Tackling non-performing loans
November 2024 | TALKINGPOINT | BANKING & FINANCE
Financier Worldwide Magazine
November 2024 Issue
FW discusses how to tackle non-performing loans with Stacey Bairner, Alan Sheeley, Jennifer Craven, Michael Reading and Faisal Attia at Pinsent Masons.
FW: How would you describe the current volume of non-performing loans (NPLs)? What key factors are behind the numbers?
Bairner: The current volume of non-performing loans (NPLs) has been a significant focus for financial institutions (FIs) and regulators. In Europe, the figure has been relatively stable, but there are concerns about potential increases. This is due, firstly, to economic pressures such as inflation and interest rates. Second, geopolitical uncertainty and economic sanctions that are disrupting markets and affecting borrowers’ ability to repay. Third, stricter regulatory requirements and oversight by central banks. Finally, sector-specific risks, with consumer finance and real estate having shown increased risk and default rates. The situation remains dynamic, and future trends will be influenced by macroeconomic and geopolitical developments.
Sheeley: Securitisation has proven effective in lowering NPL levels across Europe. Between 2015 and 2022, approximately €205bn worth of NPL securitisation deals were completed, helping banks offload distressed assets and free up balance sheet space for new lending. Securitisation is one part of the puzzle and is largely facilitated by a number of other factors. Technology advancements, for example, have meant that debt collection and servicing is more effective. Similarly, improvements in data and specific NPL software, alongside a general maturation of the servicing and acquiring industry, have meant that risk-return can be more accurately calculated and, ultimately, that debts are more likely to be collected. In a similar fashion, regulation has progressed globally, allowing more alignment across regimes than there would have been previously, which aids what is intrinsically a globally intertwined market.
Craven: Regulatory tweaks have affected and facilitated the market. Ultimately, much of the secondary and private market for NPLs came about because of the global financial crisis and regulators seeking to move risky money out of the banking system. Capital regimes by regulators sought to make it less appetising for banks to hold riskier assets, by requiring them to hold more capital to cover potential defaults. Banks have therefore sought to shift NPLs off their balance sheets to free up capital. For some portfolios, this made sense as they were not in strategically important products or geographies anymore, and local servicers would be more likely to recoup the loans than the bank. The growth of the private capital and non-bank segment of the financial services sector has also aided the demand for a growing array of asset classes, which has increased the buyer pool.
Reading: State-guaranteed securitisation schemes, like Italy’s Garanzia Cartolarizzazione Sofferenze (GACS) and Greece’s Hellenic Asset Protection Scheme (HAPS), have been crucial in managing levels in the NPL market. These schemes help reduce funding costs and provide legal certainty, facilitating the market’s ability to absorb large volumes of NPLs. The HAPS and GACS schemes have helped shift portfolios from burdened bank balance sheets and create a burst of liquidity in the market in their immediate aftermath by reducing risk for acquirers. But that initial burst plateaued and now is actually reversing: Greek and Italian banks were those that saw the largest increase in NPL ratios among European Union (EU) and European Economic Area banks in Q1 2024. These were not large increases – around 0.1 and 0.5 percentage point increases respectively – but this marks the first increase since their introduction when they made a huge impact. Greece’s ratio was at 35 percent and Italy close to 7 percent in 2020, but now both sit below 4 percent.
Attia: The 2022 data from the World Bank show that the value of NPLs in the United Arab Emirates (UAE) is 6.4 percent. This is relatively high compared to other jurisdictions in the Middle East such as the Kingdom of Saudi Arabia, where the value of NPLs stands at 1.8 percent. The key factors for NPLs in the UAE are probably poor credit assessment and lack of focus on the importance of having robust collateral. We have seen instances where banks provide facilities relying solely on personal guarantees as collateral.
“The key factors for NPLs in the UAE are probably poor credit assessment and lack of focus on the importance of having robust collateral.”
FW: What steps are banks and other financial institutions (FIs) taking to address NPLs? What measures are proving to be effective in the current market?
