Executive Summary

Non-performing loans (NPLs) in the Eurozone rose markedly between 2009 and 2015 due largely to weak economic growth that permeated euro area economies during those years. The NPL ratio has receded over the past two years, but it remains elevated at nearly 5 percent. Could a NPL crisis in the Eurozone derail the expansion that is underway in the global economy?

Greece and Cyprus have truly extraordinary NPL ratios at present, but the relatively small size of their banking systems means that those economies probably do not represent much of a systemic risk to the overall financial system in the Eurozone. In our view, Italy represents the most serious systemic risk to the European financial system given the high absolute amount of NPLs that infect the Italian banking system. But unless the Italian economy falls back into recession, which we do not anticipate, a NPL crisis in Italy does not appear to be imminent. If the Italian banking system needs to be recapitalized, should that eventuality occur, the Italian government could call upon the financial resources of the European Stability Mechanism to lend support.

NPLs in the Eurozone Are Receding Although They Remain Elevated

We recently wrote two reports in which we looked at debt issues in developing economies.1 We generally concluded that although the recent buildup in debt in the developing world probably would not cause a global financial crisis in the foreseeable future, debt developments in those economies bear watching going forward. But emerging markets are not the only economies that potentially could have debt servicing issues in coming years. Specifically, debt has risen in the euro area as well. Could European banks, where much of this debt is held, experience financial difficulties in the not-too-distant future?

In that regard, the NPL ratio among banks in the overall euro area rose sharply between 2009 and 2015 (Figure 1). Although the NPL ratio has receded over the past two years, it remains elevated at roughly 5 percent. NPL ratios in 18 of the 19 individual Eurozone economies are shown in Figure 2.2 Greece, where nominal GDP is nearly 30 percent below its 2008 peak, leads the pack with a NPL ratio in excess of 45 percent while Cyprus, where GDP has yet to regain its previous peak as well, is a close second at 38 percent. Rounding out the top five countries with the highest NPL ratios at present are Portugal (19 percent), Ireland (16 percent) and Italy (15 percent). Each of these economies suffered deep recessions in the immediate aftermath of the global financial crisis and in the depths of the European sovereign debt crisis in 2011-2013. Weak economic growth usually is associated with deterioration in loan quality.


Clearly, the banking systems in Greece and Cyprus have some issues in terms of their elevated NPL ratios. But the Greek and Cypriot banking systems are fairly small and likely do not pose much of a systemic risk to the overall European banking system. The outstanding amount of NPLs in Greece total about €85 billion, which is a manageable amount from a European-wide perspective, while Cyprus has less than €15 billion worth of NPLs (Figure 3). The Eurozone economy with the highest absolute amount of NPLs is Italy (more than €250 billion), followed by France (€150 billion), Spain (more than €125 billion) and Germany (more than €100 billion). These are the individual banking systems that would pose the largest systemic risks to the overall European banking system.


Italy: The "Problem Child" in Terms of European NPLs

We are not overly concerned about the German banking system. The overall NPL ratio in Germany is low at only 2.7 percent, and the German economy is strong at present with the yearover- year rate of nominal GDP growth closing in on 4 percent. A full-blown NPL crisis in Germany does not appear likely anytime soon. With €150 billion worth of NPLs and a ratio of 3.7 percent, France represents more of a potential systemic risk to the overall European banking system than Germany. That said, the French economy has accelerated recently with nominal GDP growth rising to a 6-year high of 2.7 percent in Q2-2017. As long as economic growth in France remains solid, the French banking system likely will not face a NPL crisis, at least not in the near term.

Spain appears to be more problematic than either Germany or France with a NPL ratio of nearly 6 percent at present. Although the outstanding amount of NPLs in Spain has slowly receded over the past two years, it still exceeds €125 billion today (Figure 4). However, Spain is among the fastest growing economies in the Eurozone at present with nominal GDP growth in excess of 4 percent. As long as Spanish economic growth remains robust, both the level of NPLs and the ratio in Spain should recede further.

In our view, Italy clearly is the real "problem child" in terms of NPL issues. Not only does the Italian banking system have the highest absolute level of NPLs (more than €250 billion), but its NPL ratio is elevated at 15 percent. Furthermore, nominal GDP growth in Italy is lackluster at present at less than 1 percent. Although base effects may have depressed the year-over-year rate of growth in Q1-2017, nominal GDP in Italy has not grown in excess of 2 percent on a sustained basis since prior to the global financial crisis.

