Lessons from Estonia: resolvingnon-performing loans

TallinnNovember 29, 2017

Why is timely resolving of NPLs important?• Banks which are unable to cope with their stock on NPLs struggle to return to profitability

• Governance costs: focus on internal processes rather than business development/growth

• NPLs lock up capital in non-productive assets

2Allikas:Komisjon

Roughly 1/3 of EU members struggle with excessively high NPL levels

3Allikas:EBA

Crisis of 2008-2009 had a severe impact on Estonian economy

4

-25,0% -20,0% -15,0% -10,0% -5,0% 0,0% 5,0%

10,0% 15,0% 20,0% 25,0%

II 06

II 07

II 08

II 09

II 10

II 11

II 12

II 13

II 14

II 15

II 16

II 17

y-o-

y

Main economic indicators of Estonia

GDP

Unemployment

CPI

0

200

400

600

800

1.000

1.200

1.400

0

100

200

300

400

500

600

03 III

05 III

07 III

09 III

11 III

13 III

III 15

III 17

Aver

age

pric

e of

m2,

EU

R

Qua

rter

ly tu

rnov

er, m

ln E

UR

Average price and turnover of apartments, all regions

Quarterly turnover (l.h.s.)

Price of m2 (r.h.s)

• GDP maximum contraction was close to 20%, unemployment rose to 20%, real estate prices fell 51% for some properties*

*m2priceintwo-roomapartments,allregions

Drastic economic conditions led to quick build-up of non-performing loans

5,07%

9,14%

6,55%

0,00%1,00%2,00%3,00% 4,00% 5,00%6,00%7,00% 8,00% 9,00%

10,00%

I 02 III 02

I 03 III 03

I 04 III 04

I 05 III 05

I 06 III 06

I 07 III 07

I 08 III 08

I 09 III 09

I 10 III 10

I 11 III 11

I 12 III 12

I 13 III 13

I 14 III 14

I 15 III 15

I 16 III 16

I 17 III 17

Loans past due more than 90 days, % of the respective credit portfolio segment

Households Non-financial companies 90d+ loans

5

Sectors connected to real estate were affected the most

6

050

100150200250300350400

mn

EUR

Loans past due 90+ days, mn EUR

2007 2008 2009 2010 2011 2012 2013

0% 5%

10% 15% 20% 25%

% o

f res

pect

ive

segm

ent

Loans past due 90+ days, %

2007 2008 2009 2010 2011 2012 2013

• All major sectors of economy experienced financial deterioration• By volume NPLs were concentrated in the mortgages and real estate segments

Additional insight was necessary to get true picture of credit quality

7

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

7,00%

I 02 III 02

I 03 III 03

I 04 III 04

I 05 III 05

I 06 III 06

I 07 III 07

I 08 III 08

I 09 III 09

I 10 III 10

I 11 III 11

I 12 III 12

I 13 III 13

I 14 III 14

I 15 III 15

I 16 III 16

I 17 III 17

Loans past due more than 90 days, restructured loans and EBA NPLs, % of loan portfolio

NPL by EBA definition, cons. 90d+ loans 90d + restructured loans, total portfolio

0%

20%

40%

60%

80%

100%

120%

-1,20%

-0,70%

-0,20%

0,30%

0,80%

1,30%

08 IV 09 IV 10 IV 11 IV 12 IV 13 IV 14 IV 15 IV 16 IV

Loan losses (-) and recoveries (+), % of credit portfolio

Provisions/90d overdue loans, rhs

Banks quickly proceeded to recognise credit loss reserves

8

Provisioning ratio and credit losses

• By 2010 Q3 the credit loss reserves reached maximum 5.4% of the credit portfolio• 80-85% of 90d+ past due loans were covered by reserves throughout the 2010-2012• Provisioning was conservative and banks could reverse some credit losses later on

Reversals of credit losses

At later foreclosure stages banks started to make write-offs to clean balance sheets

9

-4,00%

-3,50%

-3,00%

-2,50%

-2,00%

-1,50%

-1,00%

-0,50%

0,00%

-1,20%

-1,00%

-0,80%

-0,60%

-0,40%

-0,20%

0,00%

II 08

III 08

IV 08

I 09

II 09

III 09

IV 09

I 10

II 10

III 10

IV 10

I 11

II 11

III 11

IV 11

I 12

II 12

III 12

IV 12

I 13

II 13

III 13

IV 13

I 14

II 14

Cum

ulat

ive

writ

e-of

fs, %

of Q

1 08

por

tfolio

Writ

e-of

fs a

nd re

cove

ries,

% p

er q

uarte

r

Quarterly write-offs and recoveries, % of credit portfolio

Write-offs, % credit portfolio per quarter Cumulative write-offs, % of 2008 Q1 portfolio

