Methods of Regulating Non-performing Loans. The Challenge for Greece

Abstract

When an economy faces financial crisis, a secondary problem occurs regarding the management of Non-performing Exposures. According to EBA and BoG, several restructuring methods have been created in order to address this problem. This paper aims to analyze all the possible methods, creating at the same time a methodology to pick the best method for each case. Using sensitivity analysis on the impact of the restructuring methods to the financial ratios of the firms we analyzed, we concluded to a technique of choosing the most appropriate method for each case. This paper has practical implications, since its findings can help distressed businesses that face liquidity, solvency and productivity problem to choose the most appropriate restructuring method in order to face financial healthier conditions, which at the moment doesn’t exist.

1 Introduction

High levels of NPL have a negative impact on bank lending to the economy as a result of balance sheet, profitability and capital restrictions faced by banks that experience these high levels of NPL. The deliberate and sustainable reduction of NPLs in the banks’ balance sheets benefits the economy both from a micro-prudential and a macro-prudential point of view. At the same time, it is known that economic recovery is also an important factor in the final settlement of NPLs. One of the key priorities of the European Central Bank’s (ECB) Banking Supervision is to address issues related to asset quality. This issue was dealt with for the first time in the frame of the comprehensive assessment of 2014, which consisted of two key pillars - asset quality control and stress test. Following the comprehensive assessment, the ECB’s Banking Supervision intensified its work on NPL supervision. In the course of ongoing supervisory engagement, Joint Supervisory Teams (JSP) observed that banks are taking different approaches to identifying, measuring, managing and writing off NPLs. With this in mind, a high-level group was formed in July 2015, (consisting of ECB staff and national competent authorities) with a view to developing a uniform supervisory approach to NPLs. In addition, in its supervisory priorities, ECB Banking Supervision has highlighted two key risk factors for euro area banks, namely credit risk and increased levels of non-performing loans.

Without a proper management structure or an operational framework, banks will not be able to address issues related to NPLs either in a sustainable or an effective way. In accordance with international and national regulatory guidelines, the bank’s governing body should approve of and monitor the institution’s strategy.¹ For banks with high levels of NPLs, the NPL strategy and operational plan is a vital part of their core strategy. Therefore, it should be approved and coordinated by the governing body. More specifically, the governing body should:

• annually adopt and regularly review the NPL strategy, as well as the Operational Plan,

• oversee the implementation of the NPL strategy,

• set administrative targets (including a sufficient number of quality objectives) and incentives for NPL-setting activities,

• monitor periodically (at least on a quarterly basis) the progress achieved in relation to the objectives and milestones set out in the NPL strategy, including the operational plan,

• establish adequate approval procedures for NPL decisions - for large NPL exposures this should require the approval of the management body,

• approve NPL-related policies and ensure that they are fully understood by the staff,

• Ensure adequate internal controls on NPL management procedures (with particular emphasis on NPL-related activities, provisioning, collateral valuations and sustainability of regulatory measures);

• have sufficient expertise in NPL management.

The governing body and other relevant executives are required to devote part of their functions to issues related to the NPL arrangement. This should be in proportion to NPL risks within the bank. Especially when NPLs are growing in volume, the bank needs to establish and clearly document defined, efficient and consistent decision- making processes. In this context, there should be an adequate second line of defense available at all times.

International experience shows that suitable operational models for NPLs are based on NPL modules that operate separately from the source of the loan. The underlying reason for this separation is the effort to eliminate potential conflicts of interest and to use specialist NPL knowledge from the level of staff to the level of senior executives. Banks with high levels of NPL should therefore constitute separate NPL workout units (WUs), ideally from the start of arrears-with a delay of up to 90 days- but no later than the classification of an NPL exposure. This split- up approach should include not only client relationship activities (e.g. negotiation of settlement measures with clients) but also the decision-making process. With this in mind, banks will have to consider establishing specific decision-making bodies for the arrangement of NPLs (e.g. an NPL committee). In cases of overlapping with the institutions, (it is rather inevitable with managers or experts involved in the lending process), the institutional framework should ensure that potential conflicts of interest are adequately constrained. It is recognized that for a number of business sectors or exposures (e.g. where specific know-how is required), the establishment of a fully segregated organizational unit may not be possible, or a longer integration period may be required. In such cases, internal controls should be applied to make sure that potential conflicts of interest are eliminated (e.g. an independent view on the creditworthiness of borrowers). Although NPL Work Units should be separated from the lending units, regular interaction between the two functions should be encouraged, for example, to exchange the information required for handling NPL inputs or to provide feedback gained from NPLs that may be important for the launch of new activities.

