European Council announced its conclusions on an action plan to tackle NPLs in the EU, inviting EU regulators to take concrete actions in the following areas:

• Supervision

• • ESRB to develop macro-prudential approaches to prevent the emergence of system-wide NPL problems. Target Date: End-2018
  • EBA, in consultation with the ESMA, to implement enhanced disclosure requirements on asset quality. Target Date: End-2018

• NPL Management

• • ECB NPL Guidance on Non-Performing Loans. Date: March 2017
  • ECB to set expectations for a prudential provisioning backstop on both quantitative and time targets (Addendum to the ECB’s Guidance on NPLs). Date: October 2017 (effective January 2018)
  • SSM to implement guidance to less significant institutions, similar to the 2017 “Guidance to banks on Non-Performing Loans” which was aimed at SIFIs. Target Date: End-2018
  • EBA to issue general guidelines on NPL management, consistent with the aforementioned Guidance, with an extended scope applying to all banks across the EU. Target Date: Summer 2018 (but expected early 2018).

• Insolvency Regime

• • EU Commission to publish the results of the benchmarking exercise on the efficiency of national loan enforcement (including insolvency) regimes from a bank creditor perspective. Target Date: End-2017

• NPL Sales/Secondary Market

• • EU Commission to develop a “blueprint” for the potential set-up of national AMCs. Target Date: End-2017
  • EBA, ECB and EU Commission to propose initiatives to strengthen the data infrastructure with uniform and standardised data for NPLs and consider the setting-up of NPL transaction platforms. Target Date: End-2017
  • EU Commission to develop a European approach to foster the development of secondary markets for NPLs. Target Date: Summer 2018

This paper draws on several country cases and extracts some practical insights about the success factors behind specific NPL resolution strategies. It discusses the advantages and disadvantages of individual resolution tools, drawing on country cases that shed light on how such tools have been used, and what constraints authorities faced in their application. Next, the paper matches the resolution tools to the key country characteristics, to identify how such characteristics help to define the policy space for NPL resolution.

Three main lessons can be helpful in designing a response to a crisis or a medium-term strategy for crisis preparedness. First, recognising the constraints that country-specific characteristics impose on resolution policies and the associated trade-offs can help authorities select the most successful policies. Second, with time, authorities can expand their resolution toolkit, by taking stock of any hindrances to specific NPL resolution policies and considering measures to remove them. Third, NPL resolution interacts with other policies during a crisis. Macroeconomic and macroprudential policies can mitigate NPL problems, but do not represent an alternative to dealing with the underlying NPLs. Clear communication helps to pave the way for a successful resolution policy and to establish a reference point for its ex post assessment.

On 11 July, the Council of the EU announced its conclusions on an action plan to tackle NPLs in the EU, inviting EU regulators to take concrete actions. Below is a summary of the key items:

Supervision

• ESRB to develop, macro-prudential approaches to prevent the emergence of system-wide NPL problems. Target Date: End-2018
• EBA, in consultation with the ESMA, to implement enhanced disclosure requirements on asset quality. Target Date: End-2018

NPL Management

• ECB NPL Guidance on Non-Performing Loans. Date: March 2017
• ECB to set expectations for a prudential provisioning backstop on both quantitative and time targets (Addendum to the ECBs guidance on NPLs). Date: October 2017
• SSM to implement guidance to less significant institutions, similar to the 2017 “Guidance to banks on Non-Performing Loans” which was aimed at SIFIs. Target Date: End-2018
• EBA to issue, general guidelines on NPL management, consistent with the aforementioned Guidance, with an extended scope applying to all banks in the entire EU. Target Date: Summer 2018

Insolvency Regime

• EU Commission to publish the results of the benchmarking exercise on the efficiency of national loan enforcement (including insolvency) regimes from a bank creditor perspective. Target Date: End-2017

