Can public support help Europe build distressed asset markets?

Over the coming months the European financial sector will need to digest a whole spate of bank restructurings. The sale of distressed loans will be a key element in recovery plans, such as we see in the recently-approved sale of a portfolio of EUR 27 billion book value by Italian bank Monte dei Paschi.

But relying on the secondary market only will be a sensible strategy if that market is liquid. Third parties need to be able to apply workout methods in debt resolution that recover value more efficiently than banks’ in-house processes.

As the latest ECB Financial Stability Review makes clear, Europe has not succeeded in building a vibrant market for distressed debt. Private sector advisory firms estimate the stock of non-performing loans and other ‘non-core’ assets at about EUR 2 trillion, of which only about EUR 100 billion transact per year.

Some euro area countries with systemic NPL crises, such as Greece, have seen no transactions at all in recent years. In the US this market is both more liquid (with an annual investment about seven times that in the EU in 2013), and also assigns investors a more prominent role in workout efforts.

Market failure?

Transferring the ownership in a credit exposure from the originating bank to an external investor encounters a basic market failure. While the bank has built up a long-standing relationship with the client, the investor cannot know the true quality of the underlying business, and the chances of its recovery.

As with the sale of used cars, imperfect information on the buyer’s side will prevent the market from clearing fully. This is the principal reason behind the significant spreads between the price at which the bank is prepared to offer an asset, given its provisioning so far, and what a potential investor is prepared to bid.

These problems are of course more pronounced for complex and heterogeneous loans to SMEs and larger enterprises, where the workout scenario and value that could be realised from collateral are hardest to predict. And it is indeed these corporate NPLs to medium and larger corporates where the secondary NPL market has been near absent.

For these reasons successful NPL transactions generally happen where the bank has successfully bridged the information gap, in particular by providing investors with a comprehensive data picture and legal documentation. Typically, a two-stage bidding process ensues during which potential investors will undertake extensive – and costly – due diligence.

The selling bank will need to support a lengthy bidding process over many months with staff and management from various departments, and signal clear commitment to the ultimate success of the transaction (see these overviews from IFC and EBRD).

Public support

Many European banks are still ill-prepared to engage with potential investors in this demanding market. The new ECB guidelines will give a much needed impetus to an upgrade of internal capacity. Supervisors will now monitor whether dedicated workout units are set up, that portfolios are managed and tailored for the relevant workout strategies, and that the IT infrastructure supports a sale process.

But the distressed loan market may not grow organically. One option for public support was Italy’s scheme of early 2016 under which banks securitise their bad loans, and then a government guarantee protects investors in senior tranches of such portfolios. While there would now be a protection for investors who come early in the hierarchy of value recovered, such a scheme does not deal with the underlying uncertainty about the workout process.

Another idea that was recently proposed by EU Commission officials is to create NPL clearing houses at either national or EU level. Such institutions could be either private or public and would register all portfolios for sale. The key role would be to act as a single counterpart for all potential bidders, and ensure all sales are backed by consistent data quality. Unlike in the case of a ‘bad bank’, ownership of the assets would remain with the originating bank, thereby avoiding problems in determining market value.

What only asset management companies can offer

The Commission proposal would essentially concentrate within a single institution the ‘match-making’ between bidders and banks that restructure their balance sheets. This role is currently taken on by advisory firms, who charge significant fees.

The assumption seems to be that this should be a public or public-private function because the success or failure of individual transactions can have important effects on the market as a whole. Also, a single institution may be more effective in championing reforms that support the involvement of investors in the workout process.

However, it is unlikely that a central conduit would simplify the sales process. Bidders for portfolios will no doubt seek direct contact with originating banks, which will retain ownership of the underlying exposures.

Experience in Ireland and Spain has demonstrated that central asset management companies can play an important role in facilitating the emergence of a liquid NPL market. Only direct ownership of the loan portfolios supports the function of ‘market maker’ – ie pooling and phasing sales in order to provide liquidity and predictable pricing.

Complex corporate exposures, as in the NPL stocks in Italy or Portugal, call for transparent valuation techniques, the pooling of exposures, and centralising expertise in restructuring. At present, the discussion on the establishment of new national asset management companies remains on hold as the EU bank resolution directive raises the risk that state aid triggers a bail-in of investors.

Recognising the loss in value

The EU can support the emergence of secondary NPL markets. One option could be to simplify the licensing of non-bank investors and loan servicers who acquire and restructure assets. The EU’s capital markets union programme could clarify when banking-type licenses are required. Another option could be to support the engagement by the EIB and EIF in managing securitised NPL portfolios.

As more portfolios are offered in the EU distressed debt market, more realistic valuations will emerge for some types of assets. Many banks will need to face up to the reality that their portfolios are still under-provisioned, and that specialist investors will demand risk premia and rewards for their workout efforts.