Dataisbasedonconsolidatedbankinggroupsreports,doesnotincludebranches

Write-offs were aprx. 2 times larger in corporate segment vs households

10

0,00%

0,50%

1,00%

1,50%

2,00%

2,50%

3,00%

3,50%

4,00%

4,50%

5,00%

0,00%

0,20%

0,40%

0,60%

0,80%

1,00%

1,20%

1,40%

1,60%

1,80%

2,00%

II 08

III 08

IV 08

I 09

II 09

III 09

IV 09

I 10

II 10

III 10

IV 10

I 11

II 11

III 11

IV 11

I 12

II 12

III 12

IV 12

I 13

II 13

III 13

IV 13

I 14

II 14

Cum

ulat

ive

writ

e-of

s, %

Q1

'08

portf

olio

Qua

rterly

writ

e-of

fs

Write-offs by client type, % of respective outstanding loans

Households (l.h.s.) NFCs (l.h.s.) Households - cumulative (r.h.s.) NFCs - cumulative (r.h.s.)

Dataisbasedonconsolidatedbankinggroupsreports,doesnotincludebranches

Capitalization stayed comfortably above the legal minimum

11

0%

10%

20%

30%

40%

50%

07I

07III

08I

08III

09I

09III

10I

10III

11I

11III

12I

12III

13I

13III

14I

14III

15I

15III

16I

16III

17I

Averagecapital adequacy ratios of Estonian banks

Tier I - solo

CAD - solo

Tier I - cons.

CAD - cons.

• Large capital buffers allowed banks to quickly clean balance sheets and move on

Crisis losses amounted to 39% of the profits earned during 2002-2008

12

-4.000

-3.000

-2.000

-1.000

0

1.000

2.000

3.000

4.000

-800

-600

-400

-200

0

200

400

600

800

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Cum

ulat

ive

prof

it, m

n EU

R

Year

ly p

rofit

/loss

, mn

EUR

Banking sector yearly profit/loss, mn EUR

Cumulative profit (r.h.s.) Yearly profit (l.h.s.)

• Credit losses were concentrated in 2 years

Supervisory activities before and after the crisis

13

Loan granting conditions were in accordance with best banking practice

14

Loan Servicing Ratios of New Housing LoansSeptember 2006 April 2007

Up to 30% 38% 34%31-40% 31% 30%41-50% 17% 22%Over 50% 14% 14%

Loan-to-Value (LTV) RatiosSeptember 2006 April 2007

Average LTV 54% 52%

Share of loans with a high (85-90%) LTV ratio 14% 10%

Maturity of New Housing LoansSeptember 2006 April 2007

Up to 15 years 22% 18%16-25 years 28% 24%26-30 years 43% 35%Over 30 years 7% 23%

Interest Rates of New Housing Loans September 2006 April 2007

Average 4,41% 5,11%Max 12,30% 10,40%Min 3,00% 3,00%

The funding fuelling fast lending was provided by the parent banks•The average annual credit growth was 37% during 2004-2007

• Intra-group funding reached to 48% of total funding at height of boom

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

0

5.000

10.000

15.000

20.000

25.000

II 04

II 05

II 06

II 07

II 08

II 09

II 10

II 11

II 12

II 13

II 14

II 15

II 16

II 17

% o

f tot

al fu

ndin

g

mn

EUR

Funding from foreign banks, % and mn EUR

Total funding Funding from foreign banks Foreign funding, % of total funding (r.h.s.)15

Profitability and market share targets dominated over risk considerations

16

• Subsidiaries were small in the groups but systemically important for local market

• Corporate governance structures horizontally integrated – matrix style management

• Subsidiaries gave significant part of groups’ profits

0%2%4%6%8%

10%12%14%16%18%20%

H1 2007 H1 2011 H1 2012 H1 2007 H1 2011 H1 2012

EE

shar

e in

the

grou

p, %

The share of Estonian subsidiaries in consolidated groupProfit Total assets

Swedbank SEB

It was necessary to address the issue at parent banks’ level• Finantsinspektsioon raised the issue of risks of excessive lending with the home supervisors• In addition to face-to-face meetings, several official letters were sent to Swedish FSA and the management of the parent banks• Central bank imposed restricting regulations:

• The risk weight for mortgages was raised to 100% in 2005• The liquidity reserve requirement was raised to 15% in 2006

• Micro risks were mitigated: capital and liquidity buffers were formed• Prudential measures did not have much impact to limit fast lending; there were no macro-prudential tools available at that time

17

Capital buffers can decrease substantiallyIf growth of past due loans continue at the same speed capital adequacy will decrease significantlySome small banks might need to raise additional Tier I capitalTwo small banks with highest growth of past due loans have already started re-capitalization process

Extrapolated capital adequacy*

7,1%

10,7%11,3%

10,8%

14,5%15,1%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

12,0%

14,0%

16,0%

18,0%

20,0%

I 08 II 08 III 08 IV 08 I 09 II 09 III 09 IV 09 I 10 II 10 III 10 IV 10

>90d past dues, % of loan portfolio Tier I Capital adequacy Provisions

* Linear extrapolation of past due loans growth is assumed

Extrapolation

18

Supervisory activities during 2009• Ordering detailed expert analysis of loan portfolio from Ernst&Young• Full-sized credit risk inspections in two small banks• Prescription to improve provisioning rules and apply higher provisioning rate for two

small banks• Performing conservative credit risk stress-test to identify banks needing special

actions• Numerous other analysis and actions:

