EU Commission and Reduction of Non Performing Loans: consumer protection in danger

On the 18 January 2018, the European Commission published a progress report on the reduction of non-performing loans (NPL).

As background to that report,  it is worth reading a recent article in Harvard Politics, which gives an attractive overview of some of the issues that seem to guide Commission thinking:

Stagnant Waters: Non-Performing Loans and Challenges to European Banking

There needs to be an EU wide approach because EU banking systems are interdependent. However there is reluctance on the part of Member States where the overhang of NPL is small and manageable ( at a macro – level ) to get involved in sponsoring solutions to problems which are not their own. Moreover different legal systems and the varying efficiency of national legal systems greatly complicates any search for universal remedies. Hence the emphasis on issuing policy guidance specific to individual Member States.

Another layer of complication comes with the need to respect EU wide state aid rules, and because of the fragile state of some Member States’ fiscal balances.

There is a clear political orientation that even in the most acute situations, the taxpayer should not, in future, be further burdened by directly recapitalizing banks or by being liable for guarantees made to Asset Management Companies which take over the management of NPL from banks in difficulty.

Hence the search for solutions in private markets. Of course, a bank could recapitalize, and write-off the NPL on its balance sheet, by offering new equity and diluting existing equity – but frequently that is no solution, for example because of the impact on small savers and their pensions, or simply because the market has no confidence in the financial viability of the bank in question. Alternatively, another bank might buy the bank in difficulty, and make manageable the NPL in a much bigger balance sheet. But this may raise other issues of an excessive concentration in a national market of a small number of financial service providers.

Reflecting its desire to defend the unity of the eurozone and the Banking Union, and to make more feasible in practice solutions that do not involve the taxpayer, the European Commission is proposing a number of EU-wide actions to develop active, EU-wide secondary markets that can take NPL off the balance sheet of banks in difficulty, or improve their capacity to re-finance their balance sheet at reasonable cost, and in other words, facilitate private risk sharing across borders.

It is in this context that ideas such as Accelerated Extrajudicial Collateral Enforcement (AECE) to expedite out of court enforcement mechanisms that reinforce the protection of creditors, are on the table. Also measures to encourage EU wide markets in Special Purpose Vehicles (SPV) to securitize NPL, which could be attractive to private investors. But both of these ideas raise major concerns: AECE because of the absence of any assurance that the legitimate interests of indebted households in particular will be given proper weight in relation to those of creditors, SPV because of the memory of the 2008 crash caused by what Warren Buffet famously dubbed “financial weapons of mass destruction” – can it be believed that adequate regulatory controls are now in place?

Here is an idea which might be worth exploring further – that promoting AECE should go hand in hand with requiring a fiduciary duty for its managers to act in the interests of the indebted household when resolving NPL. In Ireland for example, the indebted citizen has a right to access independent financial advice and support, and to continue to live in their own home, whose ownership may be taken into the public sector’s stock of public housing and rented back. It could be a fiduciary duty of the managers of an AECE process to ensure that measures such as these are in place and effectively deployed. This could be a first step towards a wider application of this principle to financial transactions involving ordinary citizens (see below).

  1. Revisiting the notion of fiduciary duty.

 Writing about ethical and sustainable finance and the European Financial Reform Agenda in the December 2017 newsletter, the need to “reconnect finance with society” was mentioned in conclusion. But how?

A doctor has a professional obligation to do no harm – to act in the best interest of his patient. Along with the institution for which he works, he can be personally liable for malpractice. Similarly a lawyer must act in the best interest of his client, and engineers and architects have to respect safety standards and may even be liable for charges of manslaughter if they do not.

And professionals in Finance – what about them? Are they obliged to respect a professional code and is it fit for purpose?

One thing is to make money from money – or in other words, to do deals between professionals who should be equipped to understand the risks as well as the opportunities of the transactions they freely agree to make. It is a more delicate affair to make money from non-professionals, especially people who are ill-informed, badly advised, and almost always in a weak bargaining position.

For example, it is clearly wrong to knowingly mis-sell a product which is useless to the purchaser or which can be reasonably expected to contribute in a significant way to creating an unsustainable burden of debt. It is equally unacceptable to base the profitability of a business model on the expected returns from penalties imposed as a result of anticipated high rates of debtor default. But if the regulator has to chase after each “innovative” way of extracting value from the unsophisticated as and when it emerges, all too often, its intervention is too little, too late.

Fundamentally, at present, the issue is that the relationship between a provider and a user of financial services is generally seen as being purely contractual. The provider and the user freely enter into this contractual relationship, which must then be upheld in law. But maybe there is a good argument for replacing a contractual relationship certainly for non-professional users of financial products, with a fiduciary – or good stewardship – relationship.

Just imagine a world where a financial advisor/broker for financial products and loans marketed to non-professionals is legally obliged to be a member of a regulated profession, like a lawyer for example, and to act in line with a fiduciary duty (see below for a definition), or risk being excluded from such activities, or even penalized for malpractice. A world in which licensed financial intermediaries are easily and transparently accessible, at low cost, to all. Even, perhaps a step too far, a world in which the direct marketing to final users of financial products, including credit cards, is not permitted, but must be done through this licensed profession of intermediaries, like access to prescription drugs.

Set in this context, it is interesting to note that, in parallel to the European Financial Reform Agenda, and certainly also, a source of inspiration for its work, there is a review of “Fiduciary Duty in the 21st Century” being carried out under UN auspices. An interim report can be found on this link: click her

Here is the definition in that report of fiduciary duty:

“What is Fiduciary Duty?

Fiduciary duties (or equivalent obligations) exist to ensure that those who manage other people’s money act in the interests of beneficiaries, rather than serving their own interests. The most important of these duties are:

  • Loyalty: Fiduciaries should act in good faith in the interests of their beneficiaries”, ……., “should avoid conflicts of interest and should not act for the benefit of themselves or a third party.
  • Prudence: Fiduciaries should act with due care, skill and diligence”, …… “as an ‘ordinary prudent person would do. “

The intention is to look to strengthening definitions like this in law, and making them more widely and fully applicable to financial dealings. There are specific recommendations in the UN report directed to the European Union, the UK and Germany as well as to other nations including the USA. While the accent is currently on deploying a revised legal concept of fiduciary duty to lever long term, environmentally sustainable investment rather than simply seeking short-term shareholder value, there is also mention of social sustainability, but in that second respect, everything is still to be done to build practical content.

Robert Shotton