Sheeley: Indian FIs have been able to take an interesting approach. Indian ‘asset reconstruction companies’ (ARCs) have had the exclusive right to buy non-performing assets from Indian FIs. This bad bank bailout option has been heavily utilised since India’s non-performing assets ratio shot up to over 11 percent. Because ARCs were able to buy NPLs from Indian FIs, India’s non-performing assets ratio had dropped to just below 3 percent at the end of March 2024. While the bad bank approach has been very helpful for FIs, the process is artificial. ARCs are still left holding the NPLs and recovery rates have reportedly been low. The big question that ARCs face is whether they will seek to release the value of NPLs in their portfolios in circumstances where domestic and international enforcement has been rare for various economic, commercial and political reasons.
Bairner: We have seen an increase in NPL securitisation which has proven to be effective in transferring risk and improving liquidity. We have also seen a number of co-investment strategies and structures tailored to suit the differing objectives of private investors and banks, which has helped facilitate transactions. Legal and administrative reforms have, in some jurisdictions, helped streamline insolvency proceedings and improved creditor rights, which has also been effective in tackling NPLs.
Attia: Banks in the UAE now have no option but to obtain better securities under current law. We will see how far UAE banks will go to achieve this. We anticipate that UAE banks will now put in place several measures to ensure better securities are obtained. For example, personal guarantees should no longer be an acceptable form of security for lending in the UAE.
“With the reduction in NPL ratios and the growth of the secondary market, there is potential for reperforming loan securitisations to become more prominent.”
FW: In which new markets – such as the Middle East – are you seeing the most activity?
Craven: Ironically, although UAE NPLs are a particular focus for the enforcement market, recent federal law changes in the UAE mean that it is a more problematic jurisdiction in which to enforce. Federal Law number 23 of 2022 brought into effect changes to established banking law that introduced the requirement for licensed FIs to obtain “sufficient guarantees for all types of facilities provided to natural clients and private sole proprietorships”. The upshot is that this change calls into question whether personal guarantees are permissible in the security suite. The application of the law change has not been applied uniformly by each Emirate as there is uncertainty about whether the change applies to corporates and whether it applies retrospectively. For instance, Abu Dhabi courts have interpreted the changes to have retrospective application and to apply to corporates, while the Dubai courts have taken the opposite approach.
Attia: There are recent changes to the UAE federal law, whereby banks are required to obtain sufficient securities, and these changes aim put a stop to the practice of some banks providing significant loans without relevant securities. It will be very interesting to see what will happen over the next few years and how banks will react to these new changes – in particular, how banks in the UAE will comply with the requirement of obtaining sufficient securities and at the same time continue their lending business as usual.
Bairner: Despite very high levels of liquidity, we are seeing increased activity in the Middle East – particularly in the UAE – with a notable increase in sale and purchase opportunities. Third-party investors have made significant investment into the market. The UAE has become a focal point for NPL activity, but we are seeing increased activity in other Middle Eastern markets due to a combination of economic pressures, regulatory changes and the entry of third-party investors looking to capitalise on the opportunities presented by NPLs. Recent regulatory changes aimed at improving transparency and provisioning have attracted third-party investors and funders. The UAE’s proactive approach to addressing NPLs, combined with its regulatory reforms, makes it a dynamic and evolving market for NPL activity.
Sheeley: The enforcement market for NPLs is no longer just a European-centric market, it is a global one. The hottest market we are seeing is the Middle East, and in particular the UAE. We have seen multiple UAE NPL enforcement cases arising out of different Emirates that have led to devised strategies in multiple jurisdictions around the world. These claims are not necessarily straightforward to pursue. They require advisers who know what they are doing, know how local legal systems and markets operate, and know how to devise a cost-effective strategy focused on achieving value.
Reading: While the Indian market has yet to translate into much enforcement activity, it attracts much focus in the enforcement world because of the opportunity it represents. ARCs have huge NPL portfolios and they are under pressure to achieve better returns. The problem is that this has not yet translated into much, if any, international enforcement action, notwithstanding the strong likelihood that Indian high net worth individual NPL debtors have assets all over the world. If and when ARCs decide to seek enhanced recoveries through international enforcement strategies, this NPL market could become one of the most significant in the world.
“Some specialist acquirers and servicers took on a lot of debt to acquire portfolios during low rate periods, and grew to become some of the biggest in Europe.”
