Higher capital buffers give banks more flexibility to recover collateral

Going into the Covid-19 pandemic, banks were generally much better capitalised than they were before the financial crisis a decade ago and as a result they are in a stronger position to deal with the fallout in non-performing loans (NPLs) and to recover more collateral, according to Global Credit Data (GCD).

Compared with the eve of the 2007-9 global financial crisis, banks went into the current pandemic-induced economic shock with more than double the levels of capital and much of it is of higher quality as well thanks to reforms to the Basel prudential framework.

The bank-owned not-for-profit organisation said in a report called, ‘Downturn LGD [loss given default] Study 2020’ that banks may be able to minimise losses incurred from Covid-19-related defaults by waiting to sell collateral into an economic recovery phase when it is likely to fetch better prices. During previous crises some distressed banks were forced into ‘fire sales’ of assets in a bid to remain solvent.

The report highlights that almost 50% of recoveries tend to happen in the first year after default following prompt action by bank managements to return loans to a performing status.

However, the sale of collateral usually takes more than one year with more complex workouts potentially lasting more than six. Cases that take longer to work out often result in worse outcomes for banks, according to GCD.

The report focuses exclusively on corporate and non bank financial institution exposures. Data from GCD is typically used by banks, which contribute to the data sets, to benchmark the performance of their loans and also for forecasting purposes.

Timing issues

However, the report states that although high capital buffers give banks more flexibility to choose when to sell collateral, not all loans are secured. Under those circumstances, banks may have less control over when they realise losses. And even where collateral is available, banks face a challenge over picking the right time to sell it, with the risk that the market becomes flooded with similar assets, which will drive pricing down.

Also, government support measures such as temporary loan holidays are likely to delay the expected flood of NPLs as many are currently 'hidden'.

"Banks today may have better balance sheets to absorb the crisis, but they will be hit. The hidden defaults are just delaying the impact of the crisis," says Richard Crecel, executive director at GCD. He also points out that some of the assumptions around banks being able to recover their collateral depends on how long the crisis drags on for.

"If this crisis is having a more important impact than projected or a longer impact than projected, then maybe banks will not have enough breadth to wait. We do not know that yet," he says. "It is about each bank assessing how long they can hold on with their current capital structure. That also means making an assumption on how high the defaults will rise."

Positive news over the availability of vaccines able to immunise people against Covid-19 has raised hopes among economists that 2021 will be a year of economic recovery. This should see a gradual end to economically-damaging government mandated social restrictions, for instance.

But in the short-term the vaccines' impact might be muted as they will not be ready for use until the end of this year at the earliest, immunisation programmes will take time and will take longer to be rolled out globally.

"The news about the vaccines is good, but it does not mean the economy is saved today. It means there is light at the end of the tunnel, but we are still in the middle of the tunnel," warns Mr Crecel.

Lesson still valid

And though there are differences between the current crisis – induced by government measures to stop the spread of the pandemic – and previous ones – usually resulting from asset bubbles and credit excesses – they all nonetheless share some common characteristics. These include loser monetary policy, fiscal support, rising unemployment and bankruptcies and economic contraction. This means data from those previous crises can still guide banks over the likely growth of NPLs and their LGD positions. The latter measure reflects how much money a financial institution loses when a borrower defaults on a loan, expressed as a percentage of total exposure at the time of default.

"The financial dynamics of this crisis are valid as they were during the last one,” says Mr Crecel. He explains that so far banks are mirroring the trends in obligator downgrades that occurred during the GFC.

“Statistical analysis of historically observed LGD is still by far our best tool for determining future estimates,” he says.

An important observation by GCD is that recoveries made on NPLs during a crisis tend to be lower than normal. Also, such recoveries from defaults tend to take longer.

The report explained that, on average, a loan reaches its peak cash flow recovery after 546 days. By comparison it took an average 642 days to recover default cases resulting from the 2007-9 global financial crisis.

There are still many uncertainties surrounding the current crisis and whether the virus can be fully overcome. There is also a big question mark over how the economy will recuperate and whether heavily impacted sectors, such as hospitality and travel, can eventually make a full recovery and over what time frame.

All these questions will have a significant bearing on the scale of NPLs and the recovery of the collateral supporting them.

This article first appeared in The Banker's sister publication Global Risk Regulator.