Bank real estate loans and COVID-19
While it’s too early to say what the medium term impact of the COVID 19 shutdown will be on the world economy and banking system, it is possible to highlight some of the issues and areas of concern that credit officers and portfolio managers should focus on, and some of the steps they should be taking to prepare themselves.
While our observations are applicable across the banking system, we have focused particularly on the impact on real estate lending.
COVID-19 regulatory and fiscal intervention
In response to the 2008 financial crisis, regulators globally enacted a series of changes with the aim of making the banking system more robust. This involved a combination of global regulation via the Basel Committee, accounting changes (most importantly IFRS9 and, in the US, CECL), and changes to local regulation. The cumulative effect of these changes was to create a better capitalised banking system. However the changes also introduced a potential procyclical bias to banks’ behaviour when confronted with increased economic volatility or an extreme shock.
COVID-19 has created a potential perfect storm in terms of economic shock, where this procyclicality could lead to a credit and rating downgrade spiral, impairing banks’ capital positions and, importantly, their ability to continue to lend and support an economic recovery. Blindly applying the new rules would result in an almost immediate recategorization of exposures across banks’ loan portfolios, resulting in significant increases in provisions and capital usage, impairing the ability of banks to advance further funds.
Regulators have recognized this risk and globally we have seen several responses including:
- On 3 April, the Basel Committee issued technical guidance that customers granted temporary relief from loan repayments do not need to be classified as past due or defaulted, that the capital required for state supported credit facilities should reflect the appropriate sovereign risk weighting, and that a measured approach should be taken in relation to applying IFRS 9’s expected credit loss accounting framework.
- Regional and local regulators have relaxed bank capital requirements to provide increased capacity to lend; for example, on 12 March the ECB announced a number of measures allowing banks to temporarily utilize capital and liquidity buffers to provide additional lending to support their clients and the economy.
- Regional and local regulators have additionally provided guidance on the application of IFRS 9. For example, CBUAE has issued a new requirement for all banks to “apply a prudential filter to IFRS 9 expected loss provisions”, adding that it aims to minimise the IFRS 9 impact on regulatory capital “in view of expected volatility due to the COVID-19 crisis.” IFRS 9 provisions will therefore be gradually phased-in during a five-year period through the end of 2024.
- Various state guaranteed emergency lending programs and debt moratoriums have been announced and are being implemented, with varying degrees of teething problems, through local banking systems.
Out in the real world
While some of the regulatory pressures have been moderated to avoid a self-perpetuating cycle, this does not actually change the reality on the ground, it merely provides some breathing space for banks in which to make more thoughtful decisions about client and portfolio credit worthiness, and to prepare themselves for the increase in defaults and restructurings that will result. This real-world impact is reflected in the stock prices of banks which have fallen by more than the overall market and in the actions of rating agencies which have already started to issue downgrades.
The question is, what balance should a bank strike between the regulatory initiatives taken to forestall or mitigate the need for immediate action and manging the real-world impact of a credit crisis of highly uncertain breadth and depth? In our view this requires adapting and building on the current tools and frameworks that most banks have in place rather than making any wholesale change in strategy.
One of the positive outcomes of the regulation post the 2008 crisis was the issuance of the ECB’s “Guidance to Banks on Non-Performing Loans”. This Guidance put in place a common framework for NPL strategy, governance and operations, recognition and impairment measurements, and collateral valuation across the European banking system, an approach that has been followed by other regulators globally.
The ECB’s NPL Guidance has provided a common set of principles that have allowed regulators and banks to confront the 40% + NPL ratios that some jurisdictions experienced over the last 10 years. To varying degrees, banks have established or built out their NPL governance and organisational structures, policies and procedures, systems, and reporting and control processes, in some instances creating full-blown “bad banks”.
As a result, many banks have implemented detailed early warning indicator and watchlist procedures tied to their IFRS 9 significant credit deterioration triggers (for those not immersed in the jargon: a system to flag loans when they are likely to go wrong). The challenge is that under most banks’ policies and procedures, given the current environment, a reasonable credit officer’s answer to the question of “what should go on the watchlist” is “everything”. As restructuring advisors, we have some sympathy with this answer; however whilst this is in theory correct, in practice it is counterproductive. Such a simplistic answer does not allow banks to focus on the most critical credit situations, let alone implement the regulatory and government guidance to support clients and the broader economy through forbearance and, where appropriate, continue to advance new credit during this challenging period.
Real estate credit book focus
What does this mean in practice for the credit management of banks’ real estate loan books? In our view each bank’s initial portfolio triage should be risk based with an emphasis on the potential longer-term effects of the crisis rather than the broad short-term issues, as critical as the latter may be.
What we mean by this is that borrowers across the board may require short term forbearance to accommodate the fact that tenants are unwilling or unable to pay rent while they are not operating due to government-imposed lockdowns. This requires (in addition to seeking appropriate support for each bank’s foregone income) an efficient and broadly standardised approach by banks to provide forbearance and to apply a base assumption to not classify these exposures as forborne and/or IFRS 9 stage two (as permitted by the regulators). In some jurisdictions this forbearance has effectively been legislated.
In practical terms, a period of zero or reduced interest income through forbearance does not of itself lead to a significant long term deterioration in the credit profile of a loan position (particularly in a period of low interest rates where 6 months of capitalised interest may only mean a 2-3% increase in principal amounts). It will make sense for banks to proactively establish standardised and simple forbearance programs of interest roll up/maturity extension for segments of the portfolio most affected (e.g. retail) and where a bespoke solution is not necessary, practical and/or will not materially change the bank’s risk profile. For example, a granular portfolio of bilateral SME secured loans should be dealt with via a standardised approach while a large structured loan will require a bespoke solution. This strategy will inevitably mean granting forbearance to a certain number of “strategic defaulters” who otherwise would have had the capacity to keep the loan current. However, if the forbearance is a deferral of payment rather than forgiveness, we believe the overall benefits and efficiency of offering such solutions across the board outweigh the moral hazard created.
