Home ›› 27 Dec 2022 ›› Editorial
The pandemic has had a severe negative impact on economies across the globe. Increasingly, banks expect to face the consequences of companies’ bankruptcies and cash shortages. During major economic crises, commercial banks experiencing rising non-performing loans (NPLs) are challenged to minimise the impact on the core business and to secure the most value possible from the NPL portfolio. This Report describes three key options a bank can pursue to minimise the impact of NPLs on the core business and discusses the strategic considerations for choosing among these three options:
Continue business as usual. Keep NPLs on the bank’s balance sheet and follow standard procedures and processes for dealing with delinquent loans.
Set up a workout unit. Set up an independent unit with proximity to the risk and commercial banking areas and task it with mitigating the negative impact of the NPL portfolio on the ongoing business both financially and operationally.
Create a bad bank. Segregate NPLs into an external organization, operationally, financially, and legally.
Banks must carefully manage NPL portfolios, as elevated ratios can severely hurt a financial institution’s financial and operational activities. Significantly higher-thannormal NPL levels can wipe out a commercial bank’s profits and dividends for years. The capital market’s view and uncertainty of the NPL portfolios’ performance and value also can severely reduce a bank’s market share and ability to raise capital. In severe cases, NPL issues can result in regulatory capital requirement challenges that are difficult to resolve when the capital market looks unfavorably to the bank’s prospects.
To set up a workout unit, banks must take the following key dimensions into consideration:
The key responsibility of the workout unit is the collection, which includes all processes related to managing loans that are in default. The collection process starts at the time of default and ends with the settlement and asset liquidation. It consists of NPL transfer, management, and asset liquidation.
To effectively execute its NPL management and resolution tasks, a workout unit should be established as a dedicated NPL unit, the structure of which depends on each bank’s context, including its target customers. A typical organizational structure consists of NPL management, asset liquidation, and support functions.
The workout unit may either be centralized or decentralized. In the centralized form, the unit is located in one location (usually the headquarters) and handles all NPL cases. In the decentralized approach, the unit is located in multiple locations. For banks serving wide geographical areas and dealing with increased legal complexity of cases due to local regulations, we recommend the decentralized approach.
It is crucial that banks decide on the right strategy going forward. The NPL wave will hit all banks with significantly higher volumes of NPLs, impacting them financially and operationally. As managing NPLs is very time sensitive, banks should decide strategically which model of NPL management suits them best, build their capabilities, and ramp up resources well ahead of time. The banks that address their NPL situation first in their market will have the best chance of getting out of the crisis, recovering more quickly than the competition and having better access to the capital they might need.
During past crises, banks have experienced a short-term rise in defaults on NPLs, with a long-lasting impact not only on their balance sheet but also on their stock prices and future ability to raise capital (see Figure 1). The global financial crisis of 2007, for example, tripled the share of NPLs versus total loans (i.e., NPLratio) within just two years from the beginning of the crisis. The impact is typically larger on banks in emerging markets where government bailouts and support are less prevalent.
Banks must carefully manage NPL portfolios, as elevated ratios can severely hurt a financial institution’s financial and operational activities. Significantly higher-than-normal NPL levels can wipe out a commercial bank’s profits and dividends for years. Figure 2 highlights how several large banks’ profits scale to their NPL provisions. The capital market’s view and uncertainty of the NPL portfolios’ performance and value also can severely reduce a bank’s market share and ability to raise capital. In severe cases, NPL issues can result in regulatory capital requirement challenges that are difficult to resolve. High NPL levels also divert attention of staff from their normal commercial activities, which may result in missed market opportunities.
To reduce their exposure to NPLs, Greek banks commenced an aggressive collection strategy. As a result, the NPL ratio reduced significantly from 49% (2016) to 41% (2019). As most of the efforts were against loan collaterals, the collection strategy also created a real estate blast with over 20,000 owned and managed properties in Athens. The vast property portfolio not only created additional expenses for the banking entities but also created a drop in the property prices due to increased supply continue business as usual. Keep NPLs on the bank’s balance sheet and follow standard procedures and processes for dealing with delinquent loans.
