NPL Management and Markets
A lot will change in 2018
It seems as if banking regulation and accounting standards had finally discovered non-performing loans for itself. Starting in 2018, various new regulations will have significant influence on NPL practices in restructuring departments and markets, with other regulations still awaiting advancement or passage into law.
IFRS 9 ante portas – initial application from 1 January 2018
After long discussions and great implementation efforts, IFRS 9 (“Financial Instruments”; final status from 24 July 2014; Details) will finally become obligatory for reporting periods beginning on or after 1 January 2018.
IFRS 9 now envisages just two valuation categories for debt instruments: “Amortised Cost” and “Fair Value”, whereby further distinctions are made between “Fair Value Through Other Comprehensive Income” and “Fair Value Through Profit or Loss”. In the future, assignment to these categories shall be made according to IFRS 18.104.22.168 based on the company’s business model of managing financial assets (“hold”, “hold and sell” or “sell”) and the features of the contractual cash-flows (SPPI criterion). Thus, depending on the product portfolio, the modified rules present a need for fundamental change in the valuation of numerous financial instruments.
Under IFRS 9, the early generation of risk provisioning for credit risks (impairment) based on an Expected-Loss-based approach presents one of the significant changes to the previous impairment model, which focused on Incurred Loss according to IAS 39. So the Expected Loss events will be the yardstick for the up-coming impairment measurement: How far into the future these expected values are to be calculated depends on the loan quality, according to which loans shall be assigned to a so-called “three-level model” at each reporting date. The assignment shall be based on various quantitative and qualitative criteria, which can lead to considerable higher complexity. The second and third levels, which are particularly relevant for NPL, imply the calculation of expected values far into the future. As a rule of thumb, the new impairment procedures lead to a significant enlargement of write-downs for NPL.
With respect to the sale of NPL portfolios, the same requirements as in IAS 39 apply in terms of derecognition of debt claims in the context of an NPL transaction. In addition, it is of relevance whether the engagement for sale used to belong to the “hold” business model. Sales occurring due to a worsening in loan quality – as may regularly be the case for NPL portfolios – should usually be non-damaging for the “hold” business model. Questions of interpretation could come to the fore, though. Sales made for the management of credit risk concentrations, for example, are not subject to this rule. On the buyer side, the rules on Purchased or Originated Credit Impaired Financial Assets (POCI) apply.
ECB Guidance on NPL – applicable starting in 2017/2018
The ECB guidance on NPL (click here with further evidence) was published in March 2017 with an amendment following in October. The ECB formulated herein its recommendations for dealing with NPL in banks. Banks should reduce NPL stocks under the application of a uniform approach and uniform definitions, thereby improving the banks’ quality of assets. The supervisor’s expectations regarding a minimum level of risk provisioning for new NPL already made for fierce discussions at banks and in EU bodies. For loans receiving NPL status on or after 1 January 2018, banks shall hold complete coverage available after no more than 2 years for the unsecured portion of the NPL and 7 years for the secured portion according to the ECB’s addendum.
Numerous new requirements for NPL practitioners at banks as well as effects on the NPL secondary markets arise from the guidance. The freedom to follow the supervision’s recommendations, which it undermines with the word “expectation”, is de facto limited. No bank with a significant NPL stock will be able to elude these requirements.
EBA Guidelines on PD/LGD Estimation and the Treatment of Defaulted Assets
As part of the review of the IRB approach in order to minimize unjustified variability in the outcomes of internal models, the EBA finally published the final guidance in November 2017. IRB banks can expect a significant need for adjustment in the mid-term. The EBA itself proposes an implementation horizon until the end of 2020.
Action Plan of EU Ministers of Finance and Consultation of the EU Commission
However, politics have also dedicated themselves to promoting secondary markets. Ministers of finance in the EU have thus initiated a focused action plan while the EU Commission launched a consultation on NPL secondary markets. The initiatives arose from the perception that not only good management, early recognition and valuation are necessary in the context of an enhanced NPL treatment, but also a well-established possibility for banks to separate themselves completely from NPL. The highly anticipated discussion will resume in 2018.
The abundance of changes in 2018 will keep restructuring departments on tenterhooks while also presenting the potential to invigorate the secondary market for NPL significantly.