NPL Sales/Secondary Market

• EU Commission to develop a "blueprint" for the potential set-up of national AMCs. Target Date: End-2017
• EBA, ECB and EU Commission, to propose initiatives to strengthen the data infrastructure with uniform and standardised data for NPLs and consider the setting-up of NPL transaction platforms. Target Date: End-2017
• EU Commission to develop a European approach to foster the development of secondary markets for NPLs. Target Date: Summer 2018

Recognizing improvement in financial stability in the euro area, the paper notes the still high-level of NPLs and stresses the importance of completing the Banking Union and the Capital Markets Union to reduce and share risks in the banking sector. In particular, the Council of the EU is committed to addressing the NPL challenge by developing a comprehensive NPL strategy by June 2017 with clear targets, timetables and a monitoring mechanism. The NPL strategy should focus on four key policy areas: (i) Supervision, (ii) Secondary markets, (iii) Structural issues (including insolvency), and (iv) Restructuring of the banking system.

Chapter 1 of the April 2017 IMF Global Financial Stability Report notes that while important progress has been achieved in strenghtening the banking sector in Europe, further efforts are still needed to adjust bank business models, facilitate the disposal of nonperforming loans, and remove structural impediments to bank profitability. In particular, structural reforms to legal frameworks and enhanced quality of information are needed to remove barriers to NPL sales, while banks need to put the adequate buffers in place to absorb additional losses recognized on sales of bad debts.

The EU Commission puts forward a proposal for a directive aimed at increasing convergence of restructuring and insolvency frameworks in EU Member States. The objective of the proposal is for all Member States to have in place key principles on effective preventive restructuring (early intervention before a company gets into serious difficulties) and second chance frameworks (via discharge of debt), and measures to make all types of insolvency procedures more efficient – both at national and cross-border level – by reducing their length and associated costs and improving their quality. This would facilitate greater legal certainty for cross-border investors and encourage the timely restructuring of viable companies in financial distress. This proposal also discusses its own limitations, its consistency with existing policy provisions and other EU policies, budgetary implications as well as Implementation plans and monitoring, evaluation and reporting arrangements.

The high level of private debt in many EU countries has put a spotlight on the role that insolvency frameworks can play in helping to address debt overhangs and clean bank balance sheets of nonperforming loans. This paper reviews the macroeconomic relevance of insolvency frameworks from an EU perspective, discusses design issues of insolvency regimes and presents the main features of insolvency frameworks in selected EU Member States. It also reviews recently enacted reforms and examines remaining reform priorities from a macroeconomic perspective.

The IMF report provides a strategy for resolving the NPL loans problems in Europe. It analyses the extent of the problem, explaining the impediments and laying out a strategy for a Comprehensive NPL Resolution.

Extensive material including on the definition of NPLs, empirical estimations on the effect of excess leverage on corporate investment, and an extensive IMF survey on obstacles to NPL resolution and restructuring.

A detailed look at how excess private debt continues to hold back the recovery in central and eastern Europe, and the need for efficient debt resolution frameworks.

Section II of the report studies the post-2008 adjustment in private non-financial sector debt and its impact on economic activity in the CESEE region:

• How much deleveraging took place?
• What is the economic cost of deleveraging?
• Where are the remaining credit gaps across CESEE countries?
• How can CESEE countries grow out of debt?

Focuses on resolution of distressed SME loans, drawing lessons from earlier experiences in other markets.

The private non-financial sector in Europe is facing increased challenges in meeting its debt servicing obligation. In response, governments are revisiting legal tools and—in some cases—institutional arrangements to deal with over-indebtedness. For households, where the problem in some countries is large but no established best practice exists, reforms have generally sought to allow debtors a fresh start while minimizing moral hazard and preserving bank solvency and credit discipline. For the corporate sector, efforts have focused on facilitating debt restruturing (including through out of court mechanisms). Direct government intervention has been rare.

