The New Wave of NPLs

by Carmelo Spallino

The NPL market is more than ever in the spotlight. Going from the definition to what is changing in the regulatory framework, this article tries to understand the potentiality of this market in terms of risk/return, what is changing and why some of the most important PE funds around the world are raising capital to be invested in this asset class.

1. NPL Definition

A non-performing loan is any loan that can reasonably be expected to enter default. Often, if the loan isn’t already in default, the borrower has failed to make a number of payments within a specified period.

More specifically, the generic term “Non-Performing Loans” is characterized by three different classes here ranked according to the Bank of Italy definition from the most to the least unlikely to pay:

  • Bad Loans

  • Unlikely To Pay (UTP)

  • Past Due

Once a loan is considered nonperforming, lenders may have the opportunity to attempt to recover the principal. This especially applies to loans backed by specific assets, such as a home loan or vehicle loan.

In cases where there is no specified asset, such as unsecured lines of credit, the lender may begin using internal collection services to recover the missing amounts. If extenuating circumstances are affecting the borrower, the lender may choose to put the loan into forbearance, suspending the need for payments until the situation changes.

2. European Market Trend

NPL market is more than ever in the spotlight because of its size and the increased attention for “asset quality” given by the Regulator.

Indeed, the phenomenon impacts banks from several perspectives. In a nutshell, banks are required to retain “enough” capital given the quality of their assets (RWA mechanisms and other constraints) obliging them to retain/raise capital in such an unfavorable period in which ROE ratios are at historic lows. In addition, their performances are enormously impacted through writedowns and provisions.

While the NPL market was previously concentrated in UK and Ireland, banks in these areas preferred to clean massively and quickly their balance sheets during the past years and now the bulk of the market moved to Southern Europe. Italy and Spain in particular have been characterized by important transactions over the last two years and nowadays Italy seems one of the most crucial market around Europe.

Figure 1. NPLs Stock by Country at December 2015. Source: SDA Bocconi School of Management

Indeed, 2017 was a record year for the Italian market characterized by enormous transactions such as the disposal of almost €18bn by Unicredit (Project Fino) or the €16.8bn cleanup of Banca Popolare di Vicenza/Veneto Banca and the €28bn record operation started by MPS.

Overall, at the end of December 2017 PWC Italy-focused report shows a decrease of the overall market stock from €324bn at the end of 2016 to pro-forma figures equal to €250bn as of December 2017.

Figure 2. Italian NPL market as of 1H17 with pro-forma figures for year-end. Source PWC Report

This gives a very good idea of the size and the importance of the market but what is going to change? What are the keystones for the future?

3. IFRS 9 – The Big Change In The Regulatory Framework

Starting since January 2018, IAS 39 has been replaced by IFRS 9, the new framework around Europe to classify financial assets, financial liabilities and some contracts to buy or sell non-financial items.

Three are the main differences with respect to the previous standard:

  1. Some provisions relating to “Hedge Accounting”

  2. Some criteria regarding the classification and measurement of financial assets and liabilities, with the main objective of reducing the discretion of banks in the choices and classifications of financial instruments

  3. The “Impairment” process of financial assets

A better understanding of the first two points is beyond the scope of this article. What is here relevant are the changes with respect to the “Impairment Test”. The main difference is that the so called incurred losses will not be the only ones to be taken into account. There will be instead a predominance of expected losses, losses that are reasonably expected even if no “objective default event” has already revealed (see IAS 39).

The framework will consequently switch to a forward-looking approach.

Let’s see better what happens. Financial assets and some other assets regulated by IFRS 9 are subject to the impairment procedure. This process is divided into two phases: the first, classificatory; the second,  valuation-based stricto sensu.

Phase 1: Financial assets are classified into three groups (so called stages) according to their “degree of deterioration”.

  • Stage 1 (so-called Performing Activities) – Financial assets characterized by low or zero credit risk

  • Stage 2 (so-called Underperforming Activities) – Financial assets which, after the initial recognition, underwent an “identifiable deterioration” in terms of credit risk. With this respect, IFRS 9 shows as an example that an asset can be classified as underperforming in the presence of a delay in debtor’s payments exceeding 30 days. Other trigger events banks are considering in the pre-application of IFRS 9 are, for example, the downgrading of the internal rating or the decision to revise the conditions of the contract in favor of the debtor (forbearance).

  • Stage 3 (so-called Nonperforming or Impaired Activities) – Financial assets which, after initial recognition, underwent a “significant deterioration”, thus including positions in state of insolvency

Phase 2: The bank must estimate the losses attributable to all the financial assets subject to impairment tests in a forward looking approach. It must therefore use every information/element:

  • relating to the past, present and future

  • relating directly to the counterparty and indirectly to the economic and financial macroeconomic environment

Loss estimates and the related income statement imputations take place on the basis of a partly different methodology with reference to the three classification stages.

