2022 Perspectives for the Public Sector

38 Despite such welcome news, NPLs are still certain to rise in the coming months. Those loan moratoria programs still operating are scheduled to finish before the end of 2021. Various employment protection schemes and central bank liquidity support measures are due to unwind at the same time. As they do, NPLs are expected to rise towards the end of 2021 and into 2022. The outlook is likely to offer a stark contrast to the pre-pandemic situation, when NPLs were in steady decline. How will banks cope? The pandemic cut many banks’ profitability to record lows; those that entered the crisis with the highest profitability and hence capitalization are unsurprisingly fairing best. In Latin America, strong capital buffers combined with a multi-pronged policy response to support economic activity, ease financial conditions, and sustain credit intermediation have enabled banks to cope with the immediate effects of the shock. An IMF solvency stress test of a sample of 61 major banks in Brazil, Chile, Colombia, Mexico, Peru, and Uruguay shows that under the World Economic Outlook baseline scenario for 2021, bank capital ratios would decline but remain above regulatory minima. Similarly in APAC, loans under relief have declined from 2020 peaks after some moratoria ended (except in Indonesia and Vietnam where broad repayment holidays were not instituted and loans were restructured at banks’ discretion). Loan loss coverage improved year- on-year in 2021, as banks ramped up provisions before NPLs increased; the Philippines was an exception as impairments manifested sooner and more significantly. ASEAN economies are recovering at an uneven pace, with prolonged restrictions and delayed reopening likely to keep credit costs high. Meanwhile in Europe, declining profitability in 2020 has resulted in a gradual deterioration in borrowers’ creditworthiness which could feed through to increases in impaired loans in 2H21 and into 2022. Performance of loans under moratoria in Western Europe has been fairly robust to date, with just 2%-5% of loans exiting moratoria becoming past-due. There is limited downside risk on state-guaranteed loans, which has led to an expectation that cumulative default rates on these loans will average 5%- 10%: stronger countries such as France are expected to be at the low end of this range with Portuguese banks towards the upper end. According to the European Central Bank, we can expect €1.4 trillion of NPLs on SME loans as a result of COVID-19. Added to the €0.5 trillion of NPLs before COVID-19, a total of nearly €2 trillion is likely. Given that the maximum level of NPLs held following the Global Financial Crisis was just shy of €1 trillion, total NPLs after the pandemic could be more than double the NPLs during the previous financial crisis. There was a clear discrepancy between the peak of corporate default rates in 2009 and the NPL peak in 2013. This indicates that NPLs are highly correlated with the unemployment rate and inversely correlated with credit growth. We can use these two distinct indicators to monitor and predict the rise in NPLs in the coming years. How to address the NPL challenge Historically, in order to ring fence exposures created by NPLs and restore confidence in the financial system, many governments have created so-called ‘bad banks’. In setting up these institutions, governments seek to achieve three key objectives: cleaning up their balance sheets, protecting their P&L (especially maximizing the value from NPLs) and detaching management responsibility for losses. For instance, the Italian state-owned asset management company AMCO manages and purchases Italian non-performing exposures, consisting of bad loans (sofferenze) and Unlikely to Pay (UTPs). AMCO increased its assets under management by 46% in 2020, taking over more than €8 billion of Banca Monte dei Paschi di Siena’s bad loans. The Italian government guaranteed almost €150 billion of bank loans to SMEs through a fund managed by Mediocredito Centrale, a state development bank. The government is likely to turn to AMCO to manage these government-backed loans, allowing companies struggling to keep up with loan repayments to receive new financing, and therefore reducing bankruptcies. Governments Must Act to Prevent NPLs Derailing the Recovery