Micro, small, and medium enterprises (MSMEs) are among the largest commercial users of insolvency systems. MSMEs are a significant part of the global economy – and just as there are large numbers of MSMEs, there are large numbers of MSME insolvencies. However, there are a very few specialized legal regimes for MSME insolvency; most jurisdictions treat MSME insolvencies the same as for other corporate entities, or conversely, natural persons, despite MSMEs' unique attributes. This report considers the specific challenges of insolvent MSMEs (including the difficulties of defining MSMEs and distinguishing them from large corporate entities); reviews and analyzes how legislation in different jurisdictions deals with the challenges of MSME insolvency; and considers if existing international standards are sufficient to address MSME insolvency.

Read the full report here.

Discusses the role of asset management companies (AMCs) in facilitating bank restructuring and policy lessons from international experience. “There are common factors that contribute to the success of an AMC and these include the legal environment, leadership, independence, incentives, and commercial orientation.”

In July 2017, the EU Council announced an Action Plan to tackle the large overhang of Non-Performing Exposures (NPEs) which threaten the health of the Banking Union. This Action Plan includes several initiatives to be implemented in a short timeframe (mostly by the end of 2018). The proposed Guidelines issued in March 2018 by the European Banking Authority (EBA) for the management of nonperforming and forborne exposures contribute to this Action Plan.

Although the EBA aims to finalise the Guidelines by January 2019, banks should already start identifying any gaps in their NPE strategy, governance and operations against the Guidelines. All banks will need to address these gaps in policy and procedure, including the governance and operations of NPE recognition, impairment measures and write-off procedures, policies and procedures for the valuation of movable or immovable property collateral for NPEs, and the governance and operations of forbearance measures and processes.

The Guidelines are very similar to the European Central Bank's (ECB) guidance to banks on non-performing loans that was finalised a year ago. Therefore, banks supervised by the ECB will already be familiar with the substance of the EBA's Guidelines. However, the Guidelines will apply to all (over 6,000) credit institutions (hereafter "banks") in the EU.

This paper analyses the content of the EBA Guidelines and outlines what banks should do to prepare adequately for their implementation, while taking into account other recent initiatives that are likely to have a substantial impact on EU banks as they tackle the newly introduced Guidelines.

Read the full report here.

The large legacy overhang of Non-Performing Loans (NPLs) is increasingly seen as a threat to the success of the Banking Union. Regulators have recently increased their intervention to help speed up the banks' NPL risk deleveraging process. Over the past 18 months, numerous NPL task forces have been debating the topic to define the possible “optimum” pan-European solutions.1 In July 2017, the EU Council announced an Action Plan to tackle the issue. The ambitious plan introduced several initiatives to be implemented in a remarkably short timeframe (mostly in 2017-2018). The topics covered are broad, ranging from strengthening banks' management of NPL stock, to increasing incentives for banks to adequately provision and deleverage risks, as well as preventing new flows of NPLs in the future. Important progress is already being made, in line with the plan. What can EU banks expect and how will this impact them? What does this all mean for banks? Read the full analysis here.

This report was prepared by the ESRB Expert Group on non-performing loans, a substructure under the Advisory Technical Committee, which was mandated to identify macroprudential policy-oriented issues related to non-performing loans (NPLs) and to develop ideas on possible macroprudential responses to the current high levels of NPLs in the European Union (EU). The stock of NPLs in the EU banking sectors was around €1.0 trillion at end-2016, which amounted to 5.1% of total loans. The elevated NPL stock creates macroprudential and financial stability issues.The report finds that there are three main types of impediments to the resolution of NPLs (Section 2.3) relating to the supply side (banks), demand side (prospective investors) and to structural issues (all stakeholders). The policy response to the NPL overhang should aim for a least-cost NPL resolution, minimising costs across stakeholders and over time. Chapter 3 provides general practical guidance for policymakers with respect to the steps that need to be taken to design the overall response to the NPL issue. The response to high NPL stocks should conform to five high-level principles. A comprehensive policy response should be developed further, addressing all the main aspects of the NPL issue. While substantial progress, including in the euro area countries, has been made regarding microprudential policy issues,1 greater effort is needed. Further attention should also be given to impediments to the development of distressed debt markets, whereby changes may require more time to take effect.

