No. 6 - Why exceptional NPLs sales should not affect the estimated LGDs of A-IRB banks

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by Massimo Gangeri, Michele Lanotte, Giuseppe Della Corte, Giovanni RinnaJanuary 2017

The reduction of the large stock of non-performing loans (NPLs) in banks’ portfolios is a supervisory priority for the European Union and the Single Supervisory Mechanism (SSM). NPLs sales – an effective and rapid way to pursue the objective – tend to have a negative impact on banks’ capital ratios via direct losses, because the sale prices are typically lower than their book value. Therefore aggressive sales can cause economic losses and capital shortfalls that, especially in the current difficult market conditions and low profitability environment, banks may be unable to address. This represents a powerful disincentive for banks to sell. Banks using the advanced internal ratings-based method (A-IRB) face even stronger disincentives, as an additional impact on capital comes from the higher Loss Given Default (LGD) estimate induced by the NPLs sale.

This note has three main purposes. First, we provide an assessment of the impact of massive NPLs sales on LGD estimates and capital ratios. For a sample of Italian banks, we find that following a 12 percentage points increase in the LGD – an effect which could be triggered by an exceptional disposal of bad loans at “market prices” – the decrease of capital ratios stemming exclusively from the worsening of the LGD and from the increase of the IRB shortfall could be in the range of 90-190 bps. These estimates do not take into account the direct losses resulting from selling the loans at lower prices than their book value. Second, we argue that allowing the losses from such an exceptional sale to affect the LGD estimates is undesirable and unwarranted in the current situation, above all for macro-prudential reasons. Third, we provide some proposals on how to sterilize, or at least mitigate, the effect of NPLs sales on the LGD, in order to avoid any possible disincentive for A-IRB banks to sell. All proposals rely on the exceptionality of the sales and, thus, on the temporary nature of the sterilization mechanism.

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