Eight years after the onset of the global financial crisis, banks in Europe still have high levels of non-core and non-performing loans (NPLs) on their balance sheets. The proportion of loan “write-offs” in Europe is about one quarter that of the US banks. Figures recently released by the European Central Bank (ECB) indicate that “impaired” assets amount to approximately €1 trillion or 9% of the region’s GDP.
The ECB, in its recently announced priorities for 2016, has stated that “higher levels of NPLs deserve heightened supervisory attention” and they will be setting up a task force focussed on NPLs. One of the key recommendations in the European Commission’s Annual Growth Survey for 2016 is that “…Euro area Member States take action, individually and collectively, within the Eurogroup in the period 2016-2017 to facilitate the gradual reduction of banks’ non-performing loans.”
Non-core assets, sometimes known as “orphan” assets, which include non-performing loans, sub-performing loans (SPLs) and some performing loans, i.e. those that are paying satisfactorily but yielding low returns, are clogging bank balance sheets in Europe. Banks that are weighed down by non-core assets, especially those with NPLs and SPLs, find it hard to attract new capital for new lending. This reduces the prospect of economic growth. Why?
NPLs and SPLs are either in default with consequential losses for the bank, or they are at risk of defaulting and generating losses. Banks must make provisions for the risk of losses and regulators require more capital to be set aside by banks as a buffer for the risk that losses will crystallise and threaten the banks’ solvency. Setting aside capital, or more pointedly, putting equity and other forms of regulatory capital to work to absorb losses on legacy loans is an inefficient use of capital, especially when compared to using it for making new, (hopefully) lower risk loans that generate a reasonable risk adjusted return.
Banks, borrowers and the economies in which such banks operate are all worse off as a consequence, because their traditional suppliers of credit are prevented from lending and they have not been replaced by other sources.
The impact of the constraint of bank credit is felt most keenly by small and medium-sized enterprises (SMEs) that lack the scale to gain access to the bond markets. SMEs have typically gone to banks for working capital, term loans, trade finance and asset-backed loans to sustain and grow their businesses. Collectively, SMEs drive the European economy by generating more economic output, producing more goods and services and creating more jobs than large companies, so the importance of a thriving SME sector should not be under-estimated.
The scourge of NPLs goes far beyond the bank on whose balance sheets they reside – but they do have several direct and indirect consequences for the banks as well. They suppress return on equity, they absorb more than a fair share of regulatory capital, they constrain new lending, they consume an excessive amount of staff and management time, and they make the bank unattractive to new investment.
This cocktail of negative consequences, clogging and congesting the balance sheets of systemic lenders whose purpose is to provide liquidity for growth, leads to the conclusion that countries needing to revive and rehabilitate their economies have to start by mandating their banks to resolve their NPLs and SPLs through work-out or sale.
Ireland is an example to the rest of Europe. In 2009, as a first step to resolution, many of the banks were forced to sell non-core and distressed real estate loans to the recently established National Asset Management Agency (’NAMA’). Many of those loans have now been sold by NAMA to international investors and the underlying collateral refinanced. In 2016, 6 years after NAMA began its resolution work in earnest, Ireland has transformed itself into the fastest growing economy in Europe.
Of course, the sale of loans and refinancing of collateral is only a part of the story and Ireland has done much else besides. It has taken numerous other structural measures (not least maintaining its low corporation tax rate) to encourage inward investment, to increase employment and to increase the tax take from its citizens. It is regarded globally as a good place to establish headquarters from which to access European markets.
It still has a long way to go before its SMEs will feel that there is a sufficient supply of credit available, but new lenders are now emerging and its banks are returning to the loan market too.
Notwithstanding the other measures taken, it was the way that Ireland tackled its banking crisis so quickly (relative to other European nations) that has enabled it to get back on its feet. So what are the essential measures that a country needs to take to create an environment in which NPLs and SPLs can be resolved?
Nearly 8 years after the demise of Lehman and the trigger for the banking crisis on both sides of the Atlantic, the USA’s liquid capital markets and established credit markets infrastructure have enabled its lending market to recover.
In Europe however, only those countries that have the infrastructure to attract capital markets investors have recovered their supply of credit to facilitate economic growth. For other European countries, time is no longer their friend and delay will make matters worse; they need:
Finally, countries need to attract new equity and debt capital from local and international investors, not only via banks but also through funds and non-bank lenders to purchase loans and to refinance the collateral that is being recycled through work-out and loan resolution processes.
Servicers became established in the USA after the savings and loan crisis in the 1980s as a necessary component to enable loans and collateral to be recycled from banks and other lenders to the capital markets. The model was exported to Asia to help resolve the banking crisis in the 1990s and later to Europe.
Servicers are now an established part of the credit market landscape in some countries, mainly those countries where there is more liquidity in credit assets and more secondary trading of whole loans and via securitisation.
Servicers facilitate the recycling of assets and enable foreign lenders and investors to put their capital to work in jurisdictions where they have no servicing operations themselves. Servicers can become the operational hubs upon and around which loans can be originated, completed, serviced throughout their lifecycle and either refinanced as a performing asset , or recycled through work-out if they are in default.
