Regulation that incentivises banks to sell non-performing loans (NPLs) is having unintended consequences on the consumer and society.

 

By Ben Marsh, Head of Corporate Development, Hoist Finance

 

For more than two years, the media in Ireland have been actively pursuing a story that suggests thousands of consumers are being (or will be) disadvantaged by the sale of distressed Irish mortgage books to Private Equity (PE) funds.

The narrative is a familiar one: so-called ‘vulture funds’ acquiring non-performing loans to make a fast buck in as short a time as possible, with no care or thought as to how the consumer is treated, or whether there is any chance that customer may be rehabilitated to the financial mainstream. Talk in the Irish press of anything up to 40,000 being left on the street added further fuel to the fire. Such a negative characterisation of the PE market is hardly fair – they are an easy target for media criticism – but the wider issues raised by the coverage are worthy of further debate.

Ireland experienced a significant property bubble and subsequent crash, leading to significant tranches of NPLs being put up for sale. The reason that so many NPL portfolios are ending up in the hands of PE funds, however, is a consequence of legislation brought in after the Global Financial Crisis. And what is happening in Ireland – and the media furore it created – could very shortly be happening here.

Reducing NPL ratios

Since the crisis of 2008/9, regulators have been focusing on reducing the NPL ratios within banks, encouraging those banks to sell customers with defaulted products. A key component of this legislation is the Prudential Backstop which incentivises banks to sell or otherwise write off NPLs from their balance sheet by making them increasingly expensive to keep, with the costs ratcheting up over time.

The regulators hope that in making NPLs too expensive to keep, and selling them on, the originating banks may free up capital to lend to new customers. To a considerable degree this has been happening: in the recent EBA report on NPLs, the total volume of NPLs as at June 2019 stood at €636bn but that is only half the volume recorded four years earlier (€1.152bn). In Q2 2020 the total absolute amount of NPLs (gross value) for all banks in the EU stood at €588bn, though the steady decrease witnessed pre-COVID now seems to have come to a stop and is perhaps unlikely to pick up again until after the recovery has started.

But regardless of the volumes of NPLs available for purchase, what the regulators seem to have failed to take into account is what happens to the customer whose debt is sold. And while they talk of the importance of a ‘deep and liquid’ secondary market and the need even to encourage new entrants, they do not appear to have fully understood the differences between the various ‘buyers’ already present in the secondary market, or their roles or motivations.

At one end of the scale are the Investment Funds who tend to take a short-term view over every portfolio they buy, with little or no desire or capability to support a customer over the longer term or offer new financing if they should need it. In the middle are the mainstream buyers, sizeable businesses in their own right with the ability and appetite to support customers over the longer term. Out on their own are the specialist banks, who understand the customer’s position, and are willing and able to support that customer through difficult times and, like the mainstream buyers, over a much longer period because their model is based on long-term, stable returns as opposed to short-term cashflows. (Hoist Finance is one example of those specialist banks, having held a banking licence since 1996. It looks after customers for an average of 4.5 years and operates a deposits business, using those funds to acquire performing and non-performing loans.)

The problem is that these specialist banks inadvertently find themselves in a Catch 22: while they may wish to work with a customer over the long term, and ultimately returning that customer to financial health with future access to credit, the clock is ticking. As banks, and therefore subject to the same regulation as the selling banks, they are financially penalized for hanging on to the portfolios of NPLs they hold!

Offloading NPLs early is likely to be to the consumer’s detriment, excluding them from access to mainstream credit. It might also lead to more portfolios being sold to those funds at the far end of the scale with different motivations, because the bank purchaser is simply not able to compete financially.

The legislation has in effect meant that banks like Hoist Finance have been caught in friendly fire as the assets continue to weigh more heavily on balance sheets even after they are purchase.

The customer journey

So what’s to be done? Certainly, we believe that consumers are better served by specialist banks rather than unregulated investment funds. In the fairness of balance, in exploring and better understanding the defaulted customer journey, there are pros and cons on all sides, both to the customer, and to society.

Selling to a fund often leads to faster resolution of a debt problem and frees capital for the originating bank to create new lending. But there is little or no focus on customer rehabilitation and no ability to offer new credit products, which means such customers contribute little by way of any societal benefit.

Selling to a specialist bank purchaser does mean a proven focus on the customer and positive, longer-term outcomes and in rehabilitating those customers with continued access to credit which in turn means a continued contribution to society. The Prudential Backstop, however, creates what we describe as ‘a burning platform’, and restrictions in terms of the ability to offer new credit and restructure loans.

The loans could, of course, still sit with the originating banks, and not be sold at all. The original lenders are being actively encouraged to properly recognise and manage NPLs more actively, and identify vulnerability at a much earlier stage. But the desire to sell is not only driven by the regulation, but also by the fact that the relationship with their customer has broken down. Originating banks are often not set up to manage long-term NPL customers. A build-up of NPLs also prevents them from further lending.

Banks of every hue are more highly regulated than their counterparts which leads to better customer treatment generally. Current regulation, and the need to banks to offload NPLs from their balance sheet, could end up with the very thing that many are trying to avoid – a shift towards more sales only to investment funds, possibly to the consumers’ detriment at a time that the European Commission is insisting that all consumer protection obligations are upheld, irrespective of how NPLs are resolved.

The secondary market, overall, is a good thing, and a healthy and diversified market is essential. There is undoubtedly a place for PE, but as have seen in Ireland, people in debt deserve a second chance – especially in a post-COVID world – and might not get it if only taking a short-term view. Investment funds often push customers down a legal route when it comes to collateral realisation, without, perhaps, trying too hard to find an amicable solution. Judicial sale prices are inevitably lower than those realised through amicable means, and the build-up of such judicial sales is therefore more likely to drive house prices down over the longer term. That in turn creates a larger debt burden for the next set of defaulted customers, as they see lower values recovered when their own properties are sold. It’s a significant issue in Ireland and in France and could end up being a problem to UK homeowners and other borrowers, once the Government safety net is taken away, and the true extent of the economic downturn is felt.

The regulation as to stands needs to be reconsidered, and it needs to be done urgently, for I doubt very much it was intended to impact the customer in the way that it has, nor to the extent that it might. It should not be a barrier to a positive outcome for all concerned.