Since the 2008 financial crisis, European banks have been dealing with a serious non-performing loan (NPL) problem. NPL refers to loans where the borrower has not made scheduled payments within a specified period; once this period is up, banks must provision against potential losses should the customer fail to repay. Although the volume of NPL fell from its €1 trillion peak in 2016 to around €910 billion in Q3 2017, there’s still a long way to go to reduce NPL volumes to pre-financial crisis levels1.
High volumes of NPL matter, because they can be a significant drain on a bank’s performance. Not only do they require higher levels of provisioning, which decreases profitability and reduces regulatory capital, they also tie up a significant amount of human resources.
These two factors mean that NPL can impact a bank’s ability to lend money, which will in turn have an adverse effect on the economy as a whole.
Banks have recognised the scale of the challenge they face and are putting significant resources behind tackling NPL. While there is some divergence in approaches across Europe, the biggest weapon they have in their arsenals is to sell NPL portfolios on to debt purchasers who believe they can turn a profit on the loans in the long term.
NPL Divides Europe
The European NPL story is a nuanced one. The continent can be split and analysed in three main blocks, with each tackling the NPL problem in a different way, and with varying degrees of success.
Block 1 — Countries with NPL ratios above 20%
This block, which includes Greece and Cyprus, has seen little movement in the past three years with regard to average NPL ratios. Systematic barriers, such as restrictions in Greece on loan book sales, are limiting progress. The Loan Servicing Platform, a framework in Greece comprising investors and 3rd party servicers overseeing the effective restructuring and management of NPLs for a large number of banks in Greece, is expected to have an impact.
Block 2 — Countries above the EU average NPL rate (5%) but below 20%
This block, which includes Ireland and Spain, has seen the most improvement over the past three years, with falling NPL rates and increasing coverage ratios. These countries are actively addressing their issues through state Asset Management Companies, bad bank units and loan book sales.
Block 3 — Countries at or below the EU average
This block, which includes the UK, Germany, and France, is following a similar trend to Block 2 but with a much lower NPL rate. It includes large, systematically important countries to the EU. They were largely protected from massive NPL rates due to tighter lending laws before the crash.
NPL and IFRS 9: Changing the Debt Purchasers Market
One consequence of this drive to reduce NPL portfolios across Europe has been the rapid growth of larger firms in the debt purchasing market, as banks look to shed unprofitable portfolios. As a result, debt purchasers and debt collection agencies have become the preferred location for financially vulnerable customers. This development has been driven by regulatory pressure and amplified by a new force: the IFRS 9 accounting rules.
Under the previous IAS 39 regulation, loans were classed as NPL at 90 days past due (DPD). However, under IFRS 9, this border has moved to just 31 days. At this point, the bank must increase impairment from 12-month expected credit losses to lifetime expected credit losses across all the customer’s accounts: a cliff-edge banks are naturally keen to avoid.
Five Next Steps for Banks
NPL must be tackled as part of the wider challenge banks face over the next few years: the need to attract new customers while retaining existing ones. Achieving this requires decision automation technology and analytics-driven NPL strategies.
These strategies should be applied in the following five areas:
Define the treatment of the different IFRS 9 status in collections. As of June 2018, there is still no reference to IFRS 9 status within the collections risk and operational routine vocabulary – this needs to change.
Develop clear retention and exit strategies. There needs to be greater progress to understand what will happen to customers that change status, especially if they are retained by the creditor and if so, on what revised conditions.
Decide the main purchasers or servicers of non-performing forborne loans. After these purchasers have been identified, they should be planned into future contractual and physical extensions of a creditor’s operating models.
Define policy changes for the return of exited customers. Banks should assess the circumstances under which they will welcome back customers in the future.
Maximise restructure take-up at optimal post-restructure default rates through developing analytics and technology capabilities. In the past, a lack of analytic precision was affordable; this cannot continue going forward.
Banks are faced with a serious challenge, but challenge breeds innovation: if lenders are to reduce their NPL problem, become more customer-centric and survive in a shifting regulatory landscape, they must leverage analytic and decision-making technology for competitive advantage.
2. Data in this section is taken from a presentation by Alvarez & Marsal Financial Industry Advisory Services LLP at FICO’s EMEA Risk Leadership Summit in May 2018.