According to the official European definition, non-performing loans are those for which interest payments have ceased for a period of at least 90 days. As a result of this, the likelihood of the borrower defaulting on a loan rises as this situation continues.
No longer only is the lending bank no longer compensated, but due to the increased default risk of the bank’s counterparty (the borrower), the bank must strengthen its provisions. Consequently, the ability of the banking sector to support the financing of the economy is hindered by this mechanical limitation (especially in Europe where the banks participate very largely in the financing of companies).
The bank must make provisions (accounting obligation) and potentially set aside more equity (regulatory obligation) if a loan is not or no longer repaid, which reduces its ability to provide new loans; if the amount of bad debts is too high, the bank’s profitability is reduced, which can pose problems for its economic survival and harm the confidence placed in it by its financial partners.
A sharp increase in these loans occurred following the financial crisis of 2008; however, these loans have been steadily decreasing since then (but slowly according to the authorities). In spite of the fact that they are large (in the region around 780 billion euros, i.e. several percentage points of European GDP), these loans are concentrated in a few countries (Greece, Italy, etc.) and in a few types of institutions (banks).
Problems persist due to the high level of non-performing loans:
An impediment to bank profitability due to increased administrative costs and financing costs; Provisioning requirements that weigh on equity levels; A risk to banks’ viability from the high levels of non-performing loans. An impediment to monetary policy transmission and financing due to the immobilisation of capital to guarantee unproductive assets.
The European Council of July 11, 2017, adopted an action plan that led to the adoption of a package of measures by the European Commission on March 14, 2018, in an attempt to stem or, at the very least, limit this phenomenon. A new set of guidelines issued by the European Banking Authority (EBA) in October 2018 (effective June 30, 2019) will help banks better understand the loans they hold.
The following are some of the measures’ stated goals:
Underprovisioning can be avoided if automatic provisioning practises with deadlines are used; privileged creditors can be better protected; and non-performing loans can be sold on secondary markets.
We recognise the significance of eradicating these NPLs in light of the current situation. To put it another way, it makes sense to think of the PNP as being somewhere between zero and one hundred percent of the amount of money that should be reimbursed.
In this way, any financial institution can aim to:
To begin, banks must ensure that they are complying with IAS / IFRS accounting rules, which states that banks must not only provide from an accounting perspective but also from a prudential one. In order to do this, they use internal models that are based on the book value of a PNP, which is obtained by realising a discounted sum of the probable value of future reimbursements, it being specified that this value also depends on the cos. In terms of unsecured loans, the ECB’s expectations and the European Commission’s proposals are very similar: After two years of being classified as “non-performing,” a provision of 100% is expected; for secured loans, differences remain, so securitization may be necessary. Securitization is a financial technique that involves selling the NPLs in the secondary market to investors by transforming these illiquid debts into financial securities that are easily exchangeable and therefore liquid on the c-market; this technique is called “securitization.” Two types of securitizations are available to investors: the traditional one, where the bank continues to manage the credit, but no longer bears risk, and the synthetic one, where credit is transferred, but no credit is transferred. ‘assets’ are realised through a credit derivative; several factors contribute to a valuation (pricing) higher or lower NPLs in the context of securitization or, more generally, of a sale on a secondar basis. If you’d like to clear your bank’s balance sheet, you’ll need to sell PNPs at a discount of 10% to 50% of their initial value; – finally, to set up a defeasance structure, which is the last resort to do so; in order to protect the financial interests of the banking sector, these structures are typically established following a public decision that seeks to remove risky assets from the balance sheet An asset management company (SGA) acquires and manages previously valued PNPs in order to avoid a bail-in risk. More than two dozen SGAs have been set up since 2008 to assist banks in difficulty with the sale of risky assets; in practise, a defeasance structure is an asset management company (SGA).