The purpose of this paper is to create a model that connects the Cash Flow Statement, the Profit and Loss account, the Balance Sheet the Additional Funds Need Model (AFN) (Spanos et al. 2019; Liapis and Trigkas 2019) and main Ratios. Then we will apply restructuring methods in order to evaluate how these methods affect a distressed business.

Our paper is organized as follows: After the introduction follows the Methods of addressing NPEs problem—Literature Review. Then the Methodology of addressing NPEs problem is presented followed by the Findings. Finally, conclusions are presented.

2 Methods of Addressing NPEs Problem

The main purpose of settlement measures² is to create appropriate conditions so that borrowers who are unable to pay their loans, can emerge from this situation or that borrowers paying their loans will not fall into the above-mentioned category. The aim of the settlement measures should always be to restore the exposure to a viable repayment condition. However, supervisory experience has shown that in many cases settlement solutions provided by banks to borrowers in financial difficulties are not fully in line with this objective and may therefore delay the implementation of actions needed in order to address quality issues of the assets, thus leading to an erroneous representation of asset quality in the balance sheet. This happens, for example, when regulatory measures include repeated periods of grace, but they do not address the fundamental issue of the borrower’s excessive borrowing cost in relation to his capability of repaying it.

2.1 Settlement Options and Their Viability

When considering the various regulatory solutions, it is appropriate to distinguish between short and long- term settlement measures. Most solutions include a combination of different measures, possibly over a different time horizon, putting together short and long-term options. Short term regulatory measures are restructured repayment terms that are temporary and designed to deal with short-term economic difficulties, but do not deal with the final settlement of overdue debt unless combined with appropriate long-term measures. Such short-term measures should generally not last more than two years and, in the case of project finance and commercial property, one year. Short-term regulatory measures should be taken into account and provided when the borrower meets the following two criteria.

• The borrower faces a recognizable event that has temporarily compromised his liquidity. Such an event should be demonstrated in a formal manner (and not hypothetical evidence) by means of written documentation containing certain elements indicating that the borrower’s income will recover in the short term or that, based on the bank’s conclusion, it is not possible to provide long-term regulatory measures which are more general in nature or relate specifically to the borrower.

• The borrower has demonstrated a good financial relationship with the bank in a tangible manner (e.g.: that he has repaid a significant part of the due capital before the incident) and a clear willingness to cooperate.

The contractual terms of settlement arrangements should stipulate that the bank has the right to review the agreed settlement measures if the borrower’s situation improves and therefore it would be possible to impose more favorable terms for the bank (from regulatory arrangements back to the original terms of the contract). The bank should also consider including strict penalties in the contractual terms for borrowers who are unable to comply with the settlement agreement (e.g. additional security).

2.2 Sustainable Versus Non-sustainable Regulatory Measures

Banks and supervisors are clearly obliged to make a distinction between’sustainable regulatory’ solutions, i.e. solutions that actually help to reduce the balance of the borrower’s credit facilities and ‘non-sustainable’ solutions. General supervisory guidelines for the classification of viable adjustment measures are presented below:

• Generally, a settlement solution including long-term measures should be considered viable only when:

  • The institution can demonstrate (with reasonably documented financial data) that the borrower has the financial capacity to realistically meet the settlement solution.

  • The settlement of arrears is fully dealt with and it is expected that the balance of the borrower’s debt will be significantly reduced over the medium to long term period.

  • In cases where regulatory arrangements have been granted in the past, including past long-term settlement measures, the bank should ensure that additional internal controls are in place so that these follow-up measures meet the sustainability criteria as outlined below. These controls should, as a minimum, guarantee that the Risk Control Function is explicitly informed of such

    cases in advance. In addition, explicit approval should be sought from the appropriate senior decision-making body (e.g. the NPL committee).

• In general, a settlement solution including short-term measures should be considered viable only when:

  • The institution can demonstrate (with reasonably documented financial data) that the borrower has the financial capacity to meet the settlement solution.

  • The short-term measures are actually provisionally applied and the institution is satisfied and able to certify, based on reasonable economic data, that the borrower demonstrates the ability to repay the original or agreed amount (on the whole of the principal and the interest) the short- term temporary adjustment.

