Walking into a Canary Wharf or Wall Street bar/club, this is probably the worst banter that you can ever hear from junior bankers who, after hours spent in pitching companies and structuring financial models, try to approach the most wanted top-model of the night. I do not have to specify how many times this gimmick makes their chances of success terribly decrease. By the way, this simple joke contains a truth that basically everyone knows. Traditional loans bear interests, which represents the cost of the financial resources provided from lenders to borrowers. In an ideal and rose-tinted world, borrowers take the money, use it to buy goods/services or invest it in something else and then, in predetermined maturities, return those interests and reimburse the sum borrowed to the lender (mainly banks). However, this is not always the case.
NPLs or NPEs: a unique definition
Nowadays, in the European Banking System, there has been considerable debate on and attention to the so-called Asset Quality issue. Regarding Italy, a vast portion of the loans in the Italian Banks portfolio are deteriorated ones, which means they are less likely to be repaid (either in terms of interests and of principal or both) and thus worse in quality if compared with Performing Loans. Those Loans are usually defined as Non-Performing Loans / Exposures (NPLs or NPEs), depending on the regulatory framework considered (the European Banking Authority uses NPE). A NPE is any “debt instrument and/or off-balance sheet exposure which satisfies either or both of the following criteria:
- > 90 days past-due,
- unlikely to pay without realization of collateral
- even if it not recognized as defaulted or impaired
The EBA utilizes the term exposure in order to take into account into this framework also other securities that cannot be strictly defined as Loans, but may play a significant role in banks’ balance sheets. In addition to this definition, Banks in Italy are required to classify NPEs within the following categories (ordered by decreasing quality):
- Past-Due Exposures (Scaduti or Sconfinanti): problematic exposures that, at the reporting date, are more than 90 days past due on any material obligation (either the principal or the interest or both);
- Unlikely to Pay (hereinafter UTPs, formerly defined as Incagli): exposures that are unlikely to be repaid in a full and timely manner without the recourse to actions such as the realization of collaterals
- Bad Loans (Sofferenze): defaulted exposures to borrowers in a position of insolvency, even if not necessarily recognized by a court of law and regardless of the presence of any sort of collateral.
As one can easily understand, these might be dynamic classifications. In more detail, a NPE can be, for instance, classified at first as Past-Due, then as UTP and ultimately, if its quality continues to deteriorate as a Sofferenza (this phenomenon is defined as migration from one category to another). These means that, if no action is taken, there are high chances that the asset quality of a bank’s keeps deteriorating as time goes by.
Key metrics: how to evaluate Asset Quality
In order to evaluate the quality of assets, there is a wide range of accounting indicators, which thanks to an improved standardisation of financial reporting, allows to compare a bank’s books over time and with its peers. The main metrics are the following:
- Gross NPE Ratio%: computed as the ratio between Gross NPEs and Gross Loans, it indicates the percentage of NPEs on the total Book Value of the loans in the bank’s balance sheet;
- Net NPE Ratio%: computed as the ratio between Net NPEs and Net Loans, it indicates the percentage of NPEs on the total Book Value of the loans in the banks’ balance sheet, net of the cumulated Loan Loss Provisions (LLPs are non-monetary expenses, set aside in order to cover expected losses on exposures); it differs from the previous one since it considers net values, that already take into account provisions made by the bank;
- Coverage: (Gross NPEs – Net NPEs)/(Gross NPEs)%, it defines how much of the deteriorated exposures have been covered by provisions and thus indicates the extent made by the bank to limit future expected losses. This metric can be computed for each of the aforementioned categories of NPEs, thus we can compute a Bad Loans coverage, a UTP coverage and a Past-Due coverage. It goes without saying that the most critical exposures that should be covered are Sofferenze, given their lower asset quality;
- Cost of Risk (CoR): computed as the ratio of the LLPs of the year (that is a P&L item) on Net Loans, it is a measure of the risk-profile of a bank’s lending activity
Italian banks an NPEs, the current situation
Some of the reasons why European Banks (Portugal, Italy, Greece and Spain more than other countries) suffer from high level of stocks of deteriorated loans, derive from the peculiarity of these economic system, centred around Small and Medium Enterprises (with lower creditworthiness and thus more likely to default) and characterized by a limited funding diversification (they are mainly dependent on banks and less market-oriented then Anglo-Saxon Economies).
As it can be seen from the chart below, after reaching an all-time high in 2015, Italian NPEs finally started to decline. Gross were down c.-3% and Net c.-6% in H1’16, thus indicating more prudent provisioning.
Graph 1: Gross NPE stock in Italy over the period 2008 to H1’16; source PwC, “The Italian NPL Market”, Dec. 2016
Graph 2: Net NPE stock in Italy over the period 2008 to H1’16; source PwC, “The Italian NPL Market”, Dec. 2016
Impact of NPEs and the ways to reduce them
A high stock of NPEs have a great impact on a both a bank’s current and future profitability. The former is impacted by LLPs made by the bank to adjust the net value of loans to their degree of solvency, thus affecting current Net Income. The latter depends, not only on the future LLPs, but also on the loss reported when disposing the deteriorated exposure to third parties (NPEs are priced much less than their book value). In addition, the higher the losses, the higher the possible capital erosions and thus the higher the risk of not meeting the regulatory capital requirements.
It is thus fundamental for Italian banks that suffer from excessive NPEs’ accumulation to find way to simply “get a rid of them”, as fast as and, at the same time, as painlessly as possible. Among the possible alternatives (internal NPEs collection, isolation of deteriorated exposures from performing ones) Write-Offs (that is increasing the coverage of a loan to 100% and then deleting it from the book) and NPEs disposals seems to be more effective now that speed is probably the key driver of success: losses appear to be the price to pay in view of better asset quality. UniCredit might represent a virtuous example.
In 4Q’16, the main Italian bank by total assets (c.€800bn, not peanuts) disposed roughly €18bn of NPEs. This led UCG to post a huge FY16 loss of €-11.8bn, with a significant impact on capital. However, following the clean-up and the full completion of the massive €13bn capital increase, UCG is ready to recover pace in the profitability path, targeting an ambitious 2019E Return on Tangible Equity of 9%, in line with best European Peers.
To conclude, quick disposals and write-offs have of course a strong impact on profitability and capital, but can help Italian banks to grow wings and recover the lost time. Rid the cause and you will rid the symptoms, however painful, or, very simply “via il dente, via il dolore!”.