Set up a workout unit (operational separation). Set up an independent unit with proximity to the risk and commercial banking areas, and task it with mitigating the negative impact of the NPL portfolio on the ongoing business, both financially and operationally.
Create a bad bank (operational, financial, and legal separation). Segregate NPLs into an external organization, operationally, financially, and legally.
All lending institutions have processes and procedures in place to deal with delinquent loans, so these institutions already have functions and departments to deal with NPLs on a business as-usual basis. The difference with a separate workout unit is that it is temporary in nature to deal with a unique situation. The workout unit also is separate from the rest of the organization, allowing it to manage a portfolio of NPLs (or even other assets) with little consideration for the continuous commercial activities of that institution, so it can focus fully on value optimization of the portfolio.
A bad bank can be seen as an extreme case of a workout unit that is placed outside the organization legally. Though various forms of bad banks exist in literature, for the purposes of this article, the term refers to a legally, operationally, and financially separated entity into which NPLs are offloaded.
When NPL provisions and performances are manageable (i.e., impact on profitability is limited and/or accessibility to public and private recapitalization is not at risk), banks typically follow their standard procedures and processes for dealing with delinquent loans. By growing the balance sheet, the (relative) impact of the NPL portfolio can be mitigated (at least with respect to recapitalization opportunities).
Staffing is among the most challenging yet crucial activities of a workout unit. There are three options: internal sourcing, external sourcing, and a hybrid approach.
Common practice in internal sourcing is to reassign relationship managers (RMs) to the workout unit, which causes two major problems. First, due to the lack of NPL management capabilities, a bank will have to invest heavily in capability building through training. Second, RMs, with a customer-centric background, is often too soft on debtors and unable to make the hard choices NPL management requires.
External sourcing refers either to taking over a currently active collection agency or hiring people with a track record in debt collection. Although external sourcing solves the capability gap problem, it creates other major issues. Merging a collection agency into a bank creates a disconnect between banking activities and workout activities, as the new hires do not understand the banking operations; especially because the new organization limits the collection practices they can use. Furthermore, since workout units are typically temporary, employing people could cause issues in the medium- to longterm when the unit is disbanded.
We recommend a hybrid approach, allowing internal RMs and external collection agents to share best practices in both areas and creating a good foundation for performance.
Keeping top-performing collection agents motivated is a significant management challenge. A best practice is a quarterly incentive system, in which collection agents are paid a fixed monthly salary in line with the general salary level of RMs and agents in other units of the bank. At the end of each quarter, the bank creates a bonus pool based on key performance indicators (KPIs) of each department involved in the collection process, and each collection agent receives an additional bonus based on his or her contribution to that pool. This proposed remuneration scheme offers two major advantages:
As the size of the bonus pool rests on overall performance of the departments, collection agents should collaborate on solving the cases, decreasing the risk of silo working.
As each agent receives a bonus corresponding to his or her contribution to the overall unit performance, agents are incentivized to collect as much as possible to increase their share.
Align S&A incentive system with workout unit’s collection performance.
Push for performance reports, especially during the initial phases of implementation.
Invest in building S&A agents’ data-handling and data analysis skills.
Make S&A responsible for the accuracy of the workout unit database.
Implement a vendor management function in the legal operations department.
Set specific service levels for external vendors.
The NPL wave will hit all banks, financially and operationally. As managing NPLs is very time sensitive, banks should decide strategically which model of NPL management suits them best, build up the capabilities, and ramp up resources well ahead of time. The banks that address their NPL situation first in their market will have the best chance of getting out of the crisis, recovering more quickly than the competition, and having better access to capital.
The writer is MD and CEO of Community Bank. He can be contacted at masihul1811@gmail.com
