Defaulted loans are an inherent component of any lending activity. Banks include a predetermined default rate in their credit origination processes and price their credits accordingly. Loan losses generally encompass non-performing loans (NPLs), insolvency proceedings and debts with valid repayment plans, where customers’ payments fail to meet the contractual terms.
Once a loan is classified as ‘non-performing’, the probability that it will be repaid in full is substantially lower than a loan that is ‘performing’; as a result, debt purchasers can acquire NPL portfolios at a significant discount to the nominal value.
Disciplined investors know how to value an underperforming asset and can assess the cost and the possibility of recovering any value from that asset. Banks, on the other hand, often have a different view of the value of their loan portfolios, and this disconnect has hampered NPL divestments. Slow procedures and structural inefficiencies in debt recovery have also contributed to limiting the transaction market.
Since the European banks and financial institutions have nearly SEK 10,000 billion in underperforming loans on their balance sheets, this has become an increasingly pressing issue for them. The average Euro area NPL ratio has declined gradually from 8% in 2013, to 6% in 2017. Six countries still had NPL ratios of more than 10%, and some with significantly more in certain cases. With over-indebtedness among households and SMEs, banks are restricting credit and SMEs are avoiding necessary investments, which in turn hampers economic growth.
Regulations and accounting
The challenge with high NPL ratios and their inhibitive effects on economic growth has concerned authorities in Europe. As a result, the European Central Bank has proposed new, tough, provisioning standards for bad loans in 2017. Lenders will have to start making provisions against potential losses on unsecured underperforming loans and, after two years, make provisions against the full expected loss. The corresponding period for claims on secured loans that have defaulted will be 7 years. The exact design of any new requirements will be discussed further in the EU and tangible guidelines are expected in 2018.
By 2017, European banks had provisioned on average 45% of the nominal loan amount in all asset classes in their loan portfolios. It is expected that moving to 100% could lead to higher provision levels and significantly increased NPL sales over time.
The accounting standard is changing this year with the transition from IAS 39 to IFRS 9, which is expected to impact the market. To be able to predict credit losses at an earlier stage, new accounting standards have been introduced which encompass new principles for the classification and measurement of financial assets. The company’s reason for holding the asset (the business model) together with the contractual cash flows of the financial instruments – determine the basis for measurement.
Changed principles for provisions and for impairment of credit losses are also introduced, which apply a forward-looking approach. This means that the previous model based on incurred credit losses is replaced by a model based on expected credit losses. The impairment rules under IFRS 9 build on a three-stage model whereby the accounting reflects the credit risk.
Around 40% of the banks’ underperforming loans were managed by specialised companies in 2017. This share is expected to gradually increase to 60% by 2021. Independent servicers managed around SEK 1,350–1,550 billion of underperforming loans owned by banks, other financial institutions and investors. Total assets under management are expected to grow, reaching around SEK 2,000 billion in the next three years, according to PwC estimates in 2017.
Banks are divesting of NPLs for a number of reasons. Firstly, because it reduces their risk exposure, releases reserves and strengthens capital ratios by reducing risk-weighted assets. Secondly, because NPL sales translate into up-front cash payments that improve the selling banks’ liquidity positions. And thirdly because by selling NPLs, banks avoid the cost and challenges associated with maintaining an in-house debt recovery team. The divestment of NPLs also contributes to an improved return on equity, which is vital to meeting shareholder demands for continuously improved returns.
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So what does the market look like across Europe?
In the UK, Europe’s most mature market in NPL sales, there were no signs that uncertainty regarding Brexit was having any material effect on the transaction market or operations. The total acquisition volume in the region increased to SEK 1,793 million (from 1,462), of which most of acquisitions were in the UK.
In France, higher volumes of NPL sales were evident, mainly from mutual savings banks. The market also noted the arrival of first-time sellers. At least four major transactions were completed that together matched the historic annual volumes for the French market. While a less mature market compared with the rest of Europe, France represents a considerable growth opportunity for potential purchasers.
NPL sales in Spain, meanwhile, remained largely in line with expectation (at around Euro 6 billion ). Similar volumes were seen in the secured debt market. In Italy, larger volumes of NPLs in the banking sector are becoming apparent as a result of ongoing structural changes to the banking system and are expected to reach the market over the next few years. The market will be influenced, in part, by the large numbers of small businesses in the country. The pace of development has also accelerated in the Greek debt market, thereby making this market particularly interesting.
Following the Greek debt crisis, there were substantial quantities of NPLs. Instead of the market following a slow development process, which has been commonplace in many other European markets, the process is currently ongoing at a high pace. Other than accelerating divestment of NPLs, no practical alternative exists for stabilizing the country’s economy. The volume of NPLs in Greece is significant given the country’s size.
As for Belgium and the Netherlands, progress has been comparatively slow. Larger banks tend to manage their debt recovery in-house and, therefore, divestments of NPL port- folios is not as common. However, there are some signs of change and, in addition to financial companies operating in the consumer credit field, one of the major Dutch banks divested a NPL portfolio in the past year.
So what of the competition? A few large and well-known debt purchasing companies have emerged as the European debt purchasing market matures, although only a small number of these companies have a pan-European presence, operate across geographical platforms and compete in multiple markets. Efficiency and cost savings are high on the agenda for these companies and help fuel the consolidation trend.