European Union: Securitisation – The Silver Bullet For The Non-Performing Loan Market?

Introduction

In an earlier Alert,  Non-Performing Loans and Securitisation in Europe, dated April 7, 2016, we examined the basic structure of an NPL securitisation and the importance of the servicing function in the operational success of such a transaction. As the global financial crisis has left many countries with significant levels of NPLs, particularly in south and eastern Europe, techniques to successfully reduce the level of NPLs are becoming increasingly important. This is especially so given that NPLs tie up bank capital that could otherwise be used to increase lending, and so reduce the supply of credit to the real economy as well as impeding the financial recovery of the banks.

Since our earlier Alert, there have been further regulatory developments to promote the sale of NPLs and the development of a market for NPL securitisations, particularly in Italy with the creation of a €5 billion bail-out fund, Atlante, and, prior to that, the Italian state guarantee of senior notes issued by securitisation vehicles backed by NPLs, supplemented more recently by reforms to enhance debt enforcement and insolvency regimes.

This Alert examines some of the regulatory, legal and market-based challenges of deleveraging NPLs and how securitisation as a financing technique might be used effectively to address this.

Regulatory considerations applicable to NPLs

1. (Avoiding) loss recognition

What is a non-performing loan? This question was an issue interpreted differently across and within different European jurisdictions, but in 2013, the European Banking Authority ("EBA") issued a recommendation to the competent authorities in the EU to run asset quality reviews for their financial institutions, based on newly harmonised definitions of NPLs.

Pursuant to those EBA definitions, an NPL is defined as an exposure in respect of which the debtor has not made scheduled payments for a minimum period of time (90 days) or is unlikely to pay without collateral realisation, in each case even if it is not recognised as defaulted or impaired in the bank's books. An exposure can be non-performing on an individual or debtor basis, but all exposures to a debtor are deemed non-performing when on-balance sheet exposures that are more than 90 days past-due are more than 20% of the aggregate of on-balance sheet exposures to the relevant debtor.

Whilst a common declaration of what constitutes NPLs in each jurisdiction is helpful, and since its introduction has added over Euro 50 billion of additional NPLs to the European pool, it is of course not the full story. Changes to definitions have not, in and of themselves, brought about any change in accounting or regulatory treatments, which often differ between countries and which may weaken the incentives financial institutions have to resolve NPLs, for just some of the following reasons:

  1. Impact on regulatory capital requirements: though the largest EU financial institutions use IFRS accounting, the current incurred-loss approach to loan provisioning under IFRS is backward-looking and leaves much room for subjectivity, which may result in insufficient loan provisioning by a financial institution in respect of its NPLs, especially where there are other strategic reasons to avoid loss recognition such as the impact on capital adequacy ratios;
  2. IFRS 9: IFRS 9 (which comes into force on 1 January 2018) requires lower values of NPLs to be recognised on the balance sheet of a financial institution as soon as it adopts a selling strategy (known as the "business model test"), so again, financial institutions are potentially dis-incentivised from adopting such a strategy;
  3. local accounting rules: certain local regulators (for example in Spain, Hungary, Malta, Poland and Romania – which are jurisdictions that continue to harbour significant levels of NPLs) have additional accounting rules (including in respect of loan provisioning) that have a negative impact;
  4. write-offs: whilst from the perspective of transparency and capital adequacy, writing off loans that a financial institution no longer expects to be repaid appears a positive matter, retaining NPLs but increasing the provisions made in respect of them also make financial institutions appear less risky and could therefore increase financial institutions' external credit ratings, thereby creating another reason why financial institutions could be dis-incentivised to deal promptly with NPLs; and
  5. lack of commonality: as a general matter, the current lack of commonality across the EU in terms of the accounting or regulatory metrics used to estimate capital requirements, risk weighting and impairment levels could be seen as an impediment to a transparent and liquid NPL market.

2. Regulatory environment

In addition to the commercial drivers to avoid loss recognition, there have historically been regulatory hurdles to the deleveraging of NPLs using securitisation as a technique. Current regulation in this area seeks to impose high capital charges from the perspective of the financial institutions and insurers investing in such securitisations relative to other funding instruments of similar credit risk. The regulatory cost of securitisation of NPLs on the buy-side is therefore very high relative to the cost of holding the NPLs on balance sheet as originating bank or as direct purchaser of NPLs in a whole loan sale. Furthermore, the requirement for EU credit institutions to ensure that an eligible entity has "skin in the game" for the life of the transaction via the risk retention requirements in the Capital Requirements Regulation ("CRR") before investing in an NPL securitisation adds further complexity at a time when the European banking system is under pressure to deleverage its problem loans quickly and efficiently.

