fair iii – session v bank of italy maximising value of non-performing assets performance and...

BANK OF ITALYFAIR III – Session V

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


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




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”)




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

default

close-out

time

t0

t1 t2 T

2° recoverycash flow

discounting

1° recoverycash flow

Final cash flow




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)




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)




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:

BANKS N° POSITIONS

TOTAL 211 86,670 Banks with detail on collateral 108 3,713 Banks with detail on guarantees 59 1,074 Banks with detail on legal expenses 139 28,276




Time length of workout procedures in years

PROCEDURENORTH WEST

NORTH EAST

CENTERSOUTH

AND ISLANDS

ITALY

Recovery of pledged securities 2.8 2.3 2.6 3.1 2.8 Foreclosure 5.8 5.3 6.6 7.1 6.3 Legal compositions 7.4 6.0 6.2 5.4 6.2 Bankruptcy proceedings 6.4 6.0 7.3 7.3 6.8 Private settlements 2.3 2.0 2.4 2.3 2.1




% of utilization and mean recovery rates by procedure

PROCEDUREPERCENTAGE OF

UTILIZATIONMEAN RECOVERY

RATE

Recovery of pledged securities 3% 44%Foreclosure 10% 57%Legal compositions 5% 36%Bankruptcy proceedings 21% 27%Private settlements 42% 68%



Procedures in Italian Banks Average time to recovery, by province

in years

(the darker the color, the lengthier the time to recovery)




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




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




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




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




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

fair iii – session v bank of italy maximising value of non-performing assets performance and...

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