(June 2nd, 2023)
By (Francesco Pongetti, Equity)
Edited by (Ascanio Cicogna, Chief Editor)
What are NPEs / NPLs?
In the aftermath of the 2007-2008 financial crisis and the 2010-2011 debt crisis that hit the eurozone, causing the general deterioration of European banks asset quality ("The NPLs market between supply and demand" by E. Carluccio & V. Conca 2017), European regulators decided to incentivize the deleveraging of credit institutions.
To achieve this goal, the first pillar of the EU strategy was the harmonization of the different labels of impaired financial assets, which until then were "difficult and in some cases distorted" and "did not allow an assessment of the actual riskiness of bank assets" (Carluccio & Conca 2017).
In 2013, following their goal, the European Banking Agency (EBA) released the official definition of Non-Performing Exposure (NPE) and forbearance within the “Implementing technical Standards” (ITS). From these definitions we derive Non-Performing Loan (NPL). These definitions are then found in the European Commission's Implementing Regulation No. 680/2014 and define non-performing exposures as those assets with 1 of these requirements:
· Significant past due exposure for more than 90 days
· Exposures that have the risk of not being fully repaid except by enforcement of any collateral guarantee
It is important to note that this "broad" categorization does not equate the concepts of impaired and defaulted but simply that both fall into the category of non-performing.
The importance of the topic
It’s possible to state that the high level of NPLs reached in last decade have sparked a crisis in Europe.
The main countries involved in the crisis are the countries of the "Mediterranean" area of the EU community, among which we can mention:
France with the highest absolute value of NPLs (125B in 2020 and 110 in 2022), Greece with the highest ratio between performing or "in bonis" loans and non-performing loans (28.8% in 2020 and 5.2% in 2022) and Italy which suffered from a similar amount of NPLs as France but with a more aggressive reduction dynamic going from 124B in 2020 to 82B in 2022.
It should be noted that these levels are far from the peak recorded around 2015 when the amount of NPEs in Italy alone was 341B, a figure similar to the total of all European countries in 2022, i.e. 371B. (KPMG 2022).
In Italy two distinct trends can be identified for the stock of NPLs in the Italian market. The first having a Compounded annual growth rate (CAGR) of +22% in the 2008-2015 period with the maximum value of 341B reached precisely in 2015 while the second in strong counter-trend (CAGR -21.7%) in the period 2015-2021 with a value in 2021 that for the first time fell below the "starting" value of 85B in 2008 ("The Italian NPL market" 2022, PWC). This downward trend is also consolidated in 2022 with a value of 61B and a projection for 2023, on the rise, of 62B (KPMG).
Figure 1: European and Italian NPE framework
Source: (“Italian debt-sales Report 2022”), KPMG.
NPL market Framework
EBA's calculations on these non-performing loans is extremely heterogeneous, with some exceptions.
It is indeed true that there are sectors that showed weakness more than others during the crisis period. The construction sector, for example, has ratios of 15% while the food and entertainment sectors stand at 9% and 8% respectively, well above the average for all sectors, which is below 6%. (EBA 2019)
Ratios are higher for small and medium-sized enterprises (SMEs) and commercial real estate, while mortgages and large corporates are less prone to non-performing Fig 3.(EBA 2019)
A detailed analysis of the non-performing assets transferred up to 2022 shows that there is a substantial parity between secured (i.e. backed by a guarantee) assets, which make up 48% of the total, and unsecured (i.e. not backed by such a guarantee) assets, which make up 52%.("Italian debt sales report 2022", KPMG)
Italian NPLs are mainly secured by real estate and other real estate guarantees (71%). The main counterparties are firms operating in the tertiary sector (40%). Loans to construction and manufacturing companies account for 40% of total loans. The weight of the tertiary sector is expected to grow further in the future as the Italian economy is shifting towards a strong increase in this sector. (KPMG)
The Italian NPLs stock is highly correlated to the high number of assets ending up in the non-performing area. The construction sector (Real Estate + Construction) accounts for more than 31% of the stock while manufacturing accounts for around 36%. These values, alongside others that will be discussed further on, expose the country to significantly higher deterioration rates.
Also relevant, is the importance of the construction sector in terms of collateralization, given the extensive use of real estate as collateral, a collapse of the sector would also set off a domino that would be difficult to contain on the collateral for many bank loans.
Figure 2: Rate of deterioration per sector
Source: EU commission
A “lightning” deleverage.