The report concludes by making specific policy proposals for a range of measures. In the medium term, the work should concentrate on structural issues which would improve recoveries from NPLs.To avoid a future build-up in NPLs, incentives should be improved, in particular in relation to accounting.While only some of these measures may be expected to have positive effects in the short.

This report is designed to identify macroprudential policy-oriented issues and possible responses to the current high levels of NPLs in the European Union (EU). Specific areas of interest to the Expert Group included incentives for and potential impediments to the resolution of NPLs, policy experiences regarding asset management companies (AMCs), and the conditions of secondary markets for distressed assets in the EU. The report provides an overview of the NPL situation in the EU, followed by practical guidance on the process leading to NPL resolution, including a synopsis of the available options. It concludes that more effort is urgently needed to reduce NPLs and further recommends several policy actions. Whilst numerous impediments to NPL resolution have been identified, they should not be used to justify any further delay; rather, measures should be taken to address these impediments in parallel with actual NPL resolution.

Following the first stocktake undertaken in 2016, ECB's Single Supervisory Mechanism (SSM) publishes a second stocktake reviewing the range of practices relating to NPL workout in all 19 SSM countries (as opposed to only 8 high-NPL countries in the first stocktake) as at end-2016. The stocktake seeks to identify key supervisory practices and guidance in addition to current regulation, and obstacles (legal or otherwise) related to the workout of NPLs. Drawing on one of the key lessons from the financial crisis, the stocktake notes that stakeholders should be procative and make preparations in quieter times so that frameworks for managing NPLs are robust from the outset, before elevated NPL episodes arise.

In mid-2016, the Council of the European Union's Financial Services Committee established a subgroup on NPLs. The subgroup was tasked with (i) taking stock of the NPL problem in the EU (ii) analysing the current policies and framework in place to address the issue and (iii) offering new policy options for sustainable NPL resolution. This report details the findings of the subgroup

This report highlights:

• The key issues that the buyer and seller of a portfolio need to consider for Loan Portfolio transactions
• Structure and execution techniques, summarising the pros and cons for the most commonly deployed methodologies
• Financing, including debt funding options available and an overview of the issues that often arise on financing loan portfolio transactions
• An overview of jurisdiction-specific considerations

Many banks across Europe suffer from high levels of NPLs. While NPLs in the Euro Area have started gradually declining since their peak of 2013, they remain persistently high in some banks and countries. In this paper, KPMG's ECB office highlights four key impediments to NPL resolution: banks’ lack of preparedness, structural impediments, investor pricing, and limitations on government assistance. The paper then explores a number of solutions to these impediments.

Eight years after the start of Europe’s financial crisis, the legacy of NPLs and excessive private debt remains a key obstacle to the recovery of bank credit and investment.We argue that efforts to reduce and remove NPLs from the balance sheets of creditors must simultaneously remove excess debt from the balance sheets of debtors. This is the only way to ensure that bank balance sheets are restored to health sustainably, and that both supply and demand for new credit revive. A comprehensive strategy to tackle legacy assets should include national debt reduction strategies that guide bank NPL reduction targets, strengthen frameworks for restructuring and insolvency, simplify the engagement of specialist investors within the capital markets union and, crucially, create a blueprint for national asset management companies.

High levels of NPLs on bank balance sheets negatively impact credit supply and credit demand, reducing lending to the real economy at a time where, on the contrary, support to the still modest economic recovery would be needed. Monetary policy transmission in the euro area might also be negatively affected by elevated NPL ratios, in particular given the dominance of bank lending in the financing of European corporates. Feedback effects from elevated NPLs on the macroeconomic environment can give rise to a vicious circle, whereby low asset quality results in low bank profitability, low capital buffers and constrained lending to the real economy, which in turn negatively affects GDP growth, worsening the initial problems with NPLs. This clearly highlights the importance of pro-active policy actions to break such vicious circles.

