Europe | Non-performing Loans
Resolving poor corporate governance and NPLs There is a cosy link between poor corporate governance and non-performing loans, which is sinking profits and capital at European banks The existing stock of non-performing loans (NPLs) in Europe – estimated at more than €1trillion – remains a serious concern for European regulators and national authorities. NPLs impact banks’ profitability, divert banks’ resources from ordinary lending activities and reduce new lending into the economy. This ultimately holds back the country’s potential for growth and, in high NPL countries, can even pose a threat to the stability of the financial system as a whole.
The roots of the NPL crisis are largely derived from the economic and financial crisis – i.e. retail and corporate borrowers in dire straits because of the crisis – but in some cases or jurisdictions the high level of NPLs might have been exacerbated by poor corporate governance practices in banks, including the (lack of) oversight capacity of boards. The link between poor corporate governance and high NPL ratio has not yet been clearly demonstrated, but there are undoubtedly a number of factors suggesting a strong causal relationship.
Kissing shares
Some illuminating stories are now starting to appear in the media. Take Veneto Banca and Banca Popolare di Vicenza, both Italian unlisted mutual banks with a very high NPL ratio, as case studies. These banks received media attention because of a practice nicknamed ‘kissing shares’ – borrowers were granted loans that otherwise would not have been granted or would be granted on less favourable terms under the condition that they would buy shares in the banks. In this way, both banks were simultaneously expanding their capitalisation, shareholding base and their loan portfolio, which allowed ‘extravagant remuneration for directors and sweet financing deals for some on the board’.1 56 Ethical Boardroom | Summer 2017
Gian Piero Cigna, Milot Ahma & Pavle Djurić
Gian Piero is Associate Director, Senior Counsel, Milot is an Associate and Pavle is Counsel at the European Bank for Reconstruction and Development Because the banks were not listed, the price of their shares was determined on an annual basis by management, endorsed by the board, validated by auditors and submitted for approval to the shareholders’ meeting, including those shareholders that took the loans, all happy to see the share price increasing.2 Shares prices were calculated at 1.5 times the banks’ net assets, while other banks were usually pricing their shares at 0.5 times. In the course of five years, shareholders' equity halved and the net-NPLs/shareholders’ equity ratio rocketed. Few questions were asked on the sustainability and soundness of the lending practices associated with the kissing shares until it was too late. At Veneto Banca, the numbers tell the story. In 2011, it made a profit of €160million. In June 2012, it had 54,000 shareholders. But its losses began to mount – and so did the number of shareholders. In 2014, Veneto Banca had 88,000 shareholders
The shift in board composition away from insiders towards independent directors has been one of the most important developments in international corporate governance over the past few decades and made €2.4billion of new loans. It also made a €650million loss for the year, the worst in its history. 3 In 2016, the share prices of both banks crashed to 10 Euro cents from their highest value of €62.50 and €40.75 a few years before. Is there a ‘corporate governance story’ behind all this? Well, clearly kissing shares practices were not sustainable and the lesson that can be learned from it is not
much different from what was learned in the aftermath of the financial crisis.4 In particular, we could argue that not enough attention was paid to the oversight of credit risk, including the creditworthiness of borrowers and the value (and depreciation) of collaterals. Banking is an inherently risky business and ensuring a sound risk management system within banks is a key board responsibility. However, this now universally accepted truth became apparent only after the financial crisis. As a matter of example, in the 2006 Basel Committee’s eight principles for good corporate governance of banks – the key benchmark for corporate governance of banks at that time – the word ‘risk’ does not appear at all. 5 In Europe, only in 2013 did the Capital Requirements Directive IV (so-called CRD IV) provide for the first time some mandatory regulation of different governance aspects for banks, including the need for independent and qualified directors on the board and its committees. For many European banks, this came too late.6
Lessons to be learned
So, taking inspiration from the story above, we asked ourselves if there are any corporate governance lessons that can be drawn. To answer the question, we looked at the disclosure offered by those two Italian banks mentioned above. On paper, both banks appear to have sound governance in place with various committees, clearly articulated ‘lines of defence’ and charters requiring boards to be staffed with independent directors.7 However, there are a number of unanswered questions as to who was sitting in these committees, whether those sitting at the board – in both banks pretty much ‘male, pale and stale’ – and in the committees had the right mix of skills to direct the banks and keep management accountable. And, last but not least, who the ‘independent’ directors were. These are key questions, as those www.ethicalboardroom.com