Aligning with the 2017 regulation spree, the major Italian banks have disposed a huge number of exposures and have done it at a faster pace than other European banks. This trend can be seen from the analysis conducted by KPMG on the country's major groups, banks have fallen well below the EBA target of 5%, in some cases like Intesa Sanpaolo defining the "0 NPL target" in their business plan. (“Italian debt-sales Report 2022”, KPMG) To increase their resilience and to maintain this speed of deleveraging, banks were often forced to take risks, accept inefficiencies, and accept large costs.
The evolution of this regulatory environment in the area of classification and measurement (IFRS 9) and provisioning of loans (calendar provisioning) of financial instruments is forcing banks, under great pressure from the regulator, to quickly reduce their NPL stock as noted in KPMG's annual analysis.
Even more indicative are the words stated by Intesa Sanpaolo: "Any policy measures that negatively impact capital ratios, such as the forced and hasty liquidation of NPLs, could be counterproductive".
In addition, the financial institution warns that accelerating the automatic provisioning of NPLs may have a negative impact on the functioning of the secondary market due to the misleading value of non-performing assets by forcing the sector to damage lending to the real economy or indirectly forcing them to urgently liquidate positions in the face of significant losses. (“Non-performing loans and the cost of deleveraging: The Italian experience” E. Bolognesi et al. 28 oct 2020)
Of the same opinion is the European Council, which in a 2017 note puts it this way "More efforts are needed to bring NPLs ratios back to a lower sustainable level" but at the same time warns to "Avoid the disruptive effect of fire sales." (European Council, 2017)
Figure 3: NPE and Capital ration of the major Italian banks
Source: (“Italian debt-sales Report 2022”), KPMG.
UTP and Off-balance stock
Before the Covid 19 crisis the banks transferred the vast majority of their NPE stock out of their balance. This deleverage was promoted by the public actor via a different scheme in the various European country (mostly Bad banks in Northern Europe and guarantee on securitization on southern Europe).
In Italy the government adopt the “Garanzia sulla cartolarizzazione delle sofferenze” (CAGS), a public scheme duplicated in Greece that allowed banks to purchase a state guarantee under certain condition for the most secure tranches of their securitized NPE’s.
The movement of these distressed assets out of the bank’s balance sheet helped boost the ratios of the banks but sometimes can have a misleading signal because in many operations the risk of the loan is not fully transferred. In most operations the banks still have some kind of bond with the purchaser of the NPL, for example, it is normal (and required by regulation) to avoid moral hazard, that the banks retain some of the SPV securitized tranches. Moreover, when a big deal is concluded, usually acquiring the NPE stock with the operating division of the banks serving those loan it is common that one of the clauses is the commitment of the purchaser to purchase the majority of the future nonperforming assets to have the “raw material” for the new business. This creates a dependency of the banks that externalize the process to the Purchaser/servicer.
This weakness is now exposed due to the suspension of the interest expenses that froze many “Stage 2” loans on the brink of collapse on “non performing” with the mortal mix of rate hikes and post pandemic macroeconomic situation.
Figure 4: Italian Stage 2 Stock Evolution
Source: “Il mercato italiano NPE” 2020 PWC
Conclusion
Extraordinary measures were applied during the past crisis for a quick and safe deleverage that saved many institution that suffered from mismanagement, moral hazard and inefficiencies in the market.
The great cost of those measures in terms of credibility, bid ask spread and banks failure often prevent the financial institution to carry on with their main objective, namely, lending.
With a new stress period caused by covid 19 and post pandemic interest rates a better and more stable system to settle the problem has, as its main goal, the creation of an efficient secondary market for NPE’s to better allocate the risk, prevent a domino effect and reform the juridical system to speed up the recovery process allowing the purchaser/servicer to have better expectations on those NPL’s reducing the bid/ask spread.
Ultimately the possibility of provisioning in banks’ balance sheets is great for transparency purposes but a more balanced system needs to take into account the starting situation in order to prevent the “lightning” deleveraging seen in 2017.
Citations:
"The NPLs market between supply and demand" by E. Carluccio & V. Conca 2017
"Italian debt sales report” 2015-2016-2017-2018-2019-2020-2021-2022, KPMG
“Non-performing loans and the cost of deleveraging: The Italian experience” E. Bolognesi et al. 28 oct 2020)
“Note di stabilità finanziaria e vigilanza” 2016-2017-2018-2019-2020, Banca d’Italia
“Il mercato italiano NPE” 2015-2016-2017-2018-2019-2020-2021-2022, PWC
“Guidance on nonperforming loan NPLs” 2016 ECB
“Addendum on Guidance on nonperforming loan NPLs” 2017 ECB
“Study on non-performing loans in the European union” 2016 EU commission
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