  • This solution does not result in multiple, successive regulatory measures for the same exposure.

• As stated in the criteria listed below, the viability assessment should be based on the economic profile of the borrower and on the regulatory measure to be granted at that time. It should also be noted that the viability assessment should be carried out independently from the source of the regulation (e.g. the borrower using regulation clauses contained in the contract, bilateral negotiation of the arrangement between the borrower and the bank, public program of measures regulation provided to all borrowers for a particular case).

2.3 Types of Settlements and Final Arrangements Types of Short-Term Settlements

Short-term types of settlement are the types of regulation with a lifespan of up to and including 2 years in cases where repayment difficulties are judged, well founded, temporary. Short-term types of regulation are the types of regulation with a maturity of up to and including 2 years in cases where repayment difficulties are judged, well founded and temporary.

• Capitalization of Overdue Debets: Capitalizing on arrears and adjusting the payout schedule of the outstanding balance.

• Arrangement of Overdue Payables: Agreement on repayment of debts arrears with a predetermined timetable.

• Reduced Payment Above Interest: Reduction of the repayment amortization rate to a level exceeding that corresponding to the repayment of interest only for a specified short-term period.

• Interest Only: Only interest is paid during a specified short-term period.

• Reduced Payment Below Interest Only: Reduction of the amortization installment to a lower level than that corresponding to the repayment of interest only for a specified short-term period. Unpaid interest is capitalized or settled.

• “Grace Period”: Suspension of payments for a predetermined period. Interest is capitalized or settled. Short-term arrangements last for less than 2 years. However, arrangements that include only short-term actions, such as those mentioned above for a specific period of time that is likely to exceed two years, will be included in the short-term arrangements.

2.4 Types of Long-Term Settlements

These are types of settlement with a lifespan of more than 2 years that aim to reduce the interest rate and/or debt. They are classified, taking into account conservative assumptions about the estimated future repayment ability of the borrower up to the expiration of the repayment deal.

• “Interest Rate Reduction”: Decrease in interest rate or interest rate margin.

• “Loan Term Extension”: Extension of the repayment term of the loan (i.e., shifting the contractual date of payment of the last installment of the loan at a period later than 2 years).

• Split Balance: Splitting the borrower’s debt into two tranches: the part of the loan that the borrower is estimated to be able to repay on the basis of his current and estimated future repayment capacity; and the remaining part of the loan, which is settled at a later date, through the liquidation of property or through another arrangement, agreed beforehand by the two parties.

• Partial Debt Forgiveness/Write Off: Final deletion of part of the total claim so that the remaining debt reaches a level which is more likely to be settled smoothly.

• Operational Restructuring: Restructuring the business, making it viable and capable of smoothly servicing its debts. The reorganization may include actions such as management change, sale of property, cost containment, corporate transformation, credit renewal and/or new loans.

• Debt/equity swap: Converting part of the debt into equity so that the remaining debt reaches a level that is estimated to be able to be settled smoothly.

2.5 Final Settlement Solutions

A final settlement solution is defined as any change in the type of contractual relationship between the financial institution and the borrower, or its termination, with the aim of finalizing the institution’s claim against the borrower. This solution may be combined with a handover (whether voluntary or mandatory) of the collateral to the institution in order to reduce the total amount of the claim or even to liquidate the collateral to settle the claim. There are several examples of solutions offered in the scope of international practices, but the adoption of each of them is examined at all times in relation to the provisions of the Greek law:

• Other Out-of Court Settlements: Extra-judicial actions that do not fall into one of the following categories.

• Voluntary Surrender of assets: The borrower, who cannot meet the repayment terms of a mortgage loan, voluntarily grants (i.e. without requiring a court action on behalf of the institution) the ownership of the pledged property to the creditor. The agreement clearly stipulates how any remaining balance is to be settled. This solution may concern a residential or commercial property.

• Mortgage to Rent/Lease: The borrower transfers the ownership of the property to the creditor, by signing a rental/leasing agreement, which allows the latter to lease the property for a certain period of time. This solution may concern a residential or commercial property.

• Voluntary Sale of Property: The borrower voluntarily makes a sale of the trusted property to a third party with the consent of the crediting institution. If the sale price falls below the total amount of the debt, the agreement clearly sets out how any remaining balance should be settled. This solution may concern a residential or commercial property.

