Wednesday, 12 December 2018

Enhancing performance

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  • Enhancing performance

The economic fallout following the collapse of Lehman Brothers was acutely felt in Central and Eastern Europe, with the rate of non-performing loans in the region shooting up from late 2008 and into 2009. Development banks have been trying to boost the secondary market in loans to help alleviate the problem, but it has not been easy.

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One of the main functions of the development banks is to encourage new opportunities to flourish in emerging markets, bringing greater maturity to the broader economy. Nowhere is this better illustrated than in the work they have been doing in CEE to encourage the emergence of a secondary market in loans, especially in non-performing loans. This, it is hoped, will free the banks to keep lending, thus stoking broader economic growth.

“We have been targeting this business in CEE since 2008–09, and have a lot of experience in this area, following the crises in Asia in 1998, and Argentina,” said Ed Strawderman, associate director for the financial markets business in Europe and Central Asia at the International Finance Corporation. “We believe it has a material impact on the markets, by freeing up financing and cleaning up the financial sectors of those countries involved.”

The European Bank for Reconstruction and Development has also been busy in this area, having invested in a number of financial institutions buying NPLs and distressed assets in Russia and Turkey. The bank is looking at similar opportunities across CEE. Investing in NPLs gets them off bank balance sheets and frees those banks up to lend more into the real economy. In 2009 the number of NPLs in the economy was seriously hindering banks across the region, though the size of the problem varied greatly from country to country.

“Banks are not the best at loan collection, their business is making loans, not collecting on them,” said Dobrin Staikov, senior banker at the EBRD. “It makes sense to outsource that function to specialised companies that are much better at it.”

However, the IFC’s experiences in CEE have been disappointing compared with the successes it had in Asia and Latin America. Reforms had so far failed to take off in the same way, and the benefits were taking much longer to come through, said Strawderman. This was partly because earlier crises were more isolated; today, the crisis is global, and CEE was competing with much of the developed world for NPL investors.

“Banks are not the best at loan collection, their business is making loans, not collecting on them. It makes sense to outsource that function to specialised companies that are much better at it”

Where buyers gravitated to Asia and Latin America, today activity was concentrated in Ireland, Iceland and even the UK, he said. Given the choice, it is natural that investors should gravitate to head for markets with which they are more familiar. But that makes it hard to predict how long it will be before market reforms in CEE bear significant fruit.

A problem of mismatching

Another problem had been the mismatch between the expectations of buyers and sellers of NPLs in CEE, said Strawderman. This was the result of inexperience and uncertainty, and was likely to get better with time, as sellers better understood the advantages to themselves of getting NPLs off their balance sheets, and buyers get more comfortable with where recovery rates are likely to be, he said. Both sides needed to come closer before the market was likely to take off, he added.

Although the crisis had been going on for five years, in which time the IFC, the EBRD and others had been working tirelessly to promote a secondary market in NPLs, there had been precious little progress so far, said Marta Mueller, principal investment officer at the IFC. But she remains confident the market is set to turn a corner, despite the ongoing challenges.

“Many banks expected the crisis to be followed by recovery after 18–24 months, after which time NPLs would start to perform again, so there was little incentive to address the issue of NPLs on the bank balance sheets,” Mueller said. “However, since the crisis has now entered a new phase it has become clear that recovery is not immediate.” That had given the market renewed impetus to address these problems, she predicted. “We are now seeing a growing number of portfolios coming to market,” she added.

Sensitivity needed

For supranationals involved in buying distressed assets, it is important to ensure partners are carefully selected to maintain the appropriate ethical standards. Obviously, the business of collecting NPLs is sensitive, and no respectable supranational institution would want to be associated with institutions employing violence as a means to collect on NPLs, for example. The existence of reliable partners with demonstrably sound ethical standards was a prerequisite to doing business, and this had also helped limit the number of countries the EBRD had been able to operate in thus far, said Staikov.

In Russia the problem was also quite severe but mercifully short-lived, with oil prices giving the economy the shot in the arm it needed to make a speedy recovery. An initial contraction of around 7%–8% was quickly followed by moderate growth of about 4%–5%, with the government using its strategic Reserve Fund to support the economy. Russian banks sold their NPL exposure quickly, meaning there was an opportunity in the market for a specialist able to turn those loans around.

“Many banks expected the crisis to be followed by recovery after 18–24 months, after which time NPLs would start to perform again, so there was little incentive to address the issue of NPLs on the bank balance sheets”

The EBRD’s Russian venture saw it create a JV alongside two private investors that buys retail NPLs from Russian banks. The two private companies, Intrum Justitia and East Capital, own 35% each of the JV, with EBRD owning the remaining 30%, in line with its policy of always being a minority shareholder.

“We are not an expert in NPLs,” said Staikov. “Between the valuation and the debt collection, this is a complicated business. Intrum and East Capital are experienced Russian investors and have the necessary expertise in this area.” In fact, the JV had not bought many NPLs because it did not see much value in the market, but it would make investments when it saw the right opportunities, Staikov said.

A similar venture launched in Turkey in May 2011, but the circumstances surrounding the deal were quite different to what was seen in Russia, said Staikov. The effect of the global economic malaise was less pronounced in Turkey, and the secondary market for NPLs was far more developed. The country has seen a healthy market for the selling of NPLs since mid-2000, said Staikov, in a well regulated business, with several established market participants. The EBRD invested in LBT Varlık Yonetim, one of the two market leaders in Turkey with a proven track record in the business.

“The market in Turkey is well developed but it still has some way to go,” said Staikov. “At this stage the state banks are not really involved in this, and when they start selling their NPLs the market will expand significantly.”

The EBRD’s ventures in Russia and Turkey were likely to be seen again in three or four more countries in due course, said Staikov, though for now details are being kept under wraps. Bulgaria, Romania and Hungary all look like contenders, while the EBRD has already attempted to act in Ukraine once before, but was thwarted by a rival consortium.

However, it is important for the larger markets to take the lead, providing an example for their smaller neighbours to follow. It was likely that the larger economies in the region, such as Romania and Bulgaria, would see a breakthrough first, before other smaller economies across the region follow their example, said Strawderman.

Similarly, the trend was likely to be led by the subsidiaries of Western institutions, which have already seen the business work to their advantage in Western Europe and elsewhere, he said. From there it will trickle down to smaller local rivals.

For its part, the IFC has seen a boom in its own advisory work, where it works alongside authorities in local economies to encourage reforms required to allow secondary market in NPLs to emerge. This was demonstrated by the growing number of training engagements and seminars across the region, said Strawderman.

Regulators are advised to ensure tax and accounting regimes are aligned to encourage the secondary market in NPLs by enabling banks to account for all NPLs on their books and deduct the full amount from their stated income, rather than just for a small proportion of it, as can be the case in less developed economies, said Mueller.

The development banks dismiss the suggestion that weakening the link between a bank and its NPLs could undermine lending standards. “We do not see moral hazard risk,” said Staikov. “Banks suffer losses on these sales as they need to properly reserve against them / write them off. And investors usually pay very low prices leading to additional losses for selling banks.”

“We see no relationship between a secondary market in NPLs and lending standards,” agreed Strawderman. “There is too much cost involved to allow that: the cost associated with the deterioration of capital, the cost of managing NPLs, the cost of what they can be sold for.”

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