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The distressed debt landscape in Europe
The negative effects of the pandemic look set to strike European banks hard. Throughout 2020, regulatory measures and state support camouflaged deteriorating asset quality in bank books, and stabilized NPL ratios. The full impact of the crisis is therefore only likely to materialize in 2021 and 2022 as support measures are scaled back. It is at this point, according to model-based scenario analyses, that pandemic-induced defaults are expected to increase NPL volumes significantly.
Indeed, our model-based scenario analyses suggest a potential increase in the NPL ratio of European banks from the current 2.9% to 4.9% by the end of 2022. Using data from the EBA sample, and correlation analyses run by the ECB, we conclude that this increase might lead to a 25% reduction in new corporate lending across Europe.
If the upcoming challenge of distressed debt cannot be quickly resolved, a vicious cycle risks a decade of stagnation in Europe. If banks are reluctant to realize losses and resolve their distressed debt predicament, we shall see a zombification of the real economy and constrained recovery, making banks suffer even more.
On the other hand, banks can derive major benefits if they resolve their impending distressed debt situation. First, they would improve their financial position through a release of capital for new and profitable lending activities, a decrease in CET1 risks associated with uncovered distressed debt positions, and a reduction of funding costs related to the coverage of risky distressed debt portfolios.
Second, they would be able to enhance their operations. A clear and credible foundation for financial planning would be established. They could reallocate staff who would otherwise be bound up in the workout of distressed debt exposures to more forward-looking roles. On a more general level, the banking sector would receive a boost from the overall reduction in uncertainty and strengthening of its resilience.
The distressed debt resolution spectrum
Fortunately, a broad range of options are available for resolving the expected wave of distressed debt. On a macro level, these solutions may be clustered into two categories – government-led and market-led.
With the government-led approach, banks transfer distressed debt to a central resolution entity, or “bad bank”, normally initiated by the government, which then manages the workout of these assets. To achieve a solution for the European Union as a whole, an EU-wide asset management company (AMC), or various country-specific AMCs following a harmonized blueprint, could be established. More radically, some believe that the ECB could act as a direct buyer of the debt.
The main difference between the two government-led alternatives is that AMCs generate funding from private investors and/or through state aid, whereas the central bank can simply create the necessary money if required. Depending on the level of state or central bank support, prices for the transferred assets would mostly fall somewhere between net book value and market value. The relevant central entity could perform the workout in-house or by enlisting the support of external servicing companies.
Traditional examples of government-led models for distressed debt resolution include the Spanish SAREB in Spain, a central AMC established back in 2012 and funded by both private investors and the state, which focuses on non-performing real estate assets; and the VAMC in Vietnam, a state-owned AMC launched in 2013 which covers secured NPLs across all segments.
In a market-led model, banks dispose of distressed loans with private investors, either through large-scale portfolio transactions or individual loan trades. These investors would then manage the workout of the loan portfolio and seek to create value from these assets.
Both the government-led and market-led approaches generate significant benefits and also challenges.
The government-led setup is highly efficient in acquiring distressed debt and swiftly reducing the debt burden of struggling banks. Moreover, state funding can be swiftly put in place, and could help to close the gap between the pricing requested by banks and the pricing offered by investors.
However, the implementation of a government-led approach could also invite legal and political challenges as it interferes with market structures. Any misalignment of interests among the potentially diverse set of shareholders may also complicate decision making and workout processes. Moreover, additional funding involving private investors might present challenges due to differing preferences, for example with regard to asset selection or workout strategies.
Market-led solutions, meanwhile, are more flexible. They enable tailored asset selection, can effectively match investors and banks possessing aligned interests, and are better able to service different loan portfolios according to their specific needs. Also, the strength of investors’ market intelligence can be utilized for a more efficient and value-preserving workout of assets.
There are drawbacks to the market-led approach, however. Clearly, there has to be sufficient interest from investors to make it work, while continued pricing gaps would offer limited incentive for banks to sell their distressed debt exposures. Market-led solutions for distressed debt would also make it more difficult for governments to implement targeted support for specific industries, such as those most severely affected by the pandemic.
Market facilitators
Certain factors would provide a solid foundation for a distressed debt market across Europe. One potential facilitator would be the standardization of credit servicing and purchases. This may involve the harmonization of requirements, and the creation of a single market for the servicing and transfer of distressed debt to third parties; common standards, for example on authorization, available information, and enforcement; and rules on safeguarding and transparency that ensure consumer protection.
Data quality and infrastructure are also important factors in the successful functioning of a distressed debt market. Obligatory templates for standardized data transfer, as well as distressed debt transaction platforms for data integration, reporting and valuation, could foster the efficient transfer of distressed assets.
The final facilitating element is securitization, which can be used as a tool to generate portfolio transactions that are more tailored to investors’ risk appetite. However, regulatory obstacles, such as disproportionate capital requirements, would need to be reduced to enable this securitization market to develop.
Standardized state guarantee schemes for securitized distressed debt transactions, such as the GACS in Italy or Hercules in Greece, can efficiently support the development of a secondary market for distressed debt. The GACS, for example, has resulted in a quadrupling in distressed debt transactions, and a reduction in the NPL ratio of Italian banks of approximately 50% (from ~17.1% to 8.4%), within two years of its introduction in 2016. It provides an unconditional and irrevocable guarantee on senior tranches, amounting to around 80% of issued notes, and has served to bolster the debt reduction programs of many Italian banks.
How should banks and investors prepare for the distressed debt challenge?
From an institutional perspective, the potential distressed debt crisis poses a major challenge for banks. For investors, meanwhile, the upcoming proliferation of distressed debt could provide attractive opportunities. The below graphic sets outs what ought to be the key priorities for both banks and investors at this crucial juncture.
Readiness for what appears to be an inevitable sharp increase in distressed debt volumes is vital. If astute decisions are made now by both the authorities and institutions, they will help to forestall several years of European economic stagnation.
Priority topics for banks
To navigate the NPL challenge, banks need to focus on five priority topics.
- Strengthen early warning systems and identify most significant risk drivers
- Resolve organizational and capacity constraints to ensure that workout and restructuring lifecycle is sufficiently flexible
- Ensure robust governance and decision making, and convey clear guidance to front office as well as recovery units
- Develop perspective on expected distressed debt levels in own portfolio and identify capital impact
- Strengthen exit management capabilities to facilitate potential deleveraging of distressed debt from balance sheet
Priority topics for investors
Upcoming waive of distressed debt could provide attractive opportunities for investors.
- Refine distressed debt investment strategy, e.g. regional or industry focus, single tickets vs. portfolios, quality of loans
- Establish clear distressed debt management strategy, e.g. internal management vs. trading of loans and build required in-house competencies
- Develop strategic partnerships with other investors or banks to source new investment opportunities in the market ahead of the curve
- Increase operational flexibility for upscaling special capabilities to service distressed loan portfolios (internal vs. external)
- Build restructuring capabilities to increase return from distressed loan portfolio where possible (e.g. Stage 2 loans)
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