Resolving the issue of NPLs

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

Gian Piero Cigna, Milot Ahma & Pavle Djuri´c

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 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

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

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

people were supposed to ensure the soundness of the banking practices and operations, including the sustainability of the business. Having an appropriate number of qualified and independent directors was especially important in these banks as they both had an executive board chair and a substantial presence of executive committee members in the board.8

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. Indeed, we could not find a single corporate governance code in the world that does not emphasise the need for independent directors on the board. However, independence must be coupled with proper qualification to be meaningful – how can somebody be objective if he/she does not understand what they are talking about? It's a correlation that has been historically largely ignored.

Introduction of requirements

The CRD IV was the first mandatory European act that emphasised the need for diversified boards in banks so to avoid ‘group thinking’. The same directive required members of the audit and risk committees to be non-executives and ‘have the knowledge, skills and expertise required for the committees’. This requirement was then complemented by the new wording of the audit directive, which now requires the audit committee to be made up by a majority of independent directors and that the ‘committee members as a whole have competence relevant to the sector in which the audited entity is operating’ with ‘at least one member to have competence in accounting and/or auditing’.

The CRD IV also makes a specific reference to integrity and ‘independence of mind’ that all board members should possess, another important cornerstone of the reform. Thanks to the supervisory work by the European Central Bank (ECB) over banks in the Euro area, this is now becoming a standard, but it is still largely overlooked: by looking at the definition of independence in most legislation and corporate governance codes, what is generally meant as ‘independence’ is largely confused with ‘non-affiliation’.

This is misleading as the two concepts are profoundly different. While ‘non-affiliation’ can be defined in negative terms only (e.g. not being an employee of the company or not having a material business relationship with the company, etc), independence is a positive characteristic – the ‘objectivity of mind’ – which should be demonstrated and explained in practice – hence the need for proper disclosure. In practical terms, this translates to the ‘challenging attitude’ that all board members – and especially independent directors – must have. The same attitude that could have saved many banks from entering into toxic practices. The same attitude that external auditors must have and that can be undermined if the auditor becomes too entrenched with the institution being audited.

As a matter of fact, it appears that in both banks the same audit firms performed statutory audits for many years while also providing other non-auditing services in the same period.

Challenging auditors

It is not our intention – and we do not have any grounds – to provide any allegation of auditors’ misconduct, but it has been often argued that auditors that have become too close to the company or that have over-relied on income from a single source might have their objectivity challenged and independence compromised. In fact, in 2014 new European legislation entered into force to restrict the non-audit services that auditors can provide to EU public interest entities, which include banks. The same directive requires public-interest entities to have an audit committee, in charge – among others – to ‘review and monitor the independence of the statutory auditors or the audit firms… and in particular the appropriateness of the provision of non-audit services to the audited entity’.

SINKING PROFITS

Non-performing loans remain a serious comcern in Europe

In the two banks, the audit committee – which in Italy is called the ‘collegio sindacale’ – is composed of non-board members only. This is a common practice in a number of countries, but we are not convinced this is the right solution, especially when the functions delegated to the committee are typical board functions. We think instead that it is essential that audit committee members who are recommending specific actions to the board are then able to follow up on them when they are discussed and voted at the board. This would reinforce their positions and the board’s ‘objective judgement’ – to the extent that, of course, those sitting in the audit committee are truly independent and qualified board members. It's worth noting that there is no mention of qualification and independence of those sitting at the board and at the collegio sindacale in the annual report of either bank.

Further, we believe that committees’ members should have a thorough understanding of the bank’s business when performing their duties, while ‘outsiders’ – as they do not sit at the board – might only have a partial vision and understanding of the bank’s activities. While it is legitimate that committees might need external advice or expertise on specific issues, they should be able to request such advice but without allowing outsiders to take the place of board members in their determinations.

Finally, committees that include outsiders might have confidentiality and accountability issues, since outsiders might not be bound by the same duties of loyalty and care required to be board members. In some countries where this practice is allowed, audit committee members are accountable to the board but only on a contractual, not fiduciary basis. This might create perverse incentives. In other countries – as we believe it is the case in Italy - the accountability of the audit committee is directly to the shareholders. Interestingly, in Italy ‘foundations’ are major shareholders in banks9 and foundations are subject to political influence.10

Similar characteristics can be found in the Spanish cajas, which accounted for a vast majority of NPLs in Spain. Some authors suggest that in state-owned banks, the public authorities could have influenced their lending decisions towards excessive risks relative to expected returns.11 A recent study found that cajas whose chairmen were previously political appointees had significantly worse governance issues are being tackled and improvements are visible in the most recent banks’ disclosures. In Slovenia, the largest bank in the country is planning to go public during 2017 and this should also help to improve its governance. The ECB – through the Single Supervisory Mechanism – working closely with the national supervisory authorities, is leading the supervision of systemically important banks in the Eurozone. The ECB has also recently published the new Guidance to Banks on NPLs, which includes some important corporate governance elements.14 A major development, one of the ECB key priorities of 2017, that it is expected to enter into force in January 2018, is the introduction of a new IFRS 9, which should help tackling the delayed recognition of credit losses associated with loans and contribute to a better assessment and disclosure of banks’ credit portfolio quality.15

However, most of the corporate governance reform seems to stay within the European Union. Outside the EU, efforts seem mostly dedicated to NPLs workout strategies while little attention is focussed on governance of banks. A recent review of the disclosure by some banks affected by high NPL ratio in countries neighbouring the EU, reveals that the issues mentioned above are still present. Information about the qualifications and independence of board members is vague or non-existent, audit committees are staffed with outsiders and the role of the banking regulator in overseeing governance of banks is still limited to a quantitative approach, not appropriate to oversee governance practices. Clearly a lesson not yet learned.

The opinions expressed are of the authors only and do not necessarily reflect the views of the European Bank for Reconstruction and Development (EBRD).

Outside the EU, efforts seem mostly dedicated to NPLs workout strategies while little attention is focussed on governance of banks

loan performance.12 This toxic relationship seems also confirmed by a recent OECD study on Sloveniawhich points out that ‘the bust has not affected all banks equally.13 The quality of the loan portfolio has deteriorated the most for large state-controlled banks.... For these banks, the ratio of NPLs to private corporations increased from two per cent in 2007 to 30 per cent in October 2012. In comparison, the corresponding ratio for foreign banks amounted to 11 per cent and for small domestic banks to 23 per cent. This suggests that the increase in bad loans of state-controlled banks is not driven just by the business cycle’.

Reform progress inches forward

The good news is that substantial reforms are currently ongoing. Cajas in Spain and banche popolari in Italy are being restructured – even if in Italy the reform is moving slowly – and

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REFORM PROGRESS

Governance issues are being tackled