• Semi-annually overview of mortgage portfolio quality• Monitoring of credit quality compared to EE-FSA’s stress-tests• Analysis of bank’s ICAAP stress-tests, which include credit risk stress-tests (part of BASEL II SREP)• Follow-up reviews on IRB models

19

Successful supervisory co-operation is the key• Intense communication with the Swedish FSA

• Regular meetings with the Swedish and Baltic supervisory colleagues• Participating in the ICAAP evaluation process on a group level• Regular overview of refinancing needs and activities of the parent banks• Presenting overview of the Estonian banks regularly to the Swedish FSA

• Many factors facilitated successful cooperation• Close geographical area • Similar culture, no major cultural differences• Home and host countries are all the small European countries• Focused communication: small number of banks and supervisors• Practical cooperation is not very formalized• Home countries have long-term experience in cross-border cooperation

20

Example of 2009 supervisory stress-test assumptions• Income -25%

• Disposable income -25% for all households, households with DSR >55% default• Collateral value decrease 40%• Bank’s loss: difference between collateral value and outstanding loan

• Residential real estate developers• Sale price of a m2 decrease 40%• Bank’s loss: Difference between sales and outstanding loans

• Cash flow based projects (offices, shopping centres etc)• Tenant fees decrease by 35%• Collateral value decrease by 40%• Bank’s loss: Difference between outstanding loan and collateral value

• Non-real estate companies• EBITDA decrease by 40% comparing to 2008• If Debt / EBITDA > 4.0, the client defaults – no liquidity reserves accumulated• Bank’s loss: 45% of the outstanding loan

21

2009 stress-test results were used to call for re-capitalization actions• Results of EE-FSA’s stress-tests were discussed in the management of the banks• EE-FSA discussed the stress-test results with the home supervisor• EE-FSA proposal to college of supervisors:

• Demand binding action plan for re-capitalization of Estonian subsidiaries with clearly defined trigger

• Legal base for the action plan is Pillar 2 framework

• EE-FSA goal: subsidiaries should be re-capitalized at early stage before getting close the regulatory minimum

22

Other actions based on stress-test results• One small bank for which the stress-test materialized the most in 2009 1H:

• Bank presented action plan for re-capitalization• EE-FSA met with the owner of the bank where the parent bank confirmed

readiness to re-capitalize the bank• Another small bank decided to raise additional own funds from the owners before

EE-FSA actions

23

Positive experience with taking group-wide approach• Centralized liquidity management and capital planning has worked

• Positive experience with capital and liquidity intragroup mobility• Capital buffers are accumulate on the local level

• Subsidiaries are over capitalized• Did not take dividends

• Banks defined the Baltic market as home market• During crises event banks have proven this• Parent banks provided liquidity and capital support

• Did not have experience when parent bank have serious problem

24

Owners enhanced oversight over loan resolution• Parent banks have implemented structures to participate in decision-making on bad

loans• Parent banks’ representatives review and advise on tackling of each problem loan

(corporate loans)• In some banks, amendments to a loan agreement must be signed in HQ of the parent

bank• Internal reports have been amended to include detailed information on problem

loans • Amount of restructuring, collateral foreclosure, downgrades, etc

• Risk control units report directly to group risk control• The control is strict, but:

• Owners have a detailed overview of the books and are aware of potential capital need• It prevented misuse of the restructuring tool

25

Strong capital base is pre-requisite for resolving NPLs

26

• Banks with low coverage ratio are reluctant to resolve NPLs• Capital is needed to raise coverage ratio, low capital = reluctance to resolve NPLs• Strong enforcing actions are needed in case of banks with high NPL and low capital base

VirtuouscircleofNPLs andcoverageratio

Allikas:EBA

NPLs issue in Estonian EU Presidency• During Estonian presidency the Council approved NPLs action plan• Mix of policy actions to reduce NPLs stock in the following areas:

• Supervision• Insolvency and debt recovery framework• Secondary market for distressed assets• Restructuring of banking system

• Mr Tõniste on the Council’ action plan• Non-performing loans are a problem for the banking industry for which solutions have until

now been mainly defined at the national level. We need to free up these resources, make our financial system more resilient and prevent the re-emergence of NPL issues in the future.

27

Summary• Before crisis banks were capitalized and risks mitigated at the micro-level• Actions by Central Bank helped to ensure coverage for risks• When crisis started conservative forward looking stress-test helped to identify banks

where actions were needed the most• Decisive pre-emptive actions based on stress-test results before the NPLs and

capitalization reached critical level• Capital buffers and re-caps allowed to absorb losses in timely manner• Good cooperation with the home supervisor under the college framework is the key• Transparent business culture of Swedish banks set focus on identifying true NPL level

and credit losses as quickly as possible

28

29

Thank you!

www.fi.ee