The COVID Recession and Bank NPLs - A Role for Public Asset Management Companies

Summary

• The economic crisis arising from COVID-19 is likely to result in rising Non-Performing Loans (NPLs) on bank’s balance sheets limiting their capacity to provide lending. 

• At the same time, Governments all over Europe are asking banks to provide new lending guaranteed by the state which can muddle the distinction between typical private and public sector credit risk. UK banks have already estimated that up to 50% of lending under the Government’s Bounce Back Loan scheme could default.

• Should bank NPLs rise to such an extent that decentralized bank-led NPL workout strategies are insufficient and put at risk bank’s ability to support a wider economic recovery, authorities may consider more centralized strategies, including Public Asset Management Companies (AMCs).

• AMCs have played a role after both the Asian and 2008 financial crises. Recently, Andrea Enria, Chair of the Supervisory Board at the European Central Bank (ECB) expressed his support for AMCs in principle should very high NPLs materialize in late 2020/early 2021.

• While AMCs have the advantage of cleaning banks’ balance sheets quickly, freeing up lending capacity, they are not without risks particularly with respect to asset valuations. If assets are transferred at the market value, it could mean losses for the banks governments are seeking to stabilise, if priced above their fair value, it exposes the AMC, and by implication taxpayers, to losses.

• In designing AMCs, it is essential they are independent of political interference and have a clear commercial mandate to maximize returns on assets while minimizing taxpayer exposure. 

• It is too early to know whether rising NPLs will become a systemic risk. The impact on European economics will become clearer between now and the end of 2020 as Government support programs come to an end. Authorities will need to weigh up the benefits and risks associated with AMCs, but it would be prudent to ensure that AMCs are at least an operational part of the tool kits should they be needed. 

Intro

The COVID-19 public health restrictions have negatively impacted the real economy, and it is clear we now face an unprecedented economic crisis. In the UK, output plunged 20.4% in April following a 5.8% contraction in March. This already dwarfs the downturn during the 2008-09 financial crisis and is the largest contraction since records began. As noted in June by the Deputy Governor of the Bank of England, Jon Cunliffe, the depth and length of the economic impact of COVID remains uncertain, but severe losses on credit remain likely.

These conditions will result in accumulating NPLs on banks’ existing balance sheets. While banks are adept at managing normal volumes of NPLs, extreme NPL volumes reduce banks’ income and profitability while negatively impacting their capital resources. For now, banks have sufficient capital to absorb the initial shock of the crisis and rising NPLs. However, it is less clear whether they have sufficient capital to underwrite the recovery phase of the crisis. Therefore, despite government encouragement and flexibility on regulatory requirements, banks’ commercial imperatives to shore up balance sheets and maintain access to capital markets at sustainable prices may still incentivise them to restrict credit provision. In addition, some smaller, less diversified and weaker banks could also fail.

At the same time, Governments across Europe are asking banks to provide new lending sufficient to enable viable businesses access to sufficient bridging financing. Such new lending is guaranteed by the state to varying degrees, and the ECB’s May Financial Stability Review estimates that the share of bank loan losses covered by COVID-centric government credit and loan protection schemes could transfer a significant share of losses - possibly over 30% - to governments. UK banks have already estimated that up to 50% of lending under the Government’s “Bounce Back” Loan scheme will default. As these Government programs wind down towards the end of 2020, the impact of COVID-19 restrictions on the real economy and the impact of NPLs on banks will begin to be revealed. 

These risks raise some important questions for authorities on how best to manage the problem of rising NPLs in order to ensure banks optimally play their part in supporting the economic recovery while safeguarding the best interests of taxpayers related to governments’ new exposure under loan guarantee schemes, all at a time of unprecedented levels of public sector indebtedness.

Options for managing NPLs

A range of options for managing NPLs are available to authorities. After the 2008 financial crisis, banks largely managed NPLs internally through restructuring liabilities with the borrower, market disposals, enforcement of collateral, or insolvencies. Such strategies relied critically on capacity in distressed debt markets. 

However, where NPLs present a systemic risk and reliance on decentralized bank-led strategies could undermine banks’ ability to continue providing the credit necessary for recovery, authorities have in the past considered more centralized NPL strategies. After the Asian financial crisis, AMCs were relied on throughout Asian economies as a centralised mechanism for managing NPLs including in China, Indonesia, Japan and Korea. More locally, after the 2008 crisis, some European authorities (e.g. Ireland’s National Asset Management Agency, and Spain’s SAREB) established asset management companies to manage the workout of large amounts of illiquid assets. 

In a UK context, between 2009 and 2012, HM Treasury’s Asset Protection Scheme (APS) leveraged internal bank capabilities to manage NPLs by providing Government protection, in return for a fee, against losses of over £280bn of Royal Bank of Scotland’s financial assets. In addition, the UK Government established UK Asset Resolution in 2010 to wind down the less liquid assets transferred from nationalized banks (e.g. Northern Rock and Bradford & Bingley) with the remaining high-quality assets and business lines sold to Virgin Money in 2012. Currently, the UK’s “Bounce Back” Loans business lending scheme provides a 100% guarantee of banks’ subsequent lending decisions under the scheme. As of 21 June, banks had issued over £28 billion in loans under the “Bounce Back” scheme to over 900,000 applicants. Banks have already estimated that up to 50% of such lending will default, a forecast that raises important questions for the Government on how such NPLs can best be managed over the long-run.