Following the conclusion (in November 2016) of the consultation process on the draft guidance, the European Central Bank (ECB) publishes the final guidance to banks on how they should tackle NPLs. Final document available here

Initial documents published in September 2016 (draft guidance and stocktake of national practices on NPLs):

• ecb-draft-guidance-to-banks-on-non-performing-loans-september-2016
• ecb-key-content-of-the-guidance-to-banks-on-non-performing-loans-september-2016
• ecb-stocktake-of-national-supervisory-practices-and-legal-frameworks-related-to-npls-september-2016

The ECB's Single Supervisory Mechanism (SSM) publishes a stocktake reviewing the range of practices relating to NPL workout in 8 SSM countries as at end-2015. The stocktake reviews key supervisory practices and current regulation to identify obstacles (prudential, legal or otherwise) related to the workout of NPLs. Conducted together with 8 national competent authorities (NCAs), the stocktake provides input to formulate adequate policy and supervisory response to resolve NPLs in those jursidictions.

Abstract

We study the impact of credit risk determinants on the Romanian and Bulgarian banking systems using a structural Markov Regime-Switching vector autoregressive (MRSSVAR) analysis. To capture changes in the domestic macroeconomic conditions as well as the spillover effects from the Greek crisis we account for endogenous breaks in the mean and/or volatility dynamics. Our empirical results suggest that an increase of interest rate also increases the Romanian and Bulgarian credit risk in the short-run while in the medium and long-run it reduces it. We also find evidence of spillover effects from the Greek crisis on both the Romanian and Bulgarian banking system which, interestingly, are imminent in the low volatility regime.

Keywords: credit risk, structural VAR, breaks, Markov Regime Switching

Read the full study here.

The market for distressed debt will need to play a more prominent role in Europe’s emerging strategy to tackle the legacy of non-performing loans (NPLs). This market could speed up NPL resolution and allow greater flexibility in bank balance sheet management. Investors could contribute crucial skills and possibly capital to the process of workout and restructuring.

The loan sale process potentially suffers from a number of market imperfections which manifest themselves in high valuation gaps, and in the market failing to cover certain asset types.In Europe, turnover from distressed debt sales remains limited relative to the total stock of €870 billion in non-performing loans, and the additional stock of €1.1 trillion of so-called non-core banking assets, which banks also seek to divest in this market.

There has so far been little market demand for the bulk of unsecured assets among small and medium-sized companies and other corporate borrowers, loans held by smaller banks with their higher NPL ratios, or exposures to larger enterprises that could benefit from comprehensive debt restructuring and additional finance. Significant further supply might now come into the market as stricter supervisory guidelines are implemented, and as new accounting guidelines force higher provisioning levels. Improved national restructuring and insolvency regimes are beginning to attract a wider range of investors.

An initiative by EU finance ministers to improve transparency around loan quality and foster greater liquidity through transaction platforms might lower transaction-specific fixed costs somewhat. More decisive public support, for instance through asset management companies or in securitisation structures, might be needed. As a significant share of Europe’s banking assets might move into the hands of little-known investors, some of the benefits of relationship banking could be lost, and the conduct of the loan servicers will come into the focus of regulators.

Eight years after the start of Europe’s financial crisis, the legacy of non-performing loans and excessive private debt remains a key obstacle to the recovery of bank credit and investment. We argue that efforts to reduce and remove NPLs from the balance sheets of creditors must simultaneously remove excess debt from the balance sheets of debtors. This is the only way to ensure that bank balance sheets are restored to health sustainably, and that both supply and demand for new credit revive.

