Maximising Value of NonPerforming Assets

1
Maximising Value of Non-Performing Assets

• Performance and Resolution of Non-Performing
  Assets the Importance of Hard Evidence
• by P. Grippa, S. Iannotti, F. Leandri (Bank of
  Italy)
• Seoul - 11/11/2003

2
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Measuring recovery rates of bank loans is
  relevant
• to assess the performance of workout procedures
• to feed internal portfolio models and the Basle
  II Advanced-IRB regulatory function (LGDs)
• to correctly determine the value of loans
  transferred through securitization

3
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Recovery rates can be measured by
• using the market prices on defaulted bonds or
  marketable loans soon after default (market
  method)
• discounting the future cash flows resulting from
  workout from the date of default to the end of
  the recovery process (workout method)
• extracting the recovery rate from non-defaulted
  risky bond prices by means of an asset pricing
  model (implicit method)

4
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• The workout method is particularly relevant since
  portfolios of banks consist mainly of
  non-marketable loans
• Calculating workout recovery rates requires a
  discounting methodology of the cash flows

discounting
t0
t1
t2
T
5
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• In the years 2000-2001 the Bank of Italy
  conducted a survey on workout procedures and
  recovery rates in the Italian banking system
• It addressed commercial banks (foreign bank
  subsidiaries and mutual banks excluded) around
  250 banks, representing gt 90 of total loans as
  of December 1999
• It collected data on bad loans closed in 1999
  (loans for which a specific event or board
  decision has determined their cancellation from
  the banks books)

6
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Structure of the quantitative survey
• Province
• Type of obligor (household, company, public
  entity, etc.)
• Economic sector
• Default date (when classified as bad loan for
  the 1st time)
• Exposure at default (with evidence on collateral
  guarantees)
• Legal expenses
• Cancellation date
• Total amount of recoveries (capitalized at
  cancellation date)

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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• A vast majority of banks was able to respond to
  the quantitative part of the questionnaire
• but by different degrees of detail
• After controlling for data quality, the database
  showed the following figures

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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Time length of workout procedures
• in years

9
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• of utilization and mean recovery rates by
  procedure

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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Average time to recovery, by province
• in years

(the darker the color, the lengthier the time
to recovery)
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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Evidence on costs of workout procedures
• Labour costs plus external services costs in 1999
  amounted, on average, to 2.3 of each banks
  total operating expenses
• These costs varied with the location of the bank
  (northern banks seem to be more efficient)
• Weighted average total costs of workout
  procedures in 1999 amounted to 1.2 of bad loans

12
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Considerations
• The nature of data required was considered a
  compromise between
• the high detail required by advanced risk
  measurement methodologies and future regulatory
  rules (Basle II)
• and
• the current state of the art of workout databases
  (critical, as for most banking systems)
• Even so, the degree of detail required proved to
  be too demanding for many banks

13
The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Considerations
• The survey was useful, but could not, by itself,
  address the basic problem of delays in the way
  the banks address the workout function
• but things, at least in Italy, are changing
• some banking groups have created legal entities
  devoted to restructuring and workout procedures
  on the loans originated by other intermediaries
  within the group ...
• other groups have created internally workout
  divisions which are assigned a budget and are
  assessed as profit-centers

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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Considerations
• Overall, it seems that the attention on workout
  procedures has increased
• This should prompt better internal data
  collection at banks in the next future
• On its side, the Bank of Italy is planning to
  realize a centralized national database to foster
  the collection of data at banks and to provide,
  as a feedback, a national benchmark for recovery
  rates

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The Importance of Hard Evidence Results from a
Survey on Workout Procedures in Italian Banks

• Considerations
• The degree of detail needs to be much higher than
  the one adopted for the 2000 survey
• This represents a challenging task for many
  banks, but it looks as the only way to collect
  sensible data on recovery rates and on the length
  and costs of workout procedures
• It could help banks wishing to move towards the
  Advanced IRB approach under Basle II