FW: What developments have you seen in the secondary market for NPLs?
Sheeley: The development of a mature secondary market for NPLs is essential for efficient risk management. Enhanced data transparency and standardised regulatory disclosures are critical for attracting new investors and ensuring market liquidity. Enhancements in data, tech and processes have allowed servicers, specialist debt acquirers and third-party intermediaries to facilitate greater activity in the market and generally more stable infrastructure, but there is another side to that progress. Anecdotally, some market participants have reported a number of sales processes in the last year simply being an opportunity for the seller to do some benchmarking for its portfolio and see how much it is valued at. The administration and costs of these sales processes creates further cost and frustration, and may introduce greater risk, especially from a data protection perspective if details are shared with suitors and others.
Craven: Some acquirers are having a difficult time in the secondary market. Some specialist acquirers and servicers took on a lot of debt to acquire portfolios during low rate periods, and grew to become some of the biggest in Europe. However, some of those in the secondary market are now very overleveraged and lack the liquidity to continue purchasing portfolios as they were. This has taken liquidity out of the market and, more importantly, we have recently seen reports of at least one major acquirer exploring options for restructuring, including a potential Chapter 11 or insolvency to appease bondholders.
Reading: With the reduction in NPL ratios and the growth of the secondary market, there is potential for reperforming loan securitisations to become more prominent. This shift could further stabilise the European securitisation market and offer new investment opportunities. This has also been happening in the debt acquirer space. Debt acquirers have been struggling in the last year due to the high levels of debt they took on to finance portfolio acquisitions in the lower rate environment. This is now coming up for refinancing and the firms are all looking highly leveraged. In order to raise capital and lower their debt ratios they have been utilising private capital too. We have seen acquirers in the market sell portfolios but keep the maintenance and servicing contracts and fees for those loans. So they get a cleaner balance sheet – although selling the portfolio at a discount – but do get some continued revenue through fees.
Attia: I anticipate that the recent changes in the UAE law will limit the growth of the secondary market for NPLs, particularly in Abu Dhabi, at least in the short term. That said, we should see better secured loans over the next few years following these recent changes and this may encourage more debt acquirers to buy into UAE NPLs in the future. I see the recent law change as a double-edged sword when it comes to the secondary market for NPLs in the UAE.
Bairner: The secondary market has seen a significant jump in activity. With the jump in activity, secondary markets for NPLs are becoming more efficient, providing banks with better optionality and routes to avoid large volumes of build-ups of NPLs on their balance sheets. Regulatory change has also been a factor. The EU has been actively working on improving the secondary market for NPLs. The directive on credit servicers and credit purchasers has enabled more competition on the buy side by introducing harmonised requirements and a passporting regime for credit servicers. This makes it easier for banks to offload NPLs or outsource their servicing to third parties.
FW: What recovery strategies are most likely to release value from distressed portfolios?
Attia: From a UAE local perspective, recovery strategies will normally depend on many factors, but one approach which I personally find effective is to explore whether there is any route for lifting the corporate veil. UAE courts will, in the right circumstances, lift the corporate veil, but this will of course need some in-depth investigations and sound evidence. I have seen some NPL debtors in the UAE and across the Middle East that do not necessarily use sophisticated ownership structures, and this made them easier targets for lifting corporate veil applications. In my experience, the mere filing of a credible application for lifting the corporate veil could persuade the NPL debtors to settle.
Craven: Knowledge is power when developing NPL litigation strategies. Effective information gathering at the outset concerning an NPL debtor’s assets and the debtor’s link to those assets is essential. It is this information that informs the enforcement strategy and helps identify potential low hanging fruit worthy of early attention in the search for quick wins. Without a strong backbone of robust and useful intelligence, NPL strategies can falter or become unnecessarily expensive.
Bairner: Releasing value from distressed portfolios requires a combination of strategic approaches tailored to the specific circumstances of the assets involved. It really does depend on the assets, the parties and the jurisdictions. Asset sales are often effective and attractive as they help generate immediate cashflow. Loan to own is the other most common strategy as it allows investors to gain control. These strategies are typically done alongside operational improvements. These strategies, when effectively implemented, unlock value from distressed portfolios.