  1. Stage 1 Activities: Estimates are made “just” with a 12-month perspective:

    • Expected Losses = Exposure at Default * Probability of Default (PD) within 12m * Loss Given Default

  2. Stage 2 Activities: Estimates here involve a lifetime perspective (the difference it’s huge w.r.t. above):

    • Lifetime Expected Loss (to be actualized) = Exposure at Default * PD(Lifetime) * Loss Given Default

  3. Stage 3 Activities: same as before but activities here are analyzed analytically (position by position)

What really makes the difference on what above with respect to the previous framework are the forward looking perspective and the classification of Stage 2. It is enough to think that, previously, the so called Past Due class carried positions overdue by 90 days, not 30! This could bring activities previously recognized as performing to become underperforming with a huge impact for banks’ income statements (made even stronger by the stricter valuation approach).

Banks are fighting hard to relax a bit the Stage 2 classification criteria. Independently of this negotiation outcome (of which we will see the results soon in 1Q18 BSs), it seems clear that NPL stock could further increase creating more opportunities for players in the market ready to ride the wave.

4. Internal VS External Management

There are a number of reasons why banks should dispose of, and not continue to hold NPLs, once stocks reach a critical mass. NPLs can tie up scarce bank resources, including capital, funding and human resources, diverting them from more profitable activities or opportunities, with overall negative consequences for a bank. Large NPL stocks may also impact bank funding costs, as a result of uncertainty surrounding the future prospects of the institution. This and other main reasons are at the base of the increasing sales-trend of these assets.

In such a complex market, many are the issues to be considered. The biggest one is represented by information asymmetries: once the assets are pooled together and sold off, it becomes difficult (if not impossible) to evaluate ex-ante (meaning, when buying) the single positions inside.

Even if the problem per se could be overcome through extensive due diligence, this requires specialist expertise and costs can be very high. As few investors have the resources to absorb such costs, barriers to enter are strong. “This appears to explain why the euro area NPL markets display the features of an oligopsony, a situation where there is a concentration of market power among a limited number of investors, which pushes traded prices even lower”(1).

Low prices are what makes the market so interesting for potential investors able to undertake this risk and manage the procedures. As a complementary side, this is the very same reason that pushed some other banks to adopt a completely different approach (internal one), trying to work on their own on these Non-Performing Assets (an example is represented by Intesa Sanpaolo, one of the Italian leading banks)

In the graph below, SDA Bocconi School of Management well represents the possible returns of an activist approach on NPL. This remains valid, through some adjustments, both for external and internal management.

Figure 3. “NPL between Demand and Supply”. Source: SDA Bocconi School of Management

(Note: some of the drivers here reported are specifically linked to the Italian market. For example, GACS (“Garanzia Cartolarizzazione Sofferenze”) is a guarantee mechanism granted by the Italian Government to be used to facilitate the removal of non-performing loans from the books of commercial banks. Anyway, the graph provides a clear picture for the whole EU market).

5. Main Operators: PE funds

From what said above should be clear why some of the most important PE funds around the world are focusing their attention always more on this asset class. During the second part of 2017, Deloitte reported that American funds were eyeing European market, raising € 300bn to be invested in this asset class.

One of the biggest player is the American fund Cerberus Capital Management, recently in the spotlight for its interest in the airline company Alitalia. In February 2017 it raised its fourth real estate fund (€ 1.8bn in size) declaring the intention to invest at least half of its proceeds in Europe, where banks in Spain, Italy, the Netherlands and others sit on roughly €1tn of distressed debt — much of which is property related.

Figure 4. Top Buyers 2015 – H1 2017 (€bn). European Market. Source: Deloitte

<<Even if private equity groups struggle to find loan portfolios offering quick and clean returns, the stressed balance sheets of many European banks will continue to provide opportunities, insists Victor Khosla, founder of Strategic Value Partners, which specializes in investing in distressed debt. “The wave started in the UK and it’s now rolling,” he says. “This wave through Europe — this cleansing — it’s extraordinary in size compared to even what happens in the US just because these banking systems are so big.”

Mr Khosla predicts another decade of sales triggered by the ECB’s policy of forcing Europe’s commercial banks “to cleanse their balance sheets” through a mark down of assets and disposal of “noncore” loan books. “I really think you’re going to see this continue for the next 10 years.”>>(2).

Authors: Carmelo Spallino


(1) ECB: Financial Stability Review November 2017 – Special features –  November 2017

(2) Financial Times: Investors Switch Tack on Distressed Europe Debt – March 2017

Other: Financial Times, ECB, Bank of Italy, PWC reports, Deloitte reports, KPMG reports,  Cerberus Capital Management (company website).