As shown in Figure 4, the outstanding amount of NPLs in Italy has receded since their peak in 2015, but progress has been slow. Nominal GDP in Italy should accelerate somewhat in coming years. The IMF looks for 2.0 percent growth in 2018 and 2.2 percent in 2019, and these growth rates should be buoyant enough to prevent a rise in the outstanding amount of NPLs in Italy. But a sharp reduction in the NPL ratio likely will not occur unless nominal GDP growth in Italy strengthens significantly, which does not seem to be very likely. In other words, the Italian banking system may remain vulnerable to a potential NPL crisis for the foreseeable future.

Lines of Defense Against a NPL Crisis

So what would happen if the Italian economy were to stall or go into reverse, thereby causing NPLs to rise anew? The reserves of the Italian banking system would form the first line of defense. At the end of 2016, Italian banks had laid away roughly €125 billion worth of loan loss reserves that they could use to write off NPLs. However, employing their total stock of loan loss reserves would leave Italian banks in a much weakened financial position. The Tier 1 capital ratio of the entire Italian banking system is only 11.4 percent, well below the 14.7 percent ratio for the banking system in the overall euro area. Consequently, some Italian banks may need to be recapitalized if they were to encounter more financial difficulties.

In 2016, the Italian government helped to set up a private equity fund known as Atlante to assist in the recapitalization of Italian banks. However, the Atlante fund has only €4 billion or so of equity capital, so it would be insufficient for a complete recapitalization of the Italian banking system. The larger backstop would be found in the European Stability Mechanism (ESM), the organization set up by the European Union at the height of the European sovereign debt crisis in 2012 to provide financial assistance to countries in the euro area. Not only can the ESM provide direct financial assistance to governments, as it has done for Greece, Cyprus, Portugal and Ireland, but it can also be called upon to help governments recapitalize banks, as it did in Spain. The ESM currently has a disbursement of €87 billion, giving it a forward lending capacity of €376 billion. If needed, Italy could tap the ESM to recapitalize its banking system.

Of course, a NPL crisis in Italy, should one occur, would likely lead to financial market volatility not only in Italy but probably across Europe. Growth rates in other large European economies, such as in France and Spain, could weaken, which could lead to a rise in NPLs in those countries. The lending capacity of the ESM could be tested in the event of another recession in the Eurozone.


The NPL ratio in the Eurozone rose markedly between 2009 and 2015 due largely to the economic weakness that pervaded the euro area during those years. It has receded over the past two years, but generally remains elevated near 5 percent. Countries such as Greece and Cyprus have extraordinarily high ratios, but the relatively small size of those banking systems mean that they probably pose little systemic risk to the overall European banking system. In our view, Italy represents the most serious systemic risk to the European financial system given the high absolute amount of NPLs (about €250 billion) that infects the Italian banking system.

That said, we do not think a NPL crisis in Italy is imminent. Italian NPLs have been slowly trending lower, and economic growth in Italy appears to be firming. Renewed recession in Italy, which we do not anticipate at this time, seems to be the most likely catalyst for a NPL crisis in Italy. Although the capital needs of the Italian banking system could be significant in the event that the economy slipped back into recession again, the Italian government could call upon the financial backstop of the ESM to help recapitalize its banking system. The Italian banking system may be weak at present, but it likely will not trigger another global recession, at least not in the foreseeable future.

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Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. Customers should be aware that market orders for these new public companies are executed at the current market price, not the initial offering price. Market orders are executed fully and promptly, without regard to price and in a fast market this may result in an execution significantly different from the current price quoted for that security. Using a limit order can limit your risk of receiving an unexpected execution price. Large Orders in Fast Markets Large orders are often filled in smaller blocks. An order for 10,000 shares will sometimes be executed in two blocks of 5,000 shares each. In a fast market, when you place an order for 10,000 shares and the real-time market quote indicates there are 15,000 shares at 5, you would expect your order to execute at 5. In a fast market, with a backlog of orders, a real-time quote may not reflect the state of the market at the time your order is received by the market maker or specialist. Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. Although this article may provide information relating to approaches to investing or types of securities and investments you might buy or sell, Wells Fargo and its affiliates are not providing investment recommendations, advice, or endorsements. Data have been obtained from what are considered to be reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Wells Fargo makes no warranties and bears no liability for your use of this information. The information made available to you is not intended, and should not be construed as legal, tax, or investment advice, or a legal opinion.

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