This is a snapshot of the first of two technical documents providing details for the valuation of illiquid loans in workout. This article defines non-performing loans (NPL) from a legal, regulatory and accounting view and distinguishes NPL from other under-performing loans, such as loans categorized in Stage 2 of the IFRS 9 loan loss provision framework and loans subject to distressed restructuring or forbearance measures.
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Investors can benefit from recent regulatory demands on banks to collect and disclosure data and risk parameters relevant to the NPL market. Banks can use their extensive experience with models for loss given default (LGD) used in the calculation of regulatory capital charges and models for IFRS 9 loan loss provisions to provide investors with additional insight regarding recovery expectations for NPL, and thus can help overcome the information asymmetry between bank sellers and investors.
Investors who want to value and acquire NPL must project future recovery cash flows for a net present value analysis. For that investors rely on the information provided by the seller and their own experience with working out NPL. Banks who improve their data for internal model building will be in a better position to provide relevant and comprehensive data to investors on NPL portfolios offered for sale.
Unfortunately, there is a lack of detailed public information about bank loan recoveries creating a barrier to entry for new investors in the NPL market. Sellers of NPL should provide investors with historical collection cash flows on the asset offered. The EBA NPL transaction data template specifies a table for historical collection cash flows.
However, where detailed historical collection data are not available, investors will benefit from data covering similar NPL more broadly than those offered for sale. The bank regulatory disclosures, especially the risk parameters LGD, LGD in-default, as well as IFRS 9 stage 3 loan loss provisions (LLP) and coverage ratios can provide high-level benchmark data of expected recoveries. The reported risk parameters will not be a useful proxy for fair market value as banks are not required to discount recovery cash flows for LGD or LLP at the current market rate.
However, in the current low interest rate environment, the risk parameters can serve as a useful benchmark value for undiscounted expected ultimate recoveries, a key component in the valuation of NPL.
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