NPL secondary market may solve the increase in credit risk

The identification and management of non-performing loans or NPLs as early as possible by banks are among supervisors’ current high-level priorities. Indeed, when prudential, monetary, and fiscal crisis mitigation mechanisms are tapered, the weakening of borrowers’ creditworthiness could materialise, along with increasing credit risks and therefore NPLs.

This expected rise of new NPLs in European banks’ balance sheets would be added to the existing stock of NPLs piled up after the Great Financial Crisis, which remains significant, despite supervisory pressure to tackle the problem. According to the latest prudential statistics from the ECB, the amounts of NPLs in Single Supervisory Mechanism (SSM) banks increased at the end of Q1 2021 to €455bn compared to €444bn at the end of 2020, while NPLs average ratio remains very low at 2.54%, down slightly from the previous quarter.

The impact of prudential «backstops»

Andrea Enria recently reaffirmed that postponing or watering down the minimum loss coverage rules would mean accepting that the EU banking sector may remain clogged with pandemic-related secured NPLs for longer than a decade, leaving the sector unprepared to face the next recession. In addition, the so-called “prudential backstops” rules will start to materialise. The regulation (EU) 2019/630, or “backstop” regulation, which came into force on 26 April 2019, requires a minimum loss coverage from the third year of NPL vintage for unsecured exposures that would turn non-performing originating from this date. These binding Pillar 1 rules, departing from accounting provisioning standards, could force some institutions to sell their NPLs in order not to burden their regulatory capital and capital ratios. This may primarily concern institutions that post the lowest capital ratio margins for their minimum Common Equity Tier (CET) 1 requirements notified by their supervisor. However, loans that would benefit from a state guarantee in the context of the pandemic would not be subject to these requirements since they will not attract any minimum loss coverage before seven years, thanks to a provision introduced by the so-called “quick fix” Capital Requirement Regulation (CRR).

In addition, despite being incentivised by supervisors, most institutions are reluctant to use their capital buffers to absorb any losses on NPLs because of distribution restrictions that could be triggered as a consequence and more generally due to potential market stigma.

NPL portfolio sell-offs could accelerate

The forthcoming publication in the EU Official Journal of the recently adopted directive on credit servicers and credit purchasers should design the basics for an organised marketplace for sellers, such as banks, and purchasers including investors, funds, or recovery debt servicers. Additionally, the EU has also just published specific prudential rules for the securitisation of NPLs, promoting a true secondary market.

Member States might also support the establishment and cooperation of national asset management companies (AMCs). This would allow high NPL banks to remove NPLs from their balance sheets, as per the Commission’s action plan on NPLs unveiled in December 2020. However, these non-compulsory measures have only been implemented in a limited number of Member States since they may appear restrictive given their potential state aid nature.

For banks wishing to maintain capital and profitability, getting rid of NPLs may be an appropriate solution.

Fostering secondary markets through increasing transparency on NPL transactions

To increase transparency on effective transactions, the banking industry is currently being consulted through two public consultations:

• An EBA discussion paper on data templates that banks can use to disclose details of transactions carried out and thus provide background data to potential investors, based on a revised and simplified version of the EBA data templates offered in December 2017;
• A Commission consultation on the establishment of a European data hub, the data of which could be based on the abovementioned EBA templates.

According to the Commission, one of the key actions to promote secondary markets for NPLs consists in improving the quantity, quality and comparability of data on these loans. Indeed, secondary markets could be larger and more efficient if market participants would have more and better data on NPL transactions, thereby reducing information asymmetry between participants.

The Commission: (i) besides subjecting all market participants to disclosure, is considering targeted changes to the disclosure requirements under Pillar 3 such as data on NPL recovery; (ii) believes that a data hub could be set up at EU level to serve as a data repository providing details on transactions and asset recoveries. Such an electronic database would assess the relevance of the information and would only be accessible to contributing institutions.

Enhanced disclosures could therefore increase the functioning of secondary markets and encourage banks to sell their NPL portfolios. However, this might create new operational constraints similar to AnaCredit implementation, and effectiveness would only be achieved should all institutions participate in the hub.

Key actions

Overcoming NPL issues requires a perfect understanding of regulatory issues. Conducting a benefit/risk analysis of the projection of potential impacts of asset deterioration and the consequences on regulatory capital will determine the strategy to take. Subsequently, significant work to upgrade the quality of credit data and active contribution developing a data hub will foster matching market participants interests and create a true secondary market for NPLs.