Tackling Non-Performing Loans (NPLs): a crucial issue for banks
The management of NPLs is a subject that will unfortunately be a hot topic for banks in the coming quarters. NPLs are indeed one of the main sources of value destruction for banks during economic and financial crises. During each crisis, banks’ levels of provisions for credit risk rise to high levels for typically two or three years, until the activities of the defaulting clients are restructured and normal economic activity resumes. In the long run, this can be considered as the price to pay for a business which in essence is to take risk: the cost of risk in times of crisis is normally more than offset by the profits made in the good years of the economic cycle. To clarify the issues at stake, it is estimated on the basis of past crises experience that the average additional cost of risk associated with a crisis is around 100 basis points of credit assets, i.e. on average for the 4 major French banks the equivalent of 2019 net income. This justifies that banks’ management teams pay a particular attention to it.
However, experience shows that loss levels vary significantly from one bank to another and within a banking group from one business line to another. These differences are, of course, primarily due to varying levels of risk (consumer credit is generally riskier than real estate lending) or differentiated sectoral exposures. But the experience of the subprime crisis has shown that banks have levers that can significantly reduce these impacts (ringfencing, asset sales, adaptation of risk policy, etc.). Ultimately, the impacts of the crisis for banks will therefore also depend on their ability to take adequate measures to best manage the wave of credit defaults that is looming. The impact of loan defaults is therefore anything but inevitable.
The issue is particularly crucial since the COVID-19 crisis is unprecedented by the magnitude of the recession it generated, its global extent and the lasting psychological and social impacts it will have. The time it will take before a full return to normal remains as things stand a major factor of uncertainty. While monetary creation and government aid have temporarily succeeded in postponing or mitigating its effects, the crisis will, as we already know, be particularly hard on corporations, with economic impacts affecting many sectors. Most banking activities will therefore be suffering, wholesale banking of course, but also retail banking impacted by the defaults of SMEs, specialized financing such as leasing, not to mention the potential contagion on real estate or personal loans, still very uncertain at this stage. While no one is able to accurately predict the actual intensity and duration of the crisis, one thing is already clear to the banks’ management teams: one of the key performance factors throughout the crisis will be their ability to minimize the impact of NPLs.
In this context, banks must quickly get ready to deal with the wave of defaults and restructurings to come. Five major levers must therefore be considered:
- Be able to detect problematic assets: whether through sector analysis, by exploiting external sources such as rating agencies or through information gathered from borrowers themselves, early detection of problems is critical in order to take appropriate measures as quickly as possible;
- Proactively manage the NPL portfolios: as with any credit portfolio, the ability to determine portfolios’ risk exposure, to assess their transferability and monitor their evolution makes it possible for financial institutions to reduce their exposure to specific sectors, through asset disposals, risk transfer or hedging transactions;
- Manage the economic and financial impact of NPLs: this involves managing both the current impact on net income, in compliance with the prudential rules, but also strategically managing the economic impact of NPLs over time through a prospective vision of the evolution of the loan portfolio;
- Optimize the management of debt collection and restructuring: the debt collection management processes, which become instrumental in times of crisis, must be adjusted and their resources used in the most appropriate way to maximize the recovery;
- Adapt risk-taking to the context: the evolution of the crisis, which is by nature difficult to predict, requires a regular review of the risk policies by sector, product or country, with a view to managing NPLs as effectively as possible, while maintaining business targeted in healthy sectors neglected by competitors.
While none of these levers should be neglected, it is important for each institution to early identify the areas in which there is significant scope to improve. This is particularly critical since the operating modes that normally prevail over certain processes (e.g. recovery, provisions, etc.) must be reviewed in times of crisis to adapt to a much larger volume. The challenge of carrying out such an early diagnosis is first to control the P&L of the coming years with, as far as possible, the reduction of the impacts of NPLs. It is also a matter of rapidly mobilizing the entire organization around the challenges of defaulted loans (Risk, Finance, Front Office, Portfolio Management, Operations, etc.). Finally, it is a question of being able to respond to the regulator’s claim for efficient management of NPLs, with potential impacts on capital requirements for banks that would be deemed insufficient.