The principal activity of a bank is to grant loans to people, in order to buy a car or a house, or to companies, to allow them to invest, create profits and more jobs. Banks loans usually turn out to be either in bonis loans or bad loans, that is when it is difficult for the bank to get back the money lent. In particular, credits turn to be non performing in these cases:

  • Bad loans are exposures to debtors that are insolvent or in substantially similar circumstances.
  • Unlikely-to-pay exposures (aside from those included among bad loans) are those in respect of which banks believe the debtors are unlikely to fully meet their contractual obligations in full unless action such as the enforcement of contractual collaterals is taken.
  • Overdrawn and/or past-due exposures (aside from those classified among bad loans and unlikely-to-pay exposures) are those that are overdrawn and/or past-due by more than 90 days and for above a predefined amount.

This current problem scares European banks and particularly the Supervisory Authorities that face the issue and try to find solutions to manage it. The EU weighted average of NPL on March 2016 is 5.7% and it is highly disperse across EU countries: Cyprus has a NPL ratio of 49%, Greece of 47% and Italy’s bad loans are the 17% against Luxembourg, Sweden and Norway who have a NPL ratio of only 1%.

Finding the drivers that have created this situation allow to know why this whole thing has gotten out of hand. Here we try to show how the effects of the financial crisis of 2008 are linked to nowadays’ situation. In our Country, the high public debt and its structural imperfections, with fiscal evasion, oppressing bureaucracy and a slow pace of Justice of the Italian legal system above all, expanded the effects of the crisis. The most important driver in the creation of bad loans is the economic performance of a country: when it is an expansive phase, there is a reduction of Non Performing loans and when the general economic is in adverse conditions, NPL ratio tends to be bigger. If you think about it, it is reasonable argument: the more households and businesses struggle, the less their debts are likely to be repaid.

Here we use an intuiting econometric model to find the relationship between the general economic trend of a country and its NPL ratio in aggregate form. Here we study Italy, one of the countries more hit by this problem in the euro area. The time range covers 10 years, from 2007 to 2016 and the dataset is from International Monetary Fund. The linear regression single equation explain it better. For X it has been used the percent change of  the real GDP, for Y the percent change of NPL ratio. NPL is calculated from the ratio of bad loans on total loans, in aggregate level for Italy. We expected that we will find a negative and opposite relationship between NPL ratio and GPD for the data we have just described.

Based on empirical test, the linear equation will be:

Y (% Change in NPL ratio) = 7.30514 – 6.51937 X (GDP variation).

On the right part of the equation, the first value is the intercept of its model, meanwhile the second one is the value of , X’s coefficient, that represents also the grade of the straight line, that is negative.

Data source: IMF

It is clear from the graph that our hypothesis is true. The blue line shows the variation of GDP while the red one the NPL ratio percentage: they went in opposite ways during the last ten years. At the beginning the economic trend was good and so the level of Perfoming loans, but during the years the situation changed. The 2008’s crisis has had an important role in this: from 2006 there was a steep increase of NPL ratio which reached a peak between 2008 and 2010. Going on in the years the situation evolved further with NPL ratio that steadily decreased before levelling out from 2012 to 2014. In the recent years GDP growth rate exceeded NPL’s line with a slight upward trend and meanwhile NPL ratio definitely decreased.


Data source: IMF

This scatter plot graph shows a straight negative line, during the past 10 years. In particular, 7.31 is the intercept of our straight line, and -6.52 the angle coefficient, that explains the negative relation between NPL ratio’s variation and percent change of GDP.

So, how to face the problem?

Banks have two options: keep these assets on the balance sheet or not, selling them to vulture societies, that are companies who buy others loans at a very low price and try to cash from the original debtor. The first choice can be managed in two way: keep the NPLs inside or outsource them. In both cases there are two most benefits: the bank maintains a relationship with the debtors and obtain a more high value than sell’s hypothesis. The internal management of NPLs benefits the bank because not only it keeps these assets but continues to manage them. Consob president, Giuseppe Vegas, believes that Italian Banks can choose this way and have the ability and the expertise to manage this process internally. Banks, he believes, will be able to handle not only “in bonis” loans, so the core activity, but also those bad loans that threaten an involvement in long procedures like enforcement of guarantees. Give loans in outsourcing is the right thing to do when there are not so many resources to waste from core activity. In this case fixed costs become variable costs: these one can be supported only in that way the loans are repaid, with always a small amount fixed. With those options, other costs arise: knowledge, experiences, know-how and also the monitoring from the bank to this servicing societies to see how it is going. Another positive fact is that banks can choose between different servicing companies for different loans, so they have a more probability to cash from the debtor but at the same time more costs. The NPLs’ selling hypothesis consists for the bank to dispose of Non Performing credits, giving them to a collection agency at a market price that would be much lower than GBV, already sets aside. Benefits of NPLs’ selling option include: profitability, capital strength and bank riskiness. Through selling bad loans, the bank has more liquidity that can be used for new loans, in bonis, which will produce revenue from interests. Furthermore, the elimination from the balance sheet of deteriorate credits reduces bank’s riskiness and implies benefit from rating agencies. Important is consider the market price of a portfolio made by bad loans, determined by different factors: if there is a collateral or not that implies the recovery rate (how much bank have to wait to have the loan back), time frame, servicing costs and the remuneration asked by the investor to take the risk (Irr). For all those facts, the Mkt price will be obviously lower than GBV and a pricing gap between those two values. So, selling NPL there always would be a capital loss on the income statement, which will determinate a reduction of the balance sheet, already submitted to requirement of capital by Eu Authorities. After all considered above, what is the best solution then? It is important to balance positive and negative facts in order to find the best solution for the different specificity of banks.

The latest news is that ECB wants, from January First 2018, to reduce to zero NPL assets. It would take two years for assets without collaterals on the balance sheet, called “unsecured”, and seven years those with warranty, the “securities” one. This means that the ECB believes that is not useful keep on the balance sheet for more than two years bad assets “unsecured” or for more than seven years Npl with a warranty, because it will show a distort situation. There is no possibility that banks could hope to get back credits after two years or seven, so that, for the principle of prudency, banks will have to get rid of this kind of assets. Lots of Italian politicians and important personalities of the Italian financial world think that this document of consultation can determine the collapse of our country if it became law. They talk about “suicide” choices for our country, which tries to kill and not to encourage the growth. But ECB only wants the banks to act on common sense. If a bank have on its balance sheet some assets still in bonis, but there is a high probability that it has to turn them to bad assets in future, there are two choices: classify them as NPL by December 2017 or wait next years and submit to the new rules. The first options means that interest margin of this year will be reduced and will cost a lot to banks and investors. It make no sense keep a value unchanged for more than seven years if secured or two if unsecured, but it will show a distort situation. In conclusion, the ECB proposal, that maybe will become law soon, encourages a selling hypothesis among the others, being characterized by a much lower market price than before, and even that any other possible solution.

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