Sheeley: Sophisticated NPL debtors with global asset portfolios require sophisticated global asset recovery strategies. Such enforcement strategies often require claims against the same NPL debtor in multiple jurisdictions. This can be an expensive endeavour. It is therefore important for distressed portfolio owners to establish a robust and targeted enforcement strategy at the outset to ensure commerciality. Wealthy NPL debtors use sophisticated ownership structures that obscure their assets or simply make them difficult to enforce against. These structures are often based in jurisdictions which have secrecy regimes or lack public business or property registers, which can make connecting an asset to an NPL debtor challenging, and establishing a viable action aimed at capturing that asset for enforcement even harder.
Reading: Because some NPL debtors utilise offshore structures to hide their assets, enforcement strategies need to be able to adapt to the idiosyncrasies of the different offshore jurisdictions. Having a strong set of advisers on board is key to deploying effective strategies. This includes sourcing good quality local lawyers in each jurisdiction but also knowledgeable lawyers who are experienced in handling multijurisdictional cases. This last point is usually necessary because offshore ownership structures are often multijurisdictional in their make-up, and it may be necessary to take coordinated actions in multiple offshore jurisdictions to enforce against the target assets.
“The enforcement market for NPLs is no longer just a European-centric market, it is a global one. The hottest market we are seeing is the Middle East, and in particular the UAE.”
FW: What practical matters should fund managers be thinking about when considering their enforcement options?
Reading: A fund manager should make sure its lawyers always consider the entirety of the litigator’s available toolkit. Depending on the jurisdiction in which the claim sits, this toolkit might include options such as a worldwide freezing order with asset disclosure obligations, search orders, disclosure orders that can assist in obtaining financial information useful for tracing and asset following, as well as standard debt claims and insolvency related claims. Utilising these tools properly can assist a claimant in finding the breakthrough in its case or creating litigation pressure that ends in victory or settlement.
Sheeley: It is important to choose the jurisdictions that form part of an enforcement strategy wisely. Not all jurisdictions are equal, at least not in terms of enforcement. There are obvious jurisdictions to avoid – for example, those where the rule of law is not as central as it should be or where the court systems are unreliable or lengthy in respect of time to judgment. Look for assets in places where a creditor is likely to be treated fairly. England, and London in particular, attracts wealth. It is therefore often a jurisdiction in which NPL debtors have assets which may be an attractive proposition for enforcement proceedings. While the system is not perfect, England has a robust legal system including a strong rule of law, an independent and competent judiciary, and court procedures that provide a useful set of tools that litigators can use to achieve positive outcomes to enforcement actions in England and around the world.
Craven: Fund managers should always consider litigation funding options. While litigation funding is not available in all jurisdictions, it can be a savvy way to fund NPL enforcement actions where there may otherwise not be appetite for the risk of self-funding; thereby reducing the NPL value in the short term. Litigation funding markets are maturing and, subject to jurisdictional restrictions, there are multiple funding options available both with law firms, such as damages-based agreements, and funders that may be interested in one-off cases or portfolios.
Attia: From a UAE local perspective, UAE courts will provide good assistance in terms of locating assets and information which may lead to assets or routes for lifting the corporate veil. The skill is in deciding what enforcement application, against whom, should be made first. Sometimes, making the wrong enforcement application may weaken the creditor’s position and help the NPL debtors avoid their liability. In the event that the NPL debtor is subject to bankruptcy proceedings, the enforcement options will of course be affected by these proceedings and creditors will have to go through certain processes.
“Releasing value from distressed portfolios requires a combination of strategic approaches tailored to the specific circumstances of the assets involved.”
FW: Looking ahead, how do you expect the NPL landscape to unfold over the coming months and years?
Bairner: We have observed the NPL market through numerous cycles and expect to see increased activity in a number of sectors and jurisdictions. Technology is playing, and will continue to play, a significant role in activity levels and speed of execution. There has been a move away from purely manual, time intensive data gathering due diligence on NPLs during the global financial crisis toward using proprietary NPL technology to deliver due diligence in a very compressed timescale. However, many investors’ advisers still undertake due diligence in a very manual way. Some new entrants on the sell side will need support in identifying pools of loans for sale and readying books for sale.
Sheeley: As the European market slows down, it is the newer non-European markets that excite me from an enforcement perspective. Although the UAE’s NPL rate has been dropping since 2019, it sits at around 5 percent, which is still high. We therefore expect to see continued activity as UAE FIs and servicers try to leverage and work their distressed portfolios. We are also watching what is happening in Saudi Arabia as that market considers what to do with its distressed portfolios and is opening up to the world market. Only time will tell what will happen in the Indian market and its approach to global asset recovery for NPLs.
Craven: Further increases in the European Central Bank rates may stimulate the European NPL enforcement market in the same way that high interest rates have done elsewhere. European NPL portfolios have not generated much recent enforcement activity, or excitement, as newer markets have. That is, in part, because market participants are not under as much rate or capital requirements pressures, which are the usual drivers for market stimulation.
Reading: A big issue that is going to affect the medium to long term NPL enforcement outlook is whether the different Emirates comprising the UAE are going to synchronise their approach to loans and security. If Abu Dhabi changes to adopt Dubai’s more lender-friendly interpretation, there may be a wave of claims against in respect of Abu Dhabi loans and indeed Abu Dhabi-based assets, which are currently on hold. However, if Dubai and the other Emirates follow Abu Dhabi, this will not only significantly limit actions against UAE loans and indeed UAE-based assets but, in turn, this will likely have a knock-on effect on worldwide claims.
Attia: Recent changes in the UAE law may now limit the growth of the secondary market for NPLs, but the same changes may also make this market more attractive in the future. The UAE also introduced a new federal bankruptcy law which came into effect earlier this year. Among other improvements from the old bankruptcy regime, this new law introduces a bankruptcy court. This improvement in sophistication hopefully means that creditors will see improvements and better returns.
Stacey Bairner is a partner in the firm’s finance and restructuring team. She has extensive experience of the sale and purchase of performing and non-performing loans and regularly acts for banks and funds both selling and acquiring loan portfolios. Her team has acted on the sale or purchase of more than €100bn of loans in recent years. She also specialises in the delivery of innovative legal technology solutions for clients, particularly whereby the technology led approach has transformed due diligence of portfolios of loans and security. She can be contacted on +44 (0)141 249 5588 or by email: stacey.bairner@pinsentmasons.com.
Alan Sheeley heads Pinsent Masons LLP’s international civil fraud and asset recovery practice. He has extensive experience in advising clients on sensitive internal investigations, crisis management and obtaining or defending worldwide freezing injunctions. He advises domestic and international banks, professional service providers and law firms in a range of fraud-related and asset-recovery claims. He is a leading individual in Legal 500. He can be contacted on +44 (0)20 7054 2626 or by email: alan.sheeley@pinsentmasons.com.
Jennifer Craven is a legal director in Pinsent Masons LLP’s international civil fraud and asset recovery practice. She specialises in foreign and domestic commercial frauds as well as onshore and offshore trust litigation. She has acted on cases involving breach of fiduciary duties and trust, breach of directors' duties, fraudulent misrepresentations, employee fraud, deceit and conspiracy. She is also experienced in advising clients on internal investigations, asset recovery and crisis management. She can be contacted on +44 (0)20 7054 2596 or by email: jennifer.craven@pinsentmasons.com.
Michael Reading is senior associate in Pinsent Masons LLP’s international civil fraud and asset recovery practice. He specialises in financial services claims and onshore and offshore commercial fraud, including crisis management, freezing injunctions and asset recovery. His experience includes some of the highest profile fraud-related cases in recent years. He has also acted for a range of financial and professional services institutions in relation to high value and complex matters. He can be contacted on +44 (0)20 7054 2672 or by email: michael.reading@pinsentmasons.com.
Faisal Attia is a partner and heads up Pinsent Masons civil law dispute resolution practice for the Middle East region and has extensive experience in both litigating and arbitrating commercial disputes across this region. He also frequently acts as UAE law expert in foreign court proceedings. He can be contacted on +971 56 218 6992 or by email: faisal.attia@pinsentmasons.com.
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