Cyprus Mail

Taking care of non-performing loans

Ideally, many of BoC's bad loans should be transferred to a separate Asset Management Company


By Lars Nyberg and Mike Aynsley

RESOLVING THE banking crisis in Cyprus is a complex undertaking. Confidence and credibility must be restored but this will take time. Resolution is crucial since a functioning banking system that can start lending money is a prerequisite for growth. Hence, cleansing the banks’ balance sheets and working out troubled assets is necessary to ‘kick-start’ the economy. But how big should the banking system be and how should it be funded during the resolution process? A number of issues need to be addressed and addressed simultaneously.

Addressing Non Performing Loans (NPLs) on the balance sheets of Cypriot banks is a key activity in stabilising the banks through cleansing the balance sheets and laying the foundation for growth.

There is no universal recipe for taking care of problematic assets in banks. Countries have different legal systems and different traditions and these can weigh heavily on the ultimate solution adopted. Additionally, sources and availability of funding and/or required speed of deleveraging can have a material impact on the solution or results achieved. Nevertheless, a number of important principles have turned out to be valid in most jurisdictions and some of them are presented in brief below. It is hoped that by highlighting these it will assist Cyprus in avoiding many of the mistakes made in other countries in the recent past.

Separating out NPLs

The scale of NPLs currently on the balance sheets need to be dramatically reduced. So far everybody seems to agree. The best way of doing this would be to transfer the NPLs (and those which are projected to deteriorate to NPLs within the next 12 to 18 months) to a separate and independent Asset Management Company (AMC) where the loans can be systematically restructured/worked out. This is one of the important conclusions from international experience.

Although the transfer of NPLs is crucial, all NPLs need not or should not be transferred. The bank should be able to handle a normal amount of bad credits related to its core customers. Experience also indicates that loans below a certain value should also stay.

But enough NPLs must be taken away from the bank’s normal operations to make the bank viable in a sustainable way and to make management credible to rating agencies and outside investors.

Having said this, it is not always possible to create a full separation of NPLs from the bank as a legal entity. This would currently appear to be the case in Cyprus because of the practical difficulties associated with funding and possible multiple banking licences. Separation of NPLs can still be achieved in a separate department within the bank or in an independent subsidiary of the bank.

Keeping the NPLs within the balance sheet of the bank is always a second-best solution. The more serious the NPL problems are, or perceived to be by external agents, the further away from the bank they may need to be if the credibility of the bank is to be restored. In the absence of full separation of the NPLs, it is likely that the process of re-building credibility and trust with investors will take longer – as it seems to be the case with the internal core/non-core segregations promoted in some recent European cases.

Restoring normal bank operations

An important reason for putting the NPLs under separate management is that it will allow the bank board and management to focus on restoring the ordinary banking business of lending money, which is crucial to the bank’s sustainability, but also to the country.

If the bank were not to create a separation then, with high NPL ratios, the management will spend most of its time addressing problems and the pressure to de-lever the balance sheet will prevent the flow of credit to creditworthy companies and individuals. Taking away the NPLs will allow management and board to look forward instead of backwards.

Good Governance & Transparency

Another important reason for separating the handling of the NPLs is to make the bank more transparent. Markets can handle risk, but hate uncertainty. The further away from the normal banking operations that the NPLs are handled, the easier it will be to show a clean balance sheet and thus to restore credibility. If the NPLs are kept within the bank, much effort must be put into mapping, analysing and pricing them in a transparent way.

Although the eurozone banking crisis remains on-going, there is a lot of money available in the international capital markets sitting ready for speedy deployment into investments where the risks are known and where there is improved confidence in future stability. The needs of Cyprus are small compared to those of other markets. Investors will come eventually if the Bank of Cyprus can convincingly demonstrate that the NPLs are professionally handled.

The workout process

If the separation of NPLs is done professionally, whether externally in a separate AMC or internally in a separate division or subsidiary, it should help stop the downward trend in asset (notably real estate) prices and work to restart the market. It must be possible for the workout organisations to keep the asset until satisfactory restructured.

A key foundation of any workout programme must clarify the value retention assumptions – a focus on extracting maximum value; an avoidance of asset fire sale sales and the resultant negative capital consequence; a policy of working consensually with clients to repair and restructure as opposed to enforcement.

In some jurisdictions it has been necessary to make trade-offs in the timing of workout programmes to accommodate agreements with external parties such as the Troika around areas such as deleveraging targets and ELA/ECB debt reduction.

Management Structure & Expertise

The NPL workout organisation must have a separate management. This is true regardless of whether it is placed as a division of the bank, a subsidiary or a separate AMC.

If it is kept as a division or subsidiary of the bank, it is preferable for the leader of the area to report directly to the board and not to the bank CEO (this may require modification to the bank’s governance structure to allow for the necessary decision making and accountability). The workout of NPLs may imply conflicts between the workout staff and the bankers running their normal business and this should be clearly recognised from the start. One way of doing this is to create an organisation structure with co-CEO’s utilising a shared services structure.

The handling of NPLs, of the magnitude being experienced in Cyprus, needs expertise that is not generally available in banks working under normal conditions. Some less experienced bankers have disagreed on this matter but it is now internationally accepted that industrial experts, specialised corporate finance specialists, real estate people, liquidation experts etc. need to be found outside the bank if objectives are to be successfully realised. Most often the necessary resources are not available domestically, but need to be hired on the international market. This may be expensive, but there is no other way.

Sense of Urgency

Discussing the best way to handle the NPLs is important as the complexities are many and the difficulties need to be well understood. It should however not prevent or retard action in the short term. NPLs that are not taken care of tend to quickly lose in value and many countries have seen this happen.

To prevent further value destruction, the Bank of Cyprus should go to the international market and immediately hire a head (or interim head if one is available immediately) of the new NPL workout department. This individual should report directly to the board of the bank and be supported with resources to start analysing the bad loans in detail and set up the necessary organisation structure and operating protocols.

The Development Bank concept

We do not believe that transferring the non-core assets to a new bank that also should work as a development bank in addition to operating as an AMC is a good idea.

An AMC should have the clear objective of regaining as much money as possible from the distressed assets and then close its business (or change itself into a real estate company if that path has logic to it). A development bank should have other objectives and mixing the two will just introduce uncertainty, confusion and scare investors away.

The above is a summary of the views of Lars Nyberg and Mike Aynsley who took part in an Institute of Directors panel discussion last month on the “Pros and Cons of having a separate independent asset management company cum development bank to manage the BoC Non-Performing Loans (NPLs) and other problem loans”.

Lars Nyberg  was the deputy CEO of Föreningsbanken during the Swedish banking crisis of 1991-1993, and as such deeply involved in restructuring and recapitalising the bank, including establishing its AMC. Between 1999 and 2011 Nyberg was Deputy Governor of the Swedish Central Bank.

Mike Aynsley is the immediate past Group Chief Executive Officer of the Irish Bank Resolution Corporation Limited (formerly Anglo Irish Bank and the acquired Irish Nationwide Building Society), which he led from September 2009 to February 2013. Mike was hired by the Irish government to lead the restructuring and reorganisation of the group.

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