A comprehensive strategy to tackle legacy assets should include national debt reduction strategies that guide bank NPL reduction targets, strengthen frameworks for restructuring and insolvency, simplify the engagement of specialist investors within the capital markets union and, crucially, create a blueprint for national asset management companies. There is a need to strengthen policies in four key areas:

First and foremost, recapitalise banks to enable them to provision distressed loans adequately, and then actively participate in restructuring or writing off unviable loans.Second, encourage further legal reform that is also supported by adequate restructuring capacity within the banks and elsewhere in the private sector, including by attracting specialist investors.Third, create a tax regime and flexibility in revenue management that encourages the public sector to participate in debt restructuring.Finally, establish asset management companies that can overcome the various market failures in terms of removing distressed assets from banks’ balance sheets.

NPLs are concentrated in particular countries but are a problem for the entire euro-area banking system given the many financial and real spillovers across the currency area. There is a clear need for national reforms that create a more supportive environment for debt restructuring and deleveraging. But many policies will also need to be coordinated within the euro area, and possibly within the single EU capital market.

The paper presents an analysis of non-performing loans for banks in Central and Eastern Europe (CEE) based on the banks’ ownership structure. The paper starts with a general overview of non-performing loans, followed by an analysis of foreign-currency loans and the effects they have generated in the context of the economic crisis. The second part of the paper outlines the development of non-performing loans according to the ownership form of banks. Five countries from the CEE region were selected for this study, and from each country, we identified a state-owned bank and majority privately-owned bank. As key indicators for our study we chose the ratio of non-performing loans to total loans and the evolution of the banks’ profitability. Based on these indicators, the study highlights that privately-owned banks perform better than state-owned banks.

Using data on credit to nonfinancial firms in Italy between 2008 and 2015, the paper finds that credit supply from banks is not causally affected by the level of NPL ratios, but rather by changes in firms’ conditions and contractions in their demand for credit. However, the exogenous emergence of new NPLs and the associated increase in provisions can cause a negative adjustment in credit supply.

The causal relationship between Non-performing loans (NPLs) and GDP growth is the subject of much debate. While NPLs often arise from weak economic growth, NPLs resolution options include (i) economic growth (countries grow out of the problem) or (ii) active NPL resolution strategy, with the latter usually resulting in increased growth. Using data on 17 Italian regions over the period 1997–2014, this paper finds that in Italy, real GDP growth above 1.2 percent, if sustained for a number of years, is associated with a significant decline in the NPLs ratio. This suggests that Italy can achieve substantial decrease in NPLs by tackling long-standing structural rigidities to improve its growth prospects. But given the current modest growth outlook, active NPLs resolution measures are also needed.

Non-performing loans (NPLs) are a burden for both lender and borrower; they contract credit supply, distort allocation of credit, worsen market confidence and slow economic growth. So what is the best way to deal with them? This paper compares three different scenarios: actively reducing NPLs, waiting until fast growth of new loans renders the NPL problem obsolete, or doing nothing. We find that reducing NPLs has an unambiguously positive medium-term impact on the economy. And while countries that experience an influx of fresh credit grow the fastest, the economies that actively seek to resolve NPLs do comparably well. When the NPL problem is ignored, economic performance suffers.

Our findings are as follows:

• On average, the largest 100 financially distressed firms in six CESEE countries account for 8 percent of total value added and 6 percent of total employment.  In Bulgaria, Hungary and Serbia this concentration is such that the largest 10 debtors account for between 30 and 38 per cent of the debt overhang.
• Firms’ own financial distress is largely tolerated before the crisis, but became severely taxing for firm performance in the post-crisis period when banks tightened credit standards.
• In addition to this direct effect, firms’ performance is significantly affected by excessive debt of firms in other horizontally or vertically linked industries. There are substantial negative spillovers from overleveraged companies in the same industry as well as vertical debt spillover effects of the most indebted companies in vertically linked firms.
• Firms’ performance is more severely affected by poor financial health of suppliers, rather than customers. Most importantly, these effects are aggravated during the the financial crisis and are more severe for small and medium-sized firms.
• Firms that are severely distressed in terms of combination of poor revenue growth, low profitability and high net debt constitute a relatively small proportion of the number of firms (25 percent on average), however they accounted for a disproportionately large share of the total debt overhang (65 percent on average).

