NPL disposal treatment in the LGD estimates

The financial crisis resulted in an exponential increase of Non-Performing Loans (NPL) within banks’ portfolios, which hugely impacted their profitability. To push banks to get rid of the legacy of the crisis, regulators issued a number of regulations bearing significant implications for banks. Among other things, a threshold with respect to the ratio of Non-Performing Exposure to the bank’s overall Exposure (i.e. NPE ratio) has been set, past which banks become subject to a specific monitoring regime. The regulatory stance coupled with financial market pressure to lead banks to sell off material portions of their Non-Performing Loans portfolios. Since 2017 Italian banks started disposing NPL portfolios in a growing number. Disposals initially concerned portfolios of bad loans (i.e. sofferenze) to then embrace also Unlilkely-to-Pay loans. For AIRB banks (i.e. banks allowed to use internal models for capital requirements purposes) the inclusion of portfolio/massive NPL disposals into their Loss Given Default (LGD) estimates would raise capital requirements to unprecedented levels. More in detail, once massive NPL disposals are included into LGD models the expected losses estimates jump to levels that are representative of forced sell-off experiences and thus become detached from the internal workout processes used for newly defaulted loans. If used for pricing, provisioning and capital quantification purposes, such biased estimates would impair the formation of new credit, with negative macroeconomic consequences. To handle the impact of the NPL massive disposals on their LGD models, AIRB banks are working on a number of methodological approaches, that either factor in the probability that massive disposal will occur in the future or try to mitigate the extraordinary disposal prices. Having acknowledged the macroeconomic impact of the inclusion of NPL disposals into LGD models, the European Parliament provided AIRB banks with a limited leeway in their modelling practices. A specific article of the new Capital Requirement Regulation deals with this issue: article 500. This regulatory evolution is aimed at offsetting the distortive impact that the massive disposals, characterized by the disposal price, would have on the LGD parameter estimation. In fact the article allows to assume that positions object of massive disposal follow the same recovery pattern observed for workouts, as it happens for “open positions”, thus offsetting the actual anomalous recovery pattern that would introduce bias in the estimate. Different aspects of the methodology related to the implementation of article 500 continue to be examined by AIRB Italian banks.