Secondary loan supply increases as IFRS 9 bites
Participants in the secondary loan market are eyeing the possibility that more supply will be up for sale from banks as the IFRS 9 accounting regime is expected to be applied with rigour in its first year.
The International Accounting Standards Board issued the IFRS 9 Financial Instruments regulations in July 2014 and as of January 1 this year it became mandatory, replacing the previously accepted international accounting standard - IAS 39.
IFRS 9 comprises requirements for measurement and recognition, impairment, de-recognition and general hedge accounting. A key takeaway is that banks holding financial assets must include in their business model anticipated losses on instruments over the life of the asset - the “expected loss” model - rather than using a “snapshot” according to current fair value market pricing.
The capital markets community has long anticipated discrete effects of IFRS 9. These include more volatility in income statements as fair value accounting for financial assets impacts the profit and loss account; earlier recognition of impairments losses on loans and receivables than was required under IAS 39; and greater disclosure requirements, often requiring new systems and diligence to collect the data required under IFRS 9.
Greater capital provision for expected losses over the life of an asset rather than when a loss has been incurred will become the norm, even on undrawn assets such as revolving credit facilities which have not been utilised.
The hope has been since the first proposed regulations were hammered out in 2014 that IFRS 9 would lead to balance sheet optimisation and cost savings, enabling banks in particular to allocate capital with greater efficiency, to intensify diligence and the reporting process.
Of course, it is inevitable that not all banks will have acted in a timely fashion to implement IFRS 9. Indeed many have applied for deferrals until 2019 - although any actions required for compliance with the new regulation will be retroactive to January 1, 2018.
Undoubtedly all this will mean there will be some forced selling of assets. We anticipate that the Middle East will be a source of loans up for sale in the secondary market, particularly in the distressed space, where greater capital provision against expected credit losses could bring about the liquidation of portfolios which have been sitting on the books for years.
The same argument applies to European and Asian banks which will be keen to free up loans which are expensive to carry on the books under IFRS 9 in order to be able to establish new lending relationships.
Accounting firm PwC established in a survey of global banks that they anticipate provisioning will rise by 25%-50% from the levels prevailing under IAS 39.
Middle Eastern banks have experienced deteriorating loan portfolios on the back of weak oil prices and the consequent feed-through to overall economic growth. At the same time, there is considerable concentration risk in loan books to single names and a limited number of sectors, mainly in property and construction.
From our regular conversations with banks, there is more discussion around the impact of IFRS 9 for banks in the Middle East, compared to Europe or Asia, and is seen as more of a step-change in policy and impacting decisions to sell or hold distressed exposures.
Still, there has been a relaxation of the liquidity squeeze which kicked off in early 2015, and there is more money washing around the system thanks to benchmark sovereign bond issuance in large size from the region - some US$58bn printed last year - together with increased government spending.
Indeed there were signs in 2017 that credit growth at the Middle Eastern banks is returning; that momentum might indicate a need to purge loan books of delinquent paper motivated by the dynamic of IFRS 9.
At SC Lowy we have seen a lot more activity in distressed loans from the region, comprising legacy single name paper - although there is constant chatter about portfolio sales - ranging from Kuwaiti investment firms, Saudi Arabian bankruptcy claims on the big conglomerates, and Bahraini banks with exposure to Saudi risk. We have been very active this year in exposures trading from 5-95 cents. However, distressed trades at sub-25 cents have been a material part of that, as the IFRS 9 policy bites and banks look for liquidity.
The other dynamic in the market is that there are no ME-based funds dedicated to a strategy of distressed credit. We have more traction with local buyers in the performing or post-restructuring credits, but typically investors are international funds which have the bandwidth to invest outside their core markets and in the region. This creates increased sensitivity to the ‘technicals’ of the market and impact of changing yields elsewhere, for example the widening of global EM credit yields recently has changed the pricing dynamics locally as funds switch due to relative value.
Meanwhile, the European banking system continues to sit on around €1trn of non-performing loans and the reports are still filled with eye-watering statistics of each geography’s NPL problems and banks coming to market.
How much of all this is normal market behaviour in the context of a turning credit cycle and how much input the new accounting regulations is exerting is difficult to judge.
But if banks are to maintain solid credit growth in the face of greater provisioning thanks to IFRS 9, then many will have little choice but to offload underperforming loans via portfolios or as single asset sales. There remain billions of euros of pent up demand for these assets.
The advent of IFRS 9 is likely to encourage banks to actively manage their loan portfolios more actively; at least on the margins, this should create more selling and market opportunity, particularly as the credit cycle turns.