In response to these same concerns, Andrea Enria, Chair of the Supervisory Board at the European Central Bank (ECB) has recently expressed his public support for AMCs in managing high levels of COVID-related NPLs. The European Commission has already, in 2018, published a Staff Working Document entitled AMC Blueprint that outlines several of the foundational considerations that will influence today’s crisis response measures.

AMCs - Benefits, Risks, and Key Design Features

Typically, AMCs buy NPLs from financial institutions by issuing government-guaranteed bonds and then manage the NPLs centrally by engaging in restructuring negotiations with the debtors. Potential outcomes include selling off the debt or underlying assets or, in some cases, holding the assets to maturity. AMCs can also be combined with resolution of a failed bank; problem asset portfolios can be transferred to a bad bank which allows the private sector sale or IPO of the remaining viable business.  

AMCs can clean banks’ balance sheets quickly while reducing any market uncertainty related to bank solvency, instead enabling banks to lend, focus on customers, and bolster the economic recovery. This buys time by avoiding the need to crystalize losses in the short-term and by allowing assets that have been properly priced and managed to return naturally to a “performing” status. AMCs can achieve economies of scale and efficiency gains through greater centralization than banks can achieve on their own.

However, AMCs are not without risks. They entail significant upfront operational costs related to establishing and running a new specialist organization quickly. They require partial or full government guarantee for the required financing. AMCs have in the past performed best when their assets are fairly homogeneous. The more complex the assets transferred, the more costly it is to develop and update the models to value them, and further expenses accrue in finding the expertise to implement the liquidation strategy and the greater the operational risk involved in holding such credit portfolios. Some of these risks have been managed in the past through establishing loss-sharing arrangements agreed between AMCs and banks when acquiring NPLs. Still, the scale of an AMC will also significantly impact its liquidation strategy. Should AMCs hold a significant portion of the market in a given asset class, it will negatively impact the extent to which it can restructure or sell its assets without shifting the market price down.

In establishing an AMC, it is essential to consider the following key design criteria: 

• Independence – AMC mechanisms must remain independent of government and political influence. This is essential to ensure credibility with the market on valuations/disposals. They need to be free from public sector pay constraints while exercising the flexibility to procure the relevant specialist advisory expertise; 

• Mandate – a strong commercial focus with a clear mandate to maximize recoveries and reduce risk to the taxpayer;  

• Governance – management should have the relevant expertise as the market’s acceptance of AMC valuations is essential to protecting public money and the stability of market pricing for any AMC bonds issued to banks

• Transparency and accountability – AMCs should publish operational and audited financial statements and should be subject to Parliamentary oversight. 

• Financing - Most AMCs, for example those in Asia and in Ireland, purchase NPLs through the issuance of debt securities guaranteed by the government. It is important that any bonds issued to fund the AMC should meet central bank liquidity facility eligibility criteria. AMCs operational budgets should be managed separately from funds allocated for asset purchases and returns;

• Amounts and kinds of assets transferred - pricing of assets transferred is central to ensuring an effective AMC. For example, if assets are transferred at market value it could mean huge losses for the very banks which AMCs are designed to stabilise. Conversely, if assets are transferred at prices above their fair value, it exposes the AMC, and by implication taxpayers, to losses. Loss-sharing arrangements agreed between AMCs and banks when acquiring NPLs have been used to help contain risk of AMC losses;

• Liquidation strategy - This is largely driven by the complexity of the assets transferred to the AMC: the more complex the underlying assets, the more illiquid, hard-to-value assets, the more challenges the liquidation strategy faces. Complex AMC assets are particularly costly to value and carry greater operational risk for holders of such credit portfolios. AMC scale can impact the liquidation strategy. Should AMCs hold a significant portion of the market in a given asset class, this will negatively impact the extent to which the AMC can restructure or sell its assets without inadvertently shifting the market price. 

• Limited lifespan – holding assets for the medium-term can avoid incurring high discounts to par value. However, these benefits can be eroded due to higher AMC operating costs if assets are held for too long. A sunset clause is good practice and avoids the risk of creating a self-perpetuating bureaucracy or mission creep overtime.  

Conclusion

It remains too early to know with confidence whether NPLs will indeed rise to such an extent that they exceed the ability of banks to manage internally. In such circumstances, AMCs could be used to ensure that banks have the capacity to support economic recovery and enable direct management of new public credit exposures under loan protection schemes while, at the same time, protecting the taxpayer at a time of unprecedented levels of public indebtedness. However, AMCs are not without risk. They entail significant upfront financing costs for Governments, create valuation risk for both taxpayers and banks, and may still struggle to dispose of their assets over the medium term. 

The impact of COVID-19 on European economics will become clearer over time, especially towards the end of 2020 as Government support programs come to an end. Before then, authorities will need to weigh up the benefits and risks associated with AMCs and other mechanisms for managing NPLs. In the interim period, it would be prudent for authorities to ensure that AMCs are at least an operational part of their policy tool-kits should they be needed. 

Eamonn White, 

Director, Ardhill Advisory