Why distressed asset resolution is important to development finance

The World Bank
Joaquim Levy

© Jonathan Ernst/World Bank

Addressing high levels of non-performing loans (NPLs) is key to preserving financial stability and an important element of an integrated development agenda. High levels of NPLs lock in capital that could support fresh lending, and they create a negative macro-financial feedback loop, as debt overhang depresses borrowers’ investment and consumption decisions. High NPLs have particularly adverse implications in emerging market and developing economies (EMDEs), which lack fully developed capital markets and where credit is provided mostly by banks. Hence expanding the role of debt servicing companies and a secondary market for distressed debt is a constructive strategy: it should be a priority in most EMDEs.

A well-functioning credit market fosters inclusiveness and competition, two drivers of social development and economic growth. Raghuram Rajan, a professor at the University of Chicago and former Governor of the Reserve Bank of India, notes that, where credit is scarce, only incumbent firms that have retained earnings can invest and grow, which hurts competition and opportunities. Unresolved NPLs on banks’ balance sheets limit the potential credit supply, thus reducing opportunities for borrowers to reorganize their business or personal finances and fund new investments.

Recent rises in NPL ratios in EMDEs increase the need for mechanisms that deal effectively with these loans. The slowdown in economic growth, the drop in commodity prices, and the weakening of EMDE currencies since 2013 have all put pressure on the debt service capacity of many corporate borrowers. As global interest rates gradually rise, the burden of outstanding loans will also increase for EMDEs, whose borrowing cost will be higher. In Europe, a large stock of NPLs continues to weigh on banks’ balance sheets, not only in advanced economies, such as Cyprus, Greece and Italy, but also in Central and Eastern Europe. This is despite the recent slowdown in impairments and a pickup of sales on the secondary market. NPL ratios are above 10% in countries such as Bosnia and Herzegovina, Serbia, and Ukraine. In Africa, NPL ratios have been above 10% in Ghana and Nigeria, countries affected by commodity price shocks, and above 5% in Egypt and Kenya. In Asia, NPLs top 5% of total loans in both India and Pakistan; they are around 10% in Vietnam. Ratios are much lower in Latin America, where open capital accounts discipline banks and loan loss reserves tend to be robust. Nonetheless, a surge in Brazil pushed the NPL ratio towards 4% recently. Chinese authorities have also cautioned against excessive credit in their home markets: incentives to action by state banks have helped NPL ratios stabilize below 2%.

Resolute actions to address NPLs can turn an economy’s fortunes. A good example is Spain, where, in the wake of a deep recession, the government decided to address the problem with the EU’s help in 2012. The timely disposal of NPLs strengthened banks and supported labor market and other structural reforms, translating into an impressive economic recovery, with sustained growth since 2015. Spain’s government set up an asset management company, which absorbed impaired assets from banks and sold them gradually over time. This helped create conditions to establish servicing arrangements that centralized creditor discussions, fostered specialization and exploited economies of scale available for NPL resolution. Although the pace of asset sales was slow, it helped provide a pricing benchmark for a viable distressed debt market to develop beyond the asset management company.

A sound legal and regulatory framework for debt servicing companies and a strong secondary market for distressed assets are key to dealing with NPLs successfully. Factors for success include, in addition to specialized bankruptcy and consumer courts, strong prudential rules and adequate tax laws that do not unduly burden the recognition, provisioning and sale of impaired assets. The hierarchy of claims needs to be established in such a way that distressed companies can reorganize themselves with the right incentives and investors are not overburdened with unsolvable liabilities. Creating incentives to develop servicing companies and attract investors, including foreign investors, to distressed assets can also help raise the price of these assets, thus creating competition and, by reducing the “pricing gap” between banks’ carrying value of distressed debt and the market (transfer) price of these assets, encouraging banks to dispose of NPLs.

The World Bank Group is helping developing countries deal with NPLs strategically, especially through the Distressed Asset Recovery Program (DARP). DARP was launched by our private sector arm, the International Finance Corporation (IFC), in 2009 to address the growth of distressed assets after the 2008 global financial crisis. To help sustain economic growth and maintain financial stability in EMDEs, DARP focuses on acquisition and resolution of distressed assets as well as the debt restructuring of small and medium enterprises (SMEs). Since IFC started investing in the distressed asset space through DARP, it has co-invested in investment facilities dedicated exclusively to such assets in EMDEs and in local servicing companies, helping develop a global network of such companies. DARP has allowed banks to offload a total of $30 billion worth of NPLs, and helped about 7 million individuals and businesses regain creditworthiness and maintain operations. The partnerships developed by DARP are an example of how the World Bank Group mobilizes private capital to scale up our activities: this is a critical element in achieving our twin goals of eliminating extreme poverty by 2030 and increasing shared prosperity around the world.

DARP’s activities are often accompanied by World Bank advisory work with regulators on NPL resolution. In Central and Eastern Europe, for instance, the World Bank’s Finance and Markets Global Practice has worked closely with the national authorities (alongside colleagues from the IMF) on important structural reforms to foster the debt enforcement/insolvency framework (e.g., out-of-court workouts), consumer protection, and credit bureaus. In Vietnam, one of the world’s fastest-growing economies, the World Bank maintains a strong dialogue with the authorities, who created the Vietnam Asset Management Company in 2013 to acquire NPLs and adopted legal and regulatory amendments to banking restructuring. Most recently, this dialogue included an international workshop focused on improving secured collateral resolution and developing the distressed debt market by addressing the issues of eligible debt buyers and land titles. Key reforms are happening throughout Asia, notably in India, where regulations have become more favorable for foreign investors in asset recovery companies.

DARP demonstrates how the World Bank Group helps maximize financing for development by facilitating NPL resolution, which gives banks breathing room to take new risks. The two-pronged approach adopted by DARP of (i) focusing on developing the right legal and regulatory environment and (ii) using the Bank Group’s balance sheet to help credit servicers and distressed debt investors lower the “pricing gap” in the distressed debt market, enhancing banks’ willingness to move NPLs out of their balance sheet. This disposal is important to restore lending channels and foster economic growth in the short and medium term. Over the longer term, it can also help advance financial deepening and inclusion, as banks become more prepared to lend to riskier clients. DARP’s work also illustrates the Bank Group’s strategic approach of developing instruments and policies that involve the private sector to support development outcomes. We call this mobilization strategy the “Cascade” or “Maximizing Financing for Development.”

This text summarizes the observations I made when I sat down for a conversation with Randy Kroszner, on September 26, 2017, as part of the 2017 DARP Partner Summit. A former member of the Board of Governors of the U.S. Federal Reserve and Professor of Economics at the University of Chicago, he emphasized that resolving distressed assets is a significant challenge, with great potential rewards, and that it requires significant regulatory, policy, and legal reforms in many jurisdictions. He highlighted the importance of clarity in provisioning rules, as loss recognition is often the first step for the recovery of banks’ new lending and equity valuation.