The Correlation Problem

Many of the collateral assets in the small and medium-sized enterprise (SME) segment are purpose specific business premises. Therefore, when borrowers fail, this usually implies that the collateral is occupied by borrowers that have ceased operations. Worse, the type of business previously conducted from the collateral assets is often no longer viable, sharply limiting any occupier demand for the premises. This implies a high correlation between the credit difficulties of the borrower, and the deterioration in value of the collateral.

Collateral valuations often do not reflect these changed circumstances, with valuers continuing to assume underlying occupier demand that may only be theoretical. Furthermore, original lending values are often used as a benchmark in the decision-making process, while the correlation issue in the default situation is ignored.

This failure to fully understand SME collateral and the dynamics of collateral value can lead to critical decision-making errors. Or, in other words, a proper understanding of the collateral and collateral recovery dynamics is critical, not only in the monetisation phase, but also in the pre-enforcement phase. Unfortunately, this interdependency between the probability of default and the loss given default is rarely recognised.

The ‘Do-Nothing’ Option?

Evidence shows that when SME loans deteriorate, achieved recoveries are highly dependent on the type of resolution strategy adopted. For the reasons outlined above, lenders typically overestimate likely recoveries from collateral enforcement alternatives.

Under typical workout and enforcement processes in many markets, lenders can take at least two (and often many more) years before they monetise or acquire the collateral; during this time the asset is usually not maintained, and in many cases is deliberately damaged or vandalised.

In our experience, value decay amongst vacant possession cases ranks second only to the ‘Correlation Problem’ as a contributor to the greater projected recovery gap in SME NPLs. For cases where collateral-based recovery strategies are employed, this implies that speed of action (both in obtaining control of the collateral and in actively stepping in to preserve value) and effective pre-marketing remediation are critical in preserving value.

The ‘Do-Something’ Option!

First and foremost, it is essential that early warning systems are implemented so that banks can begin assessing positions and identifying the different categories of borrowers across their portfolios. In our previous note[1], we recommended the segmentation of loan portfolios as an

opportune way for lenders to accomplish these tasks while recognising the severity of individual situations.

While Resolute has previously discussed[2] how to approach large, single assets, the non-institutional nature of SME collateral necessitates fundamentally different strategies. A failure to recognise these differences and implement recovery frameworks reflecting them is often a key contributor to observed underperformance of SME NPL portfolios.

Managing SME Loan Portfolios – Our Recommended Approach

Therefore, in preparation for the end of the moratorium period, we recommend banks immediately undertake an assessment of their portfolios while determining their strategy for managing resolution of the expected increase in NPLs. The key steps are:

1. Portfolio Data Remediation – includes conducting a thorough borrower and collateral review to assess each borrower and the collaterals they have pledged to define realistic recovery objectives. This review needs, amongst other things, to clearly identify potential recovery from collateral on the basis that the in-place occupier has failed, that similar occupiers are also likely to have failed, and that following borrower failure, significant value deterioration is likely to occur during enforcement.

These collateral inspections will provide banks with a benchmark target resolution value based on a rigorous present value (PV) analysis for each collateral in the portfolio. This in turn will allow for faster decision-making in the future, as well as the proactive creation of loan provisions where necessary. In particular, this exercise helps to immunise decision-making from many of the “original valuation” biases which otherwise emerge.

Using this remediated data and the enforcement scenario PVs, the lender will not only be ready to apply the strategies and measures needed should the loan become non-performing, but will also be focused on the importance of seeking consensual solutions based on viable restructurings.

2. Identify Borrower Default Probability – Following the data remediation, banks should be able to establish an early warning system for the most likely to default cases. A reasonable suggestion would be to then place each borrower into the following categories:

  • Category 1: likely performing- or low risk exposures
  • Category 2: higher probability of default – signs of credit quality deterioration
  • Category 3: unlikely to pay- showing evidence of credit loss

3. Identify Appropriate Consensual Solutions –The bedrock of a successful consensual resolution is a healthy relationship between lender and borrower. Lenders should be in regular contact with borrowers whose businesses or jobs have most likely been affected by COVID-19 measures to work out which consensual solution may work best.

Management should ensure that workout officers have at their disposal a range of consensual tools and that they are encouraged to engage with borrowers about the appropriate option. Also essential, following the end of the holiday period, prompt discussions need to be had with borrowers who may remain viable with debt reductions or credit restructuring.

4. Establish a Decision Framework – To enable effective and rapid action by workout officers, banks should implement a top-down SME workout strategy which supports early and aggressive solutions for the cases most likely to default. Establishing appropriate policies and procedures based on remediated data and simple formulaic/algorithmic approaches helps eliminate delays due to “paralysis-by-analysis”, in particular where fuelled by reference to the at-origination value of collateral. This in turn promotes the effective use of viable restructuring, by forcing a realistic assessment of the losses likely to result from collateral enforcement.

A typical framework should include:

  • 1. A governance/management structure independent of the originating team, with clear criteria for transfer of management of each loan;
  • 2. Establish PV recovery thresholds, defined through the PV analysis of the collaterals, against which restructuring alternatives are benchmarked and (semi-)automatically approved;

A clear suite of consensual solutions, including restructuring extensions and partial write-off, which officers may use and where levels are driven by the PV recovery benchmarks;

  • 3. Scripted conversations and operating procedures clearly defined for officers dealing with borrowers;

  • 4. Narrow approval frameworks for proposed restructurings, limiting revisiting of established benchmarks, and empowering workout officers to focus on delivering recoveries.

By having in place proper borrower and collateral assessments, lenders are in a position (i) to quickly implement consensual strategies based on objective criteria, (ii) to effectively delegate the power to swiftly and decisively resolve SME NPLs, and (iii) to create an appropriate focus on avoiding the failure of SME borrowers whose viability is critical to collateral values. Finding a resolution as soon as possible will avoid the inevitable value decay of collateral seen in portfolios across Europe, some of which are still being worked through 10 years after the last crisis.

Non-Consensual Cases

For those cases which are already past the point of a consensual solution or unlikely to be consensual, lenders should also start preparing for more efficient solutions inside the framework of the enforcement or insolvency process. Namely:

  • Credit Bidding – where there is an enforcement auction process, the lender should be prepared with an updated PV of each collateral to enable the bank to make a well-informed decision with regards to the right price and moment of the process to enter a credit bid (if required).
  • Auction enhancement – focus on marketing/advertising the auctions to attract a wider market interest outside of the usual sophisticated buyers.
  • Portfolio sale – using the updated PV analysis, lenders can appropriately price their NPL portfolios. Lenders who are well prepared can take advantage of opportunistic buyers as a potential faster resolution option.

Prepare to own – REO Ready

Finally, banks should be ready to own some collateral as enforcement auctions are inherently inefficient and an inability to onboard REO often creates a situation where NPLs remain “trapped” in enforcement processes for extended periods. A carefully crafted REO strategy, focused on accelerating time-to-final-recovery, can significantly reduce NPE inventory by allowing the lender, rather than a court or public official, to control the sale process of collateral.

On-boarding physically, technically, and legally clean REOs significantly increases the efficiency and speed of the monetization process. Banks need to be sure they have the necessary expertise, either in-house or 3rd party, to lead this important value optimizing exercise.


Amongst the fallout of the 2008 crisis, we saw well-prepared lenders were able to both maximise recoveries and minimise inefficiencies all while refocusing on new business opportunities to pull themselves ahead of the pack. From this, we know it is essential that present-day lenders have the appropriate data, strategies, and frameworks in place now if they wish to avoid the same consequences faced by their predecessors.

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[2] (

Bryan Turner

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