Institutional reforms focusing on debt-resolution frameworks and specifically targeting “systemically important” larger debtor companies may provide essential support to faster economic recovery in some of the debt-ridden CESEE countries. The findings of this research suggest that achieving a timely resolution of NPLs can have far more widespread effects than previously believed with SMEs as the main beneficiaries.

Studies whether relationship banks help firms in financial distress. Combining a new and direct measure of relationship lending with unique credit registry data, I examine the effect of relationship lending on ex-post loan performance. My findings demonstrate that the same firm is more likely to become temporary delinquent on a relationship-based loan relative to a transaction-based loan. Consistent with theory, relationship banks tolerate temporary bad results, yet extract rents in the long run, that is, they forgive but do not forget.

When firms are in distress, relationship banks adjust contract terms and allow drawdowns on credit lines and overdrafts but do not inefficiently roll over loans. Moreover, relationship banks are more likely to continue to lend to firms after past non-performance. Overall, the paper uncovers a new channel of how relationship lending serves as a liquidity insurance for firms in distress.

Preliminary version of the paper. The authors find a significant debt overhang effect that leads to sluggish investment in Europe. Firms with higher debt overhang invest less prior to the European crisis and this effect intensified during the crisis. In quantitative terms, the debt overhang channel has a bigger role in explaining weak investment relative to weak bank and weak firm balance sheet channels. Firms whose main bank is relatively weak do not necessarily show more debt overhang or more sluggish investment. Firms with weak balance sheets invest less both during regular times and crisis but this effect is smaller than that of the debt overhang. Using a pan-European firm-bank matched data set including small firms, they document that the worsening of debt overhang during the crisis can be linked to an increase in sovereign risk in Southern Europe: firms who entered the crisis with higher debt overhang decreased investment relatively more when their sovereign went under stress. They also show that, although during normal times short term debt has a positive association with investment, during the crisis period, this effect becomes less positive, due to an increase in rollover risk, which is positively associated with higher sovereign risk. Worsening debt overhang outside Southern Europe can be explained by general weak demand conditions. Overall, the results show the importance of sovereign risk and lower demand intensifying negative effect of debt overhang on investment via higher uncertainty and lower earnings respectively.

The paper studies the extent of corporate leverage and range of excessive debt of Slovenian firms during the recent financial crisis. Half of all firms (of those with some non-zero debt and at least one employee) are found to face an unsustainable debt-to-EBITDA leverage ratio beyond 4, accounting for almost 80 per cent of total outstanding debt. Moreover, a good quarter of all firms experience debt-to-EBITDA ratios exceeding 10 and hold almost half of total aggregate net debt. We then examine how this financial distress affects firm performance in terms of productivity, employment, exports, investment and survival. We find that, while less important during the good times (prerecession period), lack of firm financial soundness during the period of financial distress becomes a critical factor constraining firm performance. The extent of financial leverage and ability to service the outstanding debt are shown to inhibit firms’ productivity growth as well as the dynamics of exports, employment and investment. Micro and small firms are found to suffer relatively more than larger firms from high leverage in terms of export and employment performance during the recession period.

This article reviews the origin and spread of the distressed debt problem in the transition region. We argue that while the crisis was triggered abroad, the current high level of distressed debt in various transition countries mainly reflects home-grown vulnerabilities. As in the West, the root causes of the debt problem were abundant and cheap funding and a gradual relaxation of banks’ lending standards – in particular an excessive reliance on rising real estate values. We document a strong positive relationship between pre-crisis house price increases, house price collapses during the crisis and subsequent increases in non-performing loans (NPLs). Policy options to deal with distressed debt range from decentralised approaches in which banks restructure NPLs on a case-by-case basis to more centralised options, such as a “London approach”, bad banks, or asset management companies. Centralised options may be called for if case-by-case debt restructuring is suboptimal from a system-wide perspective because of negative externalities or capacity constraints in either the banking or the judicial system.