By providing a broad forbearance program to targeted segments of their portfolios, banks can focus their credit risk management resources on the medium to longer term impact of what the “new normal” may look like:
- On tenants’ ability to pay,
- On market demand for premises if new tenants are needed,
- On valuation and collateral impact,
- On exposures to sectors where the level and timing of recovery will be most directly affected for an extended period: hospitality, secondary retail/malls, and potentially office,
- On higher risk situations including acquisition, construction and development loans, speculative grade and emerging/higher country risk exposures, concentrations in underwriting/syndication books, existing stressed/distressed situations, positions/geographies with high exposure to the oil and tourism industries, and highly levered and short dated maturities in general,
- On structured and syndicated exposures where the number of counterparties involved and documentation terms will add to the complexity of any required restructuring, particularly where non-bank lender involvement is likely to create significant complexity or inflexibility.
A critical input in segmenting exposure is understanding the availability and take-up of government support and intervention – including salary support, guaranteed loans etc. – and categorising situations between those where this support is likely to bridge the problem versus those where it will merely delay the inevitable. This type of analysis will enable banks to adapt their watchlist criteria to capture the most relevant current risk factors.
In many circumstances the inevitable outcome will be that banks have become the economic owners of a significant number of assets and businesses (i.e. where value breaks in the debt and existing equity has been wiped out). Banks will then need to determine whether the borrowers/sponsors and managers are adding value to the assets, either through capital or quality of management. Where they are not, banks will need to act swiftly and decisively to ensure appropriately capable management is in place and in action to avoid a deterioration in value of the underlying real estate collateral.
In some sectors – hotels and shopping centres are seen as the most likely candidates – we expect that banks with large exposure concentrations will need to consider a systematic and structured portfolio approach to manage the near term collapse in credit quality and what will potentially be a longer road to recovery than for other real estate asset classes.
The macro question
As a backdrop to evaluating the impact on real estate loan portfolios outlined above it is too early to say which letter put forward by economists – whether V, U, L, W or any other between A and Z – will reflect the actual shape of the recovery. It is equally not certain what permanent changes or existing secular trends the crisis might trigger or accelerate, such as high street retail transformation, office versus remote work, changes in business and leisure travel, etc. Significant determinants of the above will be the period of lockdown, the way in which countries are enabled to emerge from lockdown (with or without significant ongoing restrictions, particularly on international travel), the longer term medical solutions and how this impacts consumer sentiment (vaccine, containment and/or treatments), levels of unemployment and the aggregate monetary and fiscal stimulus successfully implemented by regulators and governments, together with the legacy burden created by such monetary and fiscal stimulus.
While the shape of the crisis and eventual recovery are uncertain, most banks’ credit, regulatory and accounting frameworks provide for the use of scenario analysis, including in relation to estimation of provisions and economic scenarios used in IFRS 9 to calculate economic loses. This flexibility embedded in existing frameworks and models should allow banks to analyse the current volatile situation, though admittedly using a wider variety of forward-looking macroeconomic scenarios, overlays and sensitivity analysis than would otherwise be the case.
In addition to serving as inputs to the accounting and provisioning process, a set of standardised scenarios combined with the above segmentation process will allow banks to identify where to focus resources across the NPL lifecycle from early warning actions, early arrears through to restructuring and foreclosure activities.
As outlined above, the existing accounting frameworks provide enough flexibility to accommodate the current uncertainty such that a wholesale change in the scenario process is not required. In addition, banks have been encouraged by regulators to adopt a balanced approach, giving greater weight to the long-term outlook when estimating credit losses and incorporating the relief measures granted by public authorities in their forecasts.
This balanced, expected outcome approach is appropriate in relation to overall provisioning and capital measures. However from a risk management perspective banks should be focused on the ability to manage and mitigate their downside scenario, both at a portfolio level, for example in terms of sufficient resources to handle peak NPL volumes, and at an individual credit level, for example in terms of “worst case” work-out scenario planning.
And finally, restructuring execution. As stated at the outset, we are of the view that banks should utilise and build on the frameworks established to tackle the 2008 crisis, modified where required. Execution, however, is the one area that will present challenges even with the appropriate infrastructure in place (i.e. the requirement to ramp up the restructuring/work-out areas of the banks with experienced and qualified personnel to deal with a significantly higher flow of NPL transactions). Though of cold comfort, banks that are still resolving the aftermath of the 2008 crises will be marginally better placed in this regard as they will still have restructuring teams and/or outsourcing arrangements in place, though they too will feel the resource strain.
In summary: the “to do” list
- Review current NPL infrastructure in terms of governance and organisational structure, policies and processes, systems and people. Determine what changes need to be implemented to deal with a material increase in NPL volumes, particularly in terms of both restructuring execution and resourcing under a downside scenario and in the most critically affected asset segments.
- Triage and segment exposures and portfolios based on risk, concentrations and ability to add value/manage risk.
- Implement a standardised and simple forbearance program of interest roll up/maturity extension for lower risk/granular segments of the CRE portfolio.
- Focus credit risk management resources on the medium-term impact of what the “new normal” economic and real estate environment will have on higher risk asset classes and exposures.
- Consider the strategic and practical implications to the bank of having to take legal ownership of a significant portfolio of assets whose stabilisation and value recovery will require long term management regardless of the shape of the overall economic recovery.
The current debt moratorium provides an opportunity to get some of the strategic planning and resourcing work underway and prepare for what will be a very busy re-opening of the global economy.
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