Non-performing loans are an essential part of the lending business, and the likelihood of non-repayment is an inherent risk. Risk of loss is part of the credit rating banks assign to borrowers and is, therefore, included in the cost of borrowing. Loan losses and NPLs generally encompass non-performing loans, insolvency proceedings and debts where customers’ payments fail to meet the contractual terms.
The probability that a loan will be repaid in full is substantially lower once the loan has been classified as non-performing. As a result, debt purchasing organisations, such as Hoist Finance, can acquire NPL portfolios at a significant discount to the loans’ nominal total value.
Perhaps not surprisingly, the banks themselves (i.e. the ‘sellers’) often have a different view of the value of their loans, which has hampered NPL divestments. Slow procedures and structural inefficiencies in debt recovery have been instrumental in limiting the transaction market.
Advantages to divestment
The principal advantages of divesting NPLs from a banking perspective is to reduce risk. But it is more than this. NPL sales not only reduce the sellers’ risk exposure, but they also release credit reserves and strengthen capital ratios by reducing risk-weighted assets.
NPL sales translate into up-front cash payments that improve the selling banks’ liquidity positions. It also enables them to focus more directly on their core business; recovering debt can be a distraction. It takes time, resources and specialised expertise to recover NPLs, so by selling the debt, banks avoid the costs and challenges associated with maintaining an in-house debt recovery operation.
Divestment of NPLs also contributes to an improved return on equity, which is vital to meeting shareholder demands for continuously improved returns.
Most banks today have sophisticated sales processes, and the quality of portfolio data is improving. Risks have, therefore, been reduced and sellers can feel more certain that they will receive an accurate and fair market price. Having started by selling unsecured loans, banks have become more comfortable with selling other asset classes as well.
This is part of the ongoing development trend. With fewer risks associated with selling and acquiring loans, the price of loan portfolios has risen. This trend has developed to varying degrees in different countries, with the UK among the markets where it has proceeded the farthest.
Performance, however, is by no means uniform across Europe. In the under-developed markets such as Spain and Portugal, there have been few if any sales. The quality of data tends to be poor, and the bid-ask price particularly broad which means there is little appetite to engage. There are some early adopters, and these tend to be the consumer credit companies and international banks. But growth is hampered by cultural barriers and ‘denial’ among banks which means that portfolios that are sold tend to be old and of very poor quality.
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In the growth markets, which include Spain and Poland, the picture is rather more encouraging. There is a healthy competition among NPL purchasers and decreasing bid-ask spreads. Local banks are gradually becoming more active, portfolios are more ‘current’ and the quality of NPLs being sold is of a generally higher standard.
In the most mature markets, such as the UK and Germany, NPL sales are an integral part of the financial ecosystem. Two particular trends are evident: firstly, the quality of the NPLs portfolios being sold; and secondly, the trend towards increased consolidation resulting in a fewer number of larger debt purchasers.
Competition for loan portfolios is a contributing factor to the price increase, which puts pressure on margins. This development has been driven over the past five or six years by lower borrowing costs, which appear to have bottomed out in 2018 and are on the way up again.
While prices may be rising, the total amount NPLs are decreasing. In Europe, the volume of outstanding NPLs in the banking sector decreased to approximately SEK 7,143bn (£580bn) as per Q3 2018, compared to approximately SEK 10,000bn in 2017. This amount represents around 3.4% of all loans, compared with 5% in 2017. The decrease, while gradual, is partly due to legislation facilitating trade in receivables aimed at reducing the number of receivables in the European banking system.
There are a number of trends that affect market development and that the debt purchasers are now planning for. These include: the impact of strong market growth; the demand for increased operational efficiency that is in turn driving industry consolidation; increasing funding costs; and continued regulation of the market and greater market maturity.
It is crucial to reduce the number of non-performing loans in Europe’s financial system. Household and SME over-indebtedness causes banks to restrict their lending, and small businesses are unable to invest; this inhibits economic growth. The transaction market is nevertheless growing, due partly to the fact that the market continues to develop and become more sophisticated.
Another factor to consider in exploring the future market is the impact of new legislation. The introduction of IFRS 9 as from 2018, for example, requires banks to calculate and make provisions for expected credit losses as early as initial recognition following the granting of new loans. The new rules have had some positive effects, in that banks are required to report their expected credit losses at an earlier stage. The purpose of the new accounting standard for classification and measurement of financial assets is to enable earlier prediction of credit losses. Additional regulations in this area are to be expected in coming years.
A few well-respected companies have emerged as the European market matures, and Hoist Finance holds a strong position as a partner to international banks and financial institutions. The company is among the five largest in Europe measured by ERC (Estimated Remaining Collections). Efficiency and cost savings are high on the agenda for these companies and help fuel the consolidation trend, and the degree of consolidation is likely to remain greater in those mature markets with lower prices.
Market consolidation is taking place in parallel with an increase in regulation. Several major and minor transactions have been conducted in recent years, and this trend is expected to continue.