Non-Performing Loans In Central Europe

Author:Mr Martin Ebner
Profession:Schoenherr Attorneys at Law

Throughout the CEE/SEE region, the percentage of non-performing loans (NPLs) to total loan receivables has increased dramatically during the current economic cycle.

In many areas, lenders appear to have reacted to this by pursuing a strategy occasionally called "extend and pretend." But in light of ever increasing regulatory (capital) pressures concerning flawed banking assets, we believe that many regulated lenders may be left with little choice other than more actively managing distressed borrowers/portfolios.

On the other hand, there is increased buy-side demand for distressed credits in a variety of industries and across asset classes, which in turn should allow current creditors to consider disposals of credit exposures (single names and portfolios) as part of the strategic management of distressed exposures.

We therefore take great pleasure in presenting to you our thoughts on some key legal issues that should be considered carefully by sell-and buy-side industry participants when looking into the viability of NPL transactions (single names and portfolios) in the region.

If you wish to discuss any of these issues in greater detail, please feel free to contact the authors of this guide, any of the members of Schoenherr's distressed assets team or any of your usual contacts in our firm.


In the last decade, in particular the current economic cycle, there has been a dramatic increase in the percentage of non-performing loans to total gross bank loans throughout the CEE/SEE region (see chart below; the data is based on the International Monetary Fund, Global Financial Stability Report).

The June 2011 financial market stability report (Finanzmarktstabilitatsbericht) by the Austrian National Bank (Oesterreichische Nationalbank (OeNB)) notes that there has been constant growth of NPLs in percentage to total gross loans across all CEE countries in the period between the last quarter of 2009 and the last quarter of 2010 (Source: OeNB, Finanzmarktstabilitatsbericht 21, June 2011). The following graph, taken from the OeNB's report, illustrates that for foreign currency denominated loans the situation is even more drastic.

This rapid increase of NPLs combined with ever increasing banking regulation throughout Europe and the impact of those assets on institutions' risk-weighted assets (RWAs) encourages credit institutions in the CEE/ SEE region to reconsider their long-term strategies concerning non-core and distressed assets.

Under the new Basel III regulations, which will be implemented in the EU by 2013 (subject to transitional provisions), credit institutions have to gradually increase their capital base. In addition, as part of the EU-level agreement on measures to restore confidence in the banking sector, certain European credit institutions are required to establish a buffer, so that the Core Tier 1 capital ratio reaches 9% by the end of June 2012.

Moreover, according to recent regulatory initiatives in Austria, certain banking groups will be required to apply Basel III capital standards as of 1 January 2013 (no phase in). These initiatives also introduce a maximum loan to deposit ratio of 110% for the CEE/SEE subsidiaries of these banks.

As a consequence, institutions are looking for options to reduce their balance sheets, thereby improving capital ratios, which should lead to further disposals of distressed assets.

Furthermore, on 27 October 2011 the ECJ handed down a judgement that clarified the VAT treatment of certain aspects of NPL transactions. By increasing transaction confidence for market participants, this judgement should also help close the current pricing gap between sell-side and buy-side.


As in any other transaction, legal and regulatory issues are only some of the aspects that impact the success or failure of structuring, implementing and executing a buy- or sell-side NPL transaction. Other key driving factors include the economics of the deal, accounting, tax, reputational and general risk management considerations. But in our experience, legal considerations (including in relation to servicing and enforcement) are among the key drivers when it comes to selling or buying a portfolio of distressed credits. This is not only due to the nature of the parties involved (in particular regulated sell-side businesses), but mainly due to the nature of the assets involved in the transaction, whether a single-name loan or a portfolio of consumer credits.

Below we have set out our thoughts on how to strategically approach a sell- or buy-side NPL transaction. Whereas this guide focuses on portfolios of non-performing corporate and consumer loans, many of the issues addressed will also be relevant to single name transactions in large corporate exposures.

This guide is structured according to transaction stages, from pre-transaction decision-making, via structuring aspects and transaction execution to post-execution servicing.

Pre-transaction aspects (decision-making)

A potential sell-side credit institution has many options for managing its clients in distress, ranging from restructuring the debt (which in the region is often confined to extending tenors and granting covenant holidays) to forcing borrowers into liquidation.

When considering whether disposal of certain assets or asset-classes may be an optimal strategy for actively managing distressed credits, the management of the potential sell-side institution will have to carefully consider whether the perceived negative effects are outweighed by the advantages.

On the down side, there may be negative effects on an institution's financials, because of losses realised on sale of assets that are not marked-to-market in an institution's books, in combination with the threat of foregoing the upside that may potentially come from a successful recovery or even from enforcement. In addition, many institutions may be concerned about managing reputational aspects. For example, they may fear media reports about selling claims against widows and orphans to aggressive investors.

On the other hand, the most obvious benefit of a successfully completed sale of NPLs is the effect on risk-weighted assets (RWAs) and the resultant freeing up of equity. Selling institutions have also received positive market and shareholder feedback (including rising stock prices once a transaction or series of transactions has been announced and completed) as well as positive ratings response to the improvement/enhancement of on-balance sheet assets that continue to be held by the institution and to the more focussed approach to core activities, such as originating new business while "outsourcing" certain aspects of problem loan management.

» Challenge yourself (sell-side)

Do I have the organisational and managerial capacities to manage and service distressed exposures in a value-preserving manner and at least in the same quality as experienced third-party special servicers? What will be the likely effect on my financials of selling non-performing loans (substantially) below par? Will my investor relations/public relations unit be able to manage reputational aspects? Am I able to define a portfolio that suits expectations on credit quality, maturity and pricing? Structuring aspects

Once an institution concludes that disposals of single names or portfolios of non-performing loans form an important pillar of its overall strategy of actively managing its problematic exposures, it is time to decide on the overall transaction structure (auction process, negotiated sales, etc.) and to start the nitty-gritty vendor due diligence process that precedes most successful sale transactions.

Accurate, reliable and complete data about the non-performing loans are the key to maximising sales proceeds. It is often at this stage of preparing information for potential investors when institutions learn more than they ever wanted to know about their own customers/borrowers and in particular the quality and consistency of documentation and data available in relation to the distressed credits. In addition to practical aspects in relation to the completeness of documentation and data quality, one has to consider that any sell-side (credit) institution will normally be bound by data protection and banking secrecy laws that limit or even prevent the full disclosure of data to potential buy-side institutions and their advisors.

However, that dilemma can usually be overcome in a manner that satisfies compliance considerations as well as investor due diligence requests. The available options range from disclosure of anonymised and aggregated data only, to full disclosure of the credit documentation to due diligence advisors formally appointed/endorsed by the selling institution, who in turn produce a report to the potential investor on an aggregated and no-names basis only (i.e., without referencing specific loans and customers).

Since a fully-fledged buy-side due diligence of each and every credit file will often not only run afoul of limitations on information disclosure and data transfer, but also will be very costly, management of the selling institution should consider what it takes for the selling institution to become comfortable that a sample of, say, 5% to 10% of all loan contracts relative to transactions included in the portfolio constitutes a representative sample of documentation used. Once this level of comfort is achieved (i.e., once the sell-side institution has established that there are no significant deviations in documentation standard), buy-side due diligence could be limited to the loan contracts included in this sample and representations to this effect in the sale/purchase documentation could be offered to investors.

During this pre-sale vendor due diligence process, any sell-side institution will also be well advised to scrutinise the credit files relating to the...

To continue reading