Europe’s non-performing loan (NPL) market appears to be at an inflection point, with lower NPL deal volumes forcing investors and servicers to examine their business models afresh to extract efficiencies.
Elevated interest rates have led to the first increase in European NPLs in a decade, with the European Banking Authority (EBA) in its July risk assessment reporting a 2.1% increase in total European bank NPLs to €365 billion in December 2023, up from €357 billion in December 2022. NPL ratios—the value of non-performing loans divided by the total value of loan portfolios—have also increased, climbing to 1.84% at the end of 2023 from 1.8% at the end of 2022.
Although NPLs may be creeping up, current levels remain significantly below the more than €1 trillion of NPLs that European banks were carrying at the height of the market in 2016. The recent uptick in NPLs has also not been met by an increase in NPL deals, where banks sell off portfolios of NPLs to third-party buyers, usually at discount to par. Instead, EBA figures show that NPL inflows of €187 billion in 2023 outpaced outflows of €178 billion.
Banks are comfortable sitting tight
The trend of NPL inflows outpacing outflows, despite that overall NPL volumes are rising in an elevated interest rate environment, indicates that banks are not under the same commercial and regulatory pressure as before to clear NPL portfolios off their books.
In the years following the 2008 financial crisis when NPL ratios in Europe climbed as high as 7.5%, banks had much less regulatory and commercial room to maneuver than today. Instead, in the early 2010s, banks were pushed to sell their NPL portfolios quickly to stabilize their balance sheets.
However, the current levels of NPL volumes and ratios appear to remain manageable. Banks have sufficient bandwidth on their workout teams to hold underperforming loans, rather than having to sell these non-performing assets at deep discounts to par. Although EU banks are still facing some pressure due to the backstop regulation, the regulatory pressure is not the same, having dealt with the extreme positions in which they found themselves following Europe’s debt crisis in the early 2010s.
Evolving times for NPL investors and servicers
The shifting dynamics of NPL deals and the banks’ position appear to be having an impact on the business models and investment strategies of NPL investors and NPL servicers (entities that collect payments and manage portfolios of non-performing credits).
Following the 2008 financial crisis, these stakeholders bought large portfolios of loans at deep discounts to par as a result of the intense pressure banks were under to sell. Moreover, in that low-interest rate environment, NPL servicers financed these bargain deals with low-cost capital.
NPL investors’ strategies were also predicated on being able to do a high number of transactions—not an issue when banks had billions in euros of NPLs to move—and then bring in a servicer to recoup some repayments from loans. The bigger the pool of NPLs that an investor can acquire, the greater the likelihood of extracting meaningful value.
The decline in NPL deal volumes appears to have altered this strategy. Banks have been less inclined to sell at discounts and, when sales do proceed, the portfolios are smaller. Additionally, as interest rates rose during the past couple of years, the cost for investors to finance NPLs acquisition increased considerably, as have the costs of refinancing existing NPL portfolios that are approaching maturities. Elevated interest rates have also weighed on recovery rates, with investors and servicers having to work harder and longer to recoup repayments from NPL portfolios.
Time for transformation
The changes in the market outlined above are forcing NPL investors and servicers to adapt and rethink their strategies.
NPL investors, who have fewer opportunities today to buy portfolios in high volumes, are relying on servicers to maximize recoveries. In some cases, they are looking to sell some of their portfolios to other investors or, alternatively, to raise additional financing secured against their portfolios to be able to hold NPL investments longer to enhance value and performance. Meanwhile, for existing servicers, scale of serviced portfolios has become critical, which will likely drive opportunities for consolidation in that part of the market. This in turn will likely generate future activity in the market as smaller portfolios are sold or actual servicing businesses are sold as part of this consolidation.
The slowdown in NPL deal volumes has made consolidation an important tool for maintaining NPL assets under administration. Consolidation also enables servicers to build the necessary economies of scale to put more money into their data analytics tools and other technologies that can help to improve their loan management administration.
The model of the future
The NPL market is still working through this transition period, and it will be interesting to see who stays in the market, who exits and how the industry reconfigures itself during the next couple of years.
Thinner annual deal volumes, higher capital costs and an emphasis on scale could lead the market to a point where NPL investors will have to have “captive servicers”—ones owned or directly controlled by NPL investors—to achieve the necessary returns on investment. Investors without captive servicers or similar tie-ups are likely to see their returns eroded by servicer fees. For servicers, a captive arrangement with an NPL investor could prove to be the best option for ensuring their asset pools are consistently replenished.
The constraints on banks due to the backstop regulation will also open up opportunities for servicers who may offer backstop solutions to the banks while benefiting from stronger servicing business.
The European NPL deal market may not be as red-hot as it was a decade ago, but it will continue to present opportunities for players who can adapt to changing circumstances and evolve their strategies accordingly.
