Bad loans at European banks hit $1.7 trillion

The trading room at Commerzbank in Frankfurt.
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Around 1.2 trillion euros ($1.7 trillion) of non-performing loans (NPLs) are parked on European banks' balance sheets, underscoring the ongoing malaise in peripheral European nations.

Despite investor optimism and upbeat growth data suggesting that is en route to economic recovery, banks' holdings of NPLs — defined by the European Central Bank (ECB) as loans on which no repayments have been made in the last 90 days — have increased by nearly 100 billion euros over the last year, according to professional services firm PwC. At the end of 2012, banks held 1.19 trillion euros in bad loans, up on 1.09 trillion euros in 2011.

The rise in NPLs has been driven largely by countries in struggling Southern Europe — mainly Italy, Spain and Greece — and Ireland.

(Read more: Greece's Piraeus Bank warns of rising bad loans)

European banks need a 'credible' stress test

The figures raise questions about the market impact, should Europe's new force banks to offload distressed assets. Last Wednesday, the ECB unveiled tough criteria for its stress tests of euro zone banks, designed to determine their ability to withstand adverse economic conditions or "stress". The region's 128 "systemically important" banks will undergo an assessment of their risky assets, the quality of their balance sheets and the amount of capital they hold.

Richard Thompson, the chairman of PwC's European portfolio advisory group, forecasted the volume of NPLs would continue rising for the next two years, driving the loan portfolio market, which will also be boosted by the ECB's prospective stress tests and the need to meet Basel III capital requirements.

"With an uncertain economic climate it is difficult to forecast any meaningful reduction in aggregate across Europe and indeed we believe that reported NPLs in many countries will continue to rise over the next couple of years, adding further impetus to the already buoyant loan portfolio market," said Thompson in PwC's biannual report on European NPLs.

(Read more: ECB bank tests may cause 'surprises and deleveraging')

Delivering alpha on distressed debt

He added that PwC already knew of over 150 different investor groups taking a "close interest" in the European NPL market, including major U.S. funds, sovereign wealth funds and far eastern investors.

"We are seeing extremely high levels of competition in the market at the moment… As the banks try to position themselves to meet the Basel III capital requirements and react to the ECB's stress tests following the Asset Quality Review, we expect more assets to come to market in 2014 and beyond," Thompson said.

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PwC's rival EY (Ernst & Young) noted in its annual NPL investor report that European distressed debt opportunities were increasingly tempting investors away from the

"European banks have increasingly begun to reduce their exposure to NPLs via portfolio sales. Consequently, global NPL investors are turning their attention to Europe, and for good reason. An estimated 1 trillion euros of NPLs are sitting on the balance sheets of the region's banks, far surpassing the magnitude of distress in the U.S.," said EY partners Howard Roth and Christopher Seyarth in the report.

Roth and Seyarth said investors viewed the , Ireland, Germany and Spain as the markets with the most prospects.

"By far, Europe represents the biggest opportunity worldwide," said Lee Millstein, head of European and Asian distressed and real estate investments at Cerberus Capital Management, quoted in EY's report.

—By CNBC's Katy Barnato