European Union: Non-Performing Loans (NPL) Update

Last Updated: 24 September 2018
Article by Alfonso Pagano

Good progress - but more needed. In a nutshell, that's the view of the European Central Bank in tackling the level of Non-Performing Loans (NPLs) across the region.

Since the economic crisis, triggered by the collapse of Lehman Bros. in 2008, banks have been saddled with a raft of NPLs. There has been significant pressure from the ECB and World Bank for banks to reduce their NPL burden. To sell a portfolio of NPLs, banks negotiate with potential buyers. Once the deal goes through, the buyer of the NPLs employs a credit-servicing business to realise the value of the loans. The spread between the ask and bid price is the return for the buyer.

Although much has been done to reduce the burden, the European Banking Authority believes there is still a stockpile of nearly €780bn worth of non-performing loans across the European economy.

The European bank bail-in regime, introduced in 2015, has been key to the NPL market's development. Banks must take losses on NPLs before they can access public money to avoid bankruptcy. A bank's decision to write down or write off the value of a portfolio of loans is the starting point of any NPL transaction.

But thanks to regulatory efforts and the ECB as driving force, the burden of NPLs has been reduced – in some countries faster than others – and investors are viewing NPLs as a good business opportunity.

Update on the pan-European NPL market

The European Central Bank has been empowering banks to offload NPLs under a supervisory framework which sets out expectations for provisioning the loans. In March 2017, ECB Banking Supervision published guidance to banks, which provided an effective toolkit for banks when tackling NPLs. Banks with high levels of NPLs had to agree strategies to address NPL stocks. In March 2018, the ECB Banking Supervision added supervisory expectations for the provisioning of new NPLs.

The ECB believes its guidelines have led to the NPL ratio of significant institutions decreasing from 8 percent in 2014 to 4.9 percent in Q4 2017. However, it says the current aggregate level of NPLs remains far too high compared to international standards, and further efforts are necessary to ensure that the NPL issue in the euro area is adequately addressed.

Regulatory and legal frameworks for NPL trade have been encouraged as part of a programme of support by the largest multilateral investors and lenders in Central and Eastern Europe - the EBRD, the EIB Group, and the World Bank Group. Under the commitment by the International Financial Institutions (IFI) Initiative, legal and regulatory training and workshops have been provided in countries such as Albania, Croatia, Hungary and Montenegro.

The potential of each NPL should be assessed in granular detail – with thorough due diligence, proper understanding of asset class and debtor, and professional assessment of the chances of recovery into a performing loan, according to economic environment and standing of the debtor.

A good knowledge of the legal framework in the relevant country is essential. Each jurisdiction will be different, and an inefficient judicial system could add years on to a foreclosure process. Consulting local experts is vital. A professional services provider such as ourselves with local-language speaking legal, accountants and business analysts in every European country, can provide the detailed knowledge needed to accurately value the potential of an NPL from an investment perspective. Robust data is key in both providing a valuation and preparing a business plan for servicing the loan. Less-digitised countries pose a challenge in obtaining good data, but local professional expertise will prove invaluable.

Each country has its own story to tell, according to historical economic growth. In Spain, for instance, the majority of NPLs are from the collapse of the real estate market. In Italy, most of its NPLs are from SME origins, when businesses suffered from the economic downturn. Some countries, such as Spain, have established a good track record in NPL trading, with over 200bn NPL reductions since 2013. But others are new to the market, and NPL performance differs. Spain has an NPL recovery time average of three years, whilst Italy tends towards seven years, by comparison.

Whilst there has been significant disposal of NPLs by banks over the past decade, particularly in the UK and Ireland, new NPLs have been identified, especially in southern Europe.

Spotlight on the Italian and Greek NPL market

Italy, the Eurozone's third largest economy, has the heaviest NPL debt in Europe. Beset by economic downturn, Italy was down €264bn in terms of non-performing exposure (NPE) at the end of last year, according to PwC.

In Italy's troubled economy, several factors have created a growing NPL burden: over-indebted companies following the sharp crisis-related drop in output; a highly complex legal system of corporate restructuring and insolvency; lengthy judicial procedures, and a tax system that until recently discouraged NPL write-offs.

Under pressure from the ECB to reduce NPL stock, two years ago the former Italian government introduced the Garanzia sulla Cartolarizzazione delle Sofferenze (GACS), a state guarantee on the senior tranches of securitised NPL transactions. The GACS was scheduled to expire this month (6 September) but the Italian treasury is awaiting an extension by the European Commission.

The former government also introduced other reforms to facilitate the disposal of bad loans, such as changes to enforcement proceedings, which include making it easier to collect information on debtors. There is now a digital register on judicial property foreclosures and insolvency proceedings which improves the availability of information for the valuation of NPLs.

There have also been changes to Italian securitisation law to broaden activities, and an improved legal framework to give comfort to foreign investments.

NPLs in Italy once caused apprehension for investors, due to their impact on the banking system, but today they are seen as an attractive investment opportunity.

By comparison with Greece, where NPLs are 45% of loans, the largest ratio in Europe, Italy's NPL burden has reduced from 16.8% in 2015 to 11.1%. But the uncertainty over the new government could rock the boat. The progress in offloading NPIs to date has relied on openness to foreign investors and any political instability in the future could harm the trading environment.

Greece has over €100 billion NPL, equivalent to 70% GDP. In a determined drive to reduce the debt, the Greek government has challenged the country's banks to achieve a 37% reduction over the next two years, to €65bn. It's a tough target, and the NPL market is still becoming established, but regulatory reform is helping.

Greece has passed several reforms to address its NPL issue and facilitate the disposal, liquidation and recovery process. It has also simplified requirements for ongoing supervision and made it easier to grant a servicing licence. What's encouraging is the fast development of a sophisticated Greek loan servicing sector. A strong partner with a good track record should be a top priority for a private equity investor. But challenges include an inefficient legal framework, poor quality of data, the likelihood or not of economic recovery, and the fact that Greece is a largely untested market with no track record for recovery curves.

Prices have dropped by 60% since 2008, and the real estate market has suffered, but the situation is improving and GDP growth of 2.4% is expected between 2018 and 2021.

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