• Settlement of Loans: An out-of-court agreement in which the creditor receives either a lump-sum cash payment (or cash equivalents) or a series of predetermined partial payments. Within the frame of the settlement, the crediting institution may partially waive the claim.

• Settlement of Claims Against Terminated Contracts: Selling the loan to another credit institution, financial institution or scheme.

• Auction—Collateral Repossession: The creditor wins the auction by acquiring the ownership of the mortgaged property or other collateral.

• Auction-Collateral Liquidation: The creditor completes the auction of tangible collaterals and collects the appropriate auction.

• Under Legal Protection: The loan has been handed over to Enforcement Law regulations (for example Law 3869/2010, Law 4307/2014, Bankruptcy Code, etc.) which are applied following a final court decision. To avoid misunderstandings, we note that this category does not include loans for which borrowers have already applied for legal protection and the verdict is pending. Provisional arrangements in the framework of an interim order for the payment of minimum amounts within the framework of Law 3869/2010 cannot considered as regulations.

• Full Debt Write-off: The creditor decides to write off the debt as long as all out-of-court and regulatory actions have been exhausted and no further recovery is expected.

All the above-mentioned restructuring methods have been summarized in Table 1.

Table 1 Restructuring methods

3 Methodology for Testing the Impacts of Restructuring Methods

First, we created a model that connects a Cash Flow Statement, a Balance Sheet, an Additional Fund Need Model (AFN Model), a Profit and Loss Account and also some Ratios. Then we created a business that face financial problems (Gouma et al. 2018) in order to apply restructuring methods and see how these methods affect the business. The year noted at “t” is the baseline year the year noted as “t + 1” is the following year. Model inputs for Year “t” are calculated automatically from the Balance sheet and the Profit and Loss account (Historical Data-Brown Colour), while Model Inputs for Year “t + 1” are produced by us, manually (Green Colour) (Table 2).

Table 2 Base model inputs

After we put the Model inputs, the balance sheet, the Profit and Loss Account and the Cash flow Statement for Year “t + 1” are produced automatically. In addition, some other model outputs are produces and are showed in Table 3.

Table 3 Base model outputs

According to this table, this business needs additional funds of 311.000 thousand euros in order to continue the operational procedure smoothly.

Now, we will test how Debt to Equity method combined with operational restructuring (Rank 11 + 12 from Table 1) affect the business. According to the base model the AFN accounts for 311.00 euros. Using restructuring methods, we will try to eliminate the Additional Funds Needs of the company.

4 Findings

As far as the operational restructuring is concerned, the firm decided to alter the Cash Target from 80.000 to 50.000, to sell some assets with value 200.000 and alter the Trading and AFS from 120.000 to 70.000. In addition, due to Debt to Equity method of restructuring, the long-term Loans and Bond account for 300.000 from 500.000 and the Common stock accounts for 280.000 from 80.000. The second column demonstrated the “t + 1” year as shown earlier and the third column the inputs after incorporating the 2 methods of restructuring (Green Colour) (Table 4).

Table 4 Model inputs

As far as the Model outputs are concerned (Table 5), the main change we expected and occurred is that the debt ratio decreased from 72 to 41%. Return on Equity increased from 0.25 to 3.19%. These two are the main changes from the restructuring methods applied to the company. In Cash Flow Statement, the main difference is the opening cash balance. This is due to the change to the Cash Target we assumed as part of the operational restructuring. At last, very important is the AFN before and after the restructuring methods. Before the restructuring methods the company needed 311.000 euros while after the restructuring method the company needs −7.528 euros allowing the company to increase its capital. This shows clearly how the restructuring methods influenced the financials of the company (Tables 6 and 7).

Table 5 New model cash flow statement

Table 6 New model output

Table 7 New model balance sheet

5 Conclusions

Non-performing Exposures is a problem of great importance. All the methods proposed by the ECB and the banking supervising authorities are very important. In our example we showed clearly that the methods have actually impact on the company. This model can be used also for Business Plans, budgets, restructuring plans.

In future analysis we are going to test all the methods separately in order to see how these affect the distressed companies. In addition, we are going to use sensitivity analysis to test also these methods under uncertainty conditions. This research may be very helpful for banks and businesses since it may help them to make the best choices when firms face financial problem in order to restructure them.