Case study: Ireland
Ireland again provides a useful illustration. In 2009, after its acquisition of €77 billion of loans from 5 Irish lenders (mostly banks), NAMA retained the banks as primary servicers to collect principal and interest and to maintain the loan accounts on its behalf. At the time NAMA did not have its own operational infrastructure, and a migration of the pool of loans was considered impractical. Data was held within the banks on nine different banking systems. Each bank could only report on its own cohort of loans and it was difficult for NAMA to get an aggregated and holistic view of its exposure to counter-parties.
NAMA engaged Capita to create a secure data and payments centre for the aggregation, maintenance, and timely remittance of loan data and cash collected to NAMA for its entire acquired portfolio of loans. Capita was also engaged as a back-up servicer to take over the primary servicing and some collection and work-out activities in the event of the failure of any of the banks.
In 2013, following the liquidation of Irish Banking Resolution Corporation, Capita was appointed primary servicer for the IBRC serviced pool of loans, (approximately €42 billion). In so doing, Capita, hired approximately 140 staff (formerly employed by the IBRC) to create a ring-fenced team dedicated to the servicing of this pool of loans. By 2016 the vast majority of these loans had been liquidated by sale and other means, and the collateral had been recycled and refinanced with new debt and equity. Many of the staff have been redeployed to new roles within Capita on new servicing mandates.
This is a good example of how a servicer, a bank and a government sponsored entity can collaborate to create a solution that works to the best advantage of all, and for the wider benefit of a country’s economy. The principles can be used in other jurisdictions, adapting the model to suit each jurisdiction’s law and business culture.
The operating infrastructure of servicers can be utilised by banks, non-bank lenders, distressed debt investors and bond investors to enable them to gain access to markets and assets without the need to invest in operational infrastructure. Investors can originate and trade assets and enter and exit markets when they need to, knowing the assets will be serviced throughout their lifecycle by a third party servicer, their operating partner.
By separating the ownership of loans from the servicing of loans, lenders and investors can retain more flexible strategies, and the countries in which the servicers operate can benefit from increased liquidity, transparency and objectivity to enable faster recycling of assets in the future. To that end, servicers can play a small but important role in increasing the liquidity of the credit markets of countries in which they operate.
A country with an apparently thriving banking sector, with ample supply of loans and demand from borrowers may see little need for servicers. In Europe, in the good years of the past, lenders have generally not sold portfolios of “whole” loans, nor outsourced the servicing of loans in great volumes to servicers, finding little benefit in doing so.
In the UK and Netherlands, the two largest mortgage backed securitisation markets in Europe, servicers have grown, become established and in a few cases become very large. But in some countries in Europe, trading loans is perceived to run the risk of falling foul of data privacy laws.
Numerous factors have weighed on banks to discourage secondary trading in some countries in Europe, and the case for servicers to enter those markets has not been made. In most cases, countries have only developed the market infrastructure to support an efficient secondary market in loans, (securitisation and/or whole loan sales) when there has been a catalyst, or a “burning platform” necessitating change. In most cases around the world, that “burning platform” has been a banking crisis and today, the need for change is most keenly felt in Europe.
Servicers are commonly associated with the debt investors (mainly US funds) with whom they frequently work. Some investors own their servicing platform, preferring to exercise de facto control via equity or quasi-equity ownership. Others prefer to work with third party servicers, but insist on aligning the financial interest of their servicer with their own financial interest, either through co-investment or incentive based fee structures.
“Time and again, servicers have emerged as an essential component for resolving banking crises in nations across the globe. Working with international distressed debt investors, so often called ‘vultures’ by the press, with all the wrong connotations attaching to that moniker, investors large and small have catalysed economic recovery from banking crises across the globe. Along with a community of servicers, they have developed expertise in identifying and extracting the real residual value from the remains of loans made some years earlier in very different economic circumstances. Servicers and investors can work, and in many countries have worked, hand in hand with banks and central banks to eliminate the corrosive effect of the NPLs and SPLs that clog and congest bank balance sheets and prevent the wheels of a well-oiled credit market from working properly.”Peter Walker
DIRECTOR, CAPITA ASSET SERVICES
A small number of servicers operate independently and have the scale and credibility to act for banks or for asset management agencies, providing services to facilitate more efficient loan work-out without the need for loan sales.
Maximisation of loan recoveries, within the law, taking into account public policy and principles of fairness is what servicers, assisted by professional advisers, bring to the process of rehabilitating a nation’s economy through the recycling of loans and their collateral.
The process of recovering money from loans can be tough for debtors, bringing recrimination and blame for mistakes of the past, but it is necessary work. It requires relentless focus, by teams whose roles are clear and unimpeded by the responsibility for, and conflict of interest arising from, the embedded relationship between the bank and its customer. This is the value that an independent loan servicer can bring, by deploying its systems, processes and people trained for the purpose.
This material is for general information only and is not intended to provide specific advice.