How to find the equilibrium in your loan portfolio?
Over the past two years, the banking sector in the EU faced several challenges: from the low interest rate environment, accounting (e.g. IFRS 9) or regulatory changes (SREP, CRD IV/CRR, BRRD, EBA Stresstest, ECB & EBA guidance on non-performing loans, New default definition, etc.) to the disruption of traditional banking business models via the entry of FinTechs. As a result, keeping a stable return on equity, compared to the necessary cost of equity, has been difficult and profitability moved in the focus of both investors and regulators.
With the increasing pressure from the supervisory bodies towards the banks’ business models (visible in e.g. SREP assessment), close monitoring of banks’ performances from their shareholders and investors and new regulatory constraints (such as upcoming Basel IV reform), the question of how to optimize loan portfolios in the balance sheet is becoming more and more important. The key challenge for bank managers in this context currently is to achieve returns with their portfolios while keeping appropriate levels of capital costs on the other hand.
We understand that portfolio optimization is a complex task and requires a thorough and precise assessment of various internal and external factors driving portfolio performance, affecting return opportunities and thus are decisive for the bank’s overall profitability.
Internal value assessment
Looking at the results of the IFRS 9 implementation coupled with latest regulatory developments related to non-performing loