From NPLs to Unlikely to Pay?

DBRS on Recent Trends of Italian NPE Market

DBRS Morningstar analysed in a Synthetic Commentary the recent trends and credit implications related to Italian unlikely-to-pay (UTP) securitization transactions.

Following the financial crisis in 2008–09, the Italian banking sector experienced an increase in nonperforming loans (NPLs) mainly due to the adverse global economic conditions at the time. In March 2017, the European Central Bank (ECB) issued guidance to banks, acknowledging that NPLs levels had a negative impact on the economy. The ECB identified the securitisation of NPLs portfolios as one possible solution to reduce European NPL stocks.

Coupled with the Garanzia sulla Cartolarizzazione delle Sofferenze (GACS), the recent and rapid growth in the market for NPL securitisation transactions across Europe has helped Italian banks achieve the accounting and regulatory derecognition of these stocks from their balance sheets and allowed them to de-risk. In December 2017, the cumulative gross book value of NPLs on Italian banks’ balance sheets was EUR 154 billion and, as of December 2022, it had reduced to EUR 24 billion1. This trend demonstrates that banks have adopted procedures and plans aimed at achieving the results required by the regulator.

Although securitisation played a central role in de-risking Italian banks’ exposure to NPLs, these banks now seem to have refocused on developing processes to avoid the classification of borrowers as NPL through a preventive intervention on those defined as unlikely to pay (inadempienze probabili) (UTPs), which is the classification prior to NPLs. Such processes should result in the preservation of borrowers' economic conditions and, therefore, the avoidance of a default. In this commentary, we analyse the latest trend toward UTPs in the Italian market, the relevant differences between UTPs and NPLs (sofferenze), and the relevant credit implications of UTP securitisations.

Unlikely to Pay: Differences from NPLs

According to the Circular no. 272 dated 30 July 2008 issued by the Bank of Italy (as amended and supplemented from time to time; the Matrice dei Conti), NPLs (sofferenze) are defined as cash and off-balance-sheet credit exposures to a party in a state of insolvency (even if not judicially ascertained) or in substantially similar situations, regardless of any loss forecasts made by the bank. The Matrice dei Conti defines UTPs as exposures for which, on the basis of the bank's sole assessment, debtors are unlikely to repay without the enforcement of guarantees.

The main difference between these two categories is that to be classified as a NPL, the debtor must be insolvent while, to be classified as a UTP, the bank must make an assessment regardless of whether the borrower has any payments in arrears. However, the Matrice dei Conti also provides for certain cases where an exposure should be classified as UTP, including cases wherein the borrower has submitted a request for a voluntary early arrangement with creditors (concordato in bianco) to the competent court or in the case of a composition with creditors on a going-concern basis (concordato preventivo con continuità aziendale).

The distinction between NPLs and UTPs also affects the securitisation process of these exposures. In most cases, NPL exposures arise from loan agreements (in different technical forms) that the bank has already terminated and, therefore, the servicer's activity will mainly focus on the recovery of unpaid amounts from the borrower once transferred to a special-purpose vehicle (SPV). On the other hand, UTP exposures arise from agreements that are still valid and binding between the parties and, sometimes, they also provide for further disbursements from the bank (e.g., in case of revolving exposures) together with any other undertakings usually provided by a loan agreement, which might include the bank's delivery of periodic communications.

This results in the need for (1) more developed skills on the servicer's management side that are required to manage a loan and a contractual relationship still in place between the parties, and (2) the restructuring of the position that could not occur without the transfer of the underlying agreement and, due to regulatory constraints, it is usually carried out in favour of a bank or financial intermediaries. These rearrangements could also require the disbursement of further loans to facilitate the reclassification of the relevant debtors since these borrowers could face temporary difficulties due to particular market conditions, such as the recent pandemic or the war in Ukraine. The further loans could be financed by the SPV through the collections, an external financing or the issuance of a class of super senior notes.

From a true-sale perspective, the fact that the underlying agreements of UTP exposures are still valid and binding between the parties could result in some issues regarding the transferability of receivables arising therefrom. In some cases, such agreements can contain clauses either limiting or restricting the transferability of the agreements or the relevant receivables to third parties. Although these limitations should not affect the validity of the transfer of the receivables in favour of an SPV, co-operation with the originator could be required to transfer the amounts repaid by the borrowers to an SPV.

To mitigate any commingling risk arising from the fact that the originator can hold collections, such collections should frequently be transferred into an issuer's accounts, which are segregated in favour of the noteholders by a mandatory provision of law. On the other hand, receivables classified as NPLs usually arise from agreements that have been terminated and, therefore, there are not particular issues regarding their transferability in favour of the SPV. Since the agreements are no longer effective between the parties, any provision limiting the transferability is not applicable.

Although there could be cases where the borrower continues erroneously paying the originator, this cannot be considered as a feature of the transaction. According to the Bank of Italy2, in Q4 2022, exposures classified as UTPs in the Italian banking system amounted to EUR 38 billion. As shown in Exhibit 3 below, Italian credit institutions are now also focusing on the reduction of receivables classified as UTP while, for NPLs, Italian banks had already identified a process to reduce the NPL stock—a process that, in most cases, results in the securitisation of NPL portfolios.

Although the Italian UTP market cannot be considered as developed as the NPL market, DBRS Morningstar understands that Italian banks will be facing in the coming years a new challenge: the development of clear and efficient procedures for managing their UTP stocks. Considering the regulatory constraints, in our view, securitisation and AIF structures could play an important role and, therefore, banks could continue developing specialised platforms with such purpose.

Furthermore, DBRS Morningstar is of the opinion that proactive management of UTP stocks could lead to a decrease in Italian banks' NPL ratios since a preventive intervention could result in the preservation of a borrower's economic conditions and the avoidance of default.

Compared with NPLs, DBRS Morningstar's view is that UTP receivables can be considered as a more challenging asset class due to their characteristics that require proactive management, more developed skills, financial capacity, as well as advanced IT platforms to support servicers' and originators’ activities. Indeed, depending on the characteristics of each borrower, servicers and originators, in order to maximise their collections, are required to develop specific credit recovery strategies, expertise, and to continuously improve specific policies and procedures.

Due to the current macroeconomic environment, DBRS believes that these strategies could change as a consequence of high-interest rates and inflation that might result in the borrowers' difficulty to (1) obtain new finance and (2) repay their loans even if these have already been restructured or managed properly. Indeed, DBRS Morningstar believes that such macroeconomic conditions are not as relevant in NPLs as they are in UTPs, given that for NPLs the management activity is mostly focused on the judicial recovery and not on the avoidance of default.

Link to the report:

https://www.dbrsmorningstar.com/research/415594/from-npls-to-unlikely-to-pay-recent-trends-and-credit-implications-in-the-italian-nonperforming-exposures-market

This newsletter is free please consider supporting it with a small donation

Check my personal blog mostly in Italian

See my full professional profile (available for consulting projects)

My Podcast on Financial News and Education

My new Podcast on Italian Politics