By Balazs Koranyi and Francesco Canepa
FRANKFURT (Reuters) - The European Central Bank is planning to give euro zone banks non-binding guidance by the end of 2016 or early 2017 to cut their bad debt pile, raising the heat on lenders but not forcing their hand, sources said.
The ECB, which supervises 129 of the biggest banks in the euro zone, will eventually set confidential quantitative and qualitative targets but not all will necessarily come in writing, the sources told Reuters.
This would give banks some flexibility and suggests that the ECB will at least initially rely heavily on persuasion.
Weighed down by around 900 billion euros ($1 trillion) of bad debt, banks have delayed fixing this legacy of Europe's debt crisis, worried that write-offs would lead to losses, limiting dividends and also executive pay.
Regulators are keen to give banks a push, however, as a huge stock of bad loans depresses bank valuation, increases funding costs and ultimately holds back economic growth, countering the very stimulus the ECB's monetary policy arm is trying to provide.
Indeed, the ECB estimates 7.1 percent of euro zone bank loans were not performing at the end of last year, nearly five times the level in the United States. Italy and Greece are among the top laggards.
The focus on tailor-made non-binding guidance in the ECB's first exercise focused on bad debt suggests that the supervisor will avoid any heavy handed steps, easing concerns that banks would have to quickly sell off bad debt but potentially prolonging Europe's bad debt epidemic.
Another source added that no decision has been made so the ECB's thinking could still evolve, particularly regarding the timeline. The ECB declined to comment for this article.
The sources said that banks not complying could see the guidance firmed up in a regular regulatory review, possibly feeding into their capital requirements.
"Some banks just sit on bad loans and hope for better times," a source with direct knowledge of the ECB's deliberations said. "Bad loans just sitting on the books need to be written off or banks will have to increase provisions to maybe 50 or 70 percent."
Italy's UniCredit <CRDI.MI> has nearly 80 billion euros of non-performing loans, 15 percent of its loan book, while Intesa Sanpaolo <ISP.MI> had 33 billion euros at the end of the first quarter. Greek banks are meanwhile sitting on around a 100 billion euros of bad debt.
Analysts warned that a rapid sale or write down would require many banks to raise capital since provision levels are just over 40 percent on average and current market pricing of such debt would result in losses.
Supervisors, though keen to move fast, accept that the legal framework is still patchy with big variations in insolvency, foreclosure and tax regulations among euro zone members.
Regulators also recognize that even as quick write offs would heal lenders quicker, the unavoidable one off shock would counter the ECB's monetary policy aim of boosting lending to lift growth and inflation, a potential source of conflict between two separate arms of the bank.
"There is a market globally for NPLs," another source said. "But it is not a liquid market because it depends heavily on national legislation, like how quickly the collateral can be regulated, or how quickly the NPLs can be sold, how one can approve the covenants, etc."
Though some banks may be given timelines and provisioning target levels, the sources played down the significance of these numerical targets, arguing that aim is to get banks to become more transparent and active in dealing with bad debt.
The ECB will ask banks to set up processes to deal with bad loans with executive or board level oversight, and the new rules will treat differently bad loans on the books for years than recently soured debt.
Banks will be measured on how much collateral they have repriced, for instance to reflect worse economic conditions, and how many corporate borrowers they have reassessed to estimate their chances of repaying their loan, another source said.
Information will also be demanded about whether the banks have exercised forbearance -- an agreement with a borrower to delay a foreclosure -- and for how long.
The supervisor will also ask how many loans banks have re-classified, for example from being performing to non-performing, and on how many they have taken action to recover the money.
(Additional reporting by Mark Bendeich Editing by Jeremy Gaunt)