Maximising Value of Non-Performing Assets

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 BANK OF ITALY

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 BANK OF ITALY

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”) BANK OF ITALY

Final cash flow 2° 1° recovery recovery cash flow cash flow time default close-out 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 BANK OF ITALY

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 > 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 bank’s books) BANK OF ITALY

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) BANK OF ITALY

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: BANK OF ITALY

The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks • Time length of workout procedures • in years BANK OF ITALY

The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks • % of utilization and mean recovery rates by procedure BANK OF ITALY

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) BANK OF ITALY

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 bank’s 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 BANK OF ITALY

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 BANK OF ITALY

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 BANK OF ITALY

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 BANK OF ITALY

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 BANK OF ITALY

Maximising Value of Non-Performing Assets