Structured securities and NPLs: Bank of Italy findings and new tools offered by CRIF Group

European banks are not out of the woods yet. This was the finding of a recent international meeting organized by the Catholic University of Milan, together with CRIF Group and the Credit Risk Club. The speakers focused on the so-called “illiquid assets” held by lenders, and more precisely non-performing loans and structured securities (financial instruments without reliable market prices, and which accounting standards require to be recorded according to internal estimates).

During the meeting, two recent research papers by the Bank of Italy were presented and discussed by a panel that included academics, analysts and executives from international banks, regulators and supervisory authorities.

Alarm bells were set off in relation to structured securities by Rosario Roca, an experienced auditor with the Bank of Italy, as well as expert in accounting rules and banking management practices. These financial instruments, held primarily by a few large French and German banks, are hard to value, for both banks and supervisory authorities. What everybody agrees upon, however, is that even a slight error in the values attributed to these securities could have a dramatic impact on lenders’ assets. Therefore, European supervisory authorities may want to pay more attention to this aspect, which historically has not always ranked high in their priorities.

Another expert from the Bank of Italy, Piergiorgio Alessandri, discussed non-performing loans (“NPLs”), reporting the results of a complex and in-depth study analyzing data on an individual bank and borrower level. The research does not support the conventional view that banks “burdened by NPLs” are bound to lend less and to slow down the economy. On the contrary, an increase in NPLs and a weaker demand for loans by companies (leading to a slower growth in credit) are both caused by the same thing, i.e., the poor performance of the real economy. Therefore, the purging of NPLs from balance sheets (as repeatedly requested by the ECB to large lenders in Italy and other peripheral countries in the Eurozone) is not enough to kick-start lending and trigger economic development.

Following on from these results, the Bank of Italy’s Deputy Governor, Fabio Panetta, asked for effective supervisory action, but without forcing banks to offload NPLs at any cost. In a similar vein, Roberto Gualtieri, Chair of the European Parliament’s Economic and Financial Affairs Committee (“ECON”), noted that an indiscriminate increase in NPL-related provisions cannot be imposed across the board, unless a new specific piece of legislation is passed (which, however, should only apply to future loans).

NPLs were also addressed by Andrea Resti, Professor at Bocconi University in Milan and Senior Advisor to CRIF Group. His speech included two recent innovations that could benefit these processes, as shown by pilot projects that have been developed by CRIF over recent months.

The first innovation relates to a more accurate estimate of expected recovery times associated with different types of non-performing loan. The most common practices used by banks and investors today are based on the type of exposure, the collateral, and the geographical area, particularly where the judicial procedure takes place. Other strong drivers, however, are often overlooked, including some characteristics of the defaulted borrower (e.g., longer recovery times for larger companies). Using these additional factors in a bank’s forecasting models would make recovery estimates more reliable, driving up prices when NPLs are sold to third-party investors.

The second area where significant improvements can be achieved is the so-called “Online Civil Trial” (OCT) that has been adopted by all civil courts in Italy over the last decade. The OCT requires that legal documents are filed and accessed via an online, paperless system, and this is often perceived as an additional burden. However, it may significantly improve the effectiveness of the workout process, e.g. by helping banks to closely monitor the activities of external lawyers, as well as by making it possible for outsourcers to access a vast, updated database supporting them in loan recovery actions. For this to happen, however, OCT data must be entered into the banks’ legacy systems, rather than being managed alongside the banks’ old IT procedures (leading to double workloads and to potential misalignments across different archives).

These are just some examples of how NPL management can be made more efficient, rather than just giving in to the loan sale requirements of supervisory authorities (who would like non-performing loans to be quickly removed from the balance sheet, even when such sales mean that banks may forego a large part of the profits from future recoveries). In short, lenders must act proactively to avoid being brought to task over the issue.