3. Risk retention

In terms of risk retention rules, the definition of a securitisation transaction for the purposes of the CRR is wide-ranging. It captures any transaction under which the credit risk associated with an underlying exposure is tranched, payments are dependent on the performance of the assets and where the risk of losses is throughout the life of the transaction. To consider this further, a typical structure for a NPL acquisition is as follows:

  1. NPL portfolio is sold by a financial institution to a private equity fund (the "Fund") after the completion of a competitive bidding process;
  2. the Fund acquires the portfolio via a newly incorporated vehicle (the "SPV"), which funds the acquisition by issuing/borrowing senior debt and subordinated debt (either of which could take the form of notes or loans) – the senior debt being in the form of funding from third-party financiers and the subordinated debt representing the "equity" interest of the Fund;
  3. the subordinated debt is contractually subordinated to the senior debt; and
  4. collections from the NPL portfolio (whether by way of collections from the underlying borrowers or from disposals of the NPLs and/or the underlying properties, pursuant to an enforcement or otherwise) are applied in repayment of the senior and subordinated finance parties pursuant to an agreed priority of payments.

It is clear that the above structure involves a pool of exposures being funded by debt that is tranched, with the debt being dependent on cashflows from the underlying NPLs, with any losses from the NPL portfolio being throughout the life of the loan and being borne first by the subordinated debt. On the face of it, therefore, this is a securitisation for the purposes of the CRR, which requires an EU credit institution investing in the transaction (e.g., by way of the senior funding) to ensure that an eligible entity undertakes to retain (at risk to itself) a minimum of 5% of the overall risk for the life of the transaction, in an eligible form (usually this is effected by a holding of the first loss piece, or a vertical slice of the overall portfolio risk).

In the context of a NPL transaction, however, it is not immediately obvious which entity is the eligible entity to retain the risk. The CRR states that this can be either the original lender of the underlying loans, the sponsor of the transaction or the originator of the underlying loans. Taking each of these in turn - the original lender of the underlying loans is the financial institution selling the NPLs, so this is not relevant. The "sponsor" of the transaction has to be a regulated credit institution or investment firm, which would not be satisfied in respect of the Fund itself. A regulated manager of the Fund may qualify but would not typically be capitalised to fund a risk retention. Finally, the definition of "originator" is split so that, as well as capturing the "real" originator (i.e., the entity involved in the original creation of the loans or the seller of those loans if already transferred), it also captures an entity that buys the assets "for its own account and subsequently securitises them". While the SPV is not, strictly speaking, an originator, market practice has developed so that an entity like the entity providing the subordinated funding would be regarded as the originator, the analysis being that an "originator" includes an entity that purchases loans for the purpose of securitising them; the process of acquiring and securitising loans is often (and for good reasons) organised through special purpose vehicles; and the subordinated finance provider, whilst not purchasing the loans for the purposes of securitising them itself, can be said to be doing so through the SPV, an entity to which it provides the subordinated funding thus making it an originator.

We have seen varying approaches to documenting risk retention in the context of NPL securitisations. In our view, the analysis described above achieves substantive compliance with the risk retention requirement. However, for now, it should be recognised that there are other views.

Legal and market environment

One of the key factors in achieving a swift resolution of NPLs is the legal and judicial system within which the loans operate. The following obstacles (among others) should be considered:

  1. low average recovery due to the long duration and high cost of the legal process –  especially in jurisdictions with high NPL ratios. This can be due to various factors, including regimes which allow debtors to apply for postponement orders (which are usually granted), or high taxes that are applicable upon a sale of underlying properties. There is significant variation across EU legal systems on this;
  2. complexity of the insolvency law and proceedings – it is not uncommon for the relevant proceedings to last longer than three years and in some jurisdictions over five years. The pricing differential between the on-balance sheet book value and the market value becomes all the more pronounced when lengthy recovery procedures are factored in (although countries like Italy are aware of this issue, and in Italy recent legislation has been introduced to seek to speed up the time to dispose and reduce the cost of doing so); and
  3. lack of a securitisation law – not all European jurisdictions have securitisation rules enshrined in civil law. Those without such rules suffer from reduced marketability.

In addition to issues referred to above around loss recognition, there are other more market-based obstacles to NPL resolution, including reputational issues and lack of transparency borne out of a difficulty in obtaining standardised and reliable real estate valuations.

Conclusion

Regulators have taken significant steps to strengthen the EU banking sector since the global financial crisis, including in respect of NPLs. However, and as we have noted above, there remains some work to be done in terms of harmonising the supervisory guidance in respect of the deleveraging of NPLs. There is, for example, as we have seen, a considerable amount of uncertainty and divergence in approach – including in terms of whether outright disposals of NPL portfolios funded by senior and subordinated debt should be caught by the retention requirements of the CRR. In light of the need to resolve the considerable NPL overhang in Europe, a balance needs to be struck between removing the hindrances to a fully functioning portfolio acquisition finance market (including by way of "securitisation" as described above) whilst fostering a stable regulatory environment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.