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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.

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Maximising value of non performing assets

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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks
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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks1
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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”)

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks2

Final cash flow

recovery

recovery

cash flow

cash flow

time

default

close-out

The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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

discounting

t0

t1

t2

T

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks3
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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)

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks4
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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)

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks5
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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:

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks6
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • Time length of workout procedures

    • in years

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks7
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • % of utilization and mean recovery rates by procedure

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks8
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • Average time to recovery, by province

    • in years

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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks9
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks10
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks11
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian 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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks12
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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

BANK OF ITALY


The importance of hard evidence results from a survey on workout procedures in italian banks13
The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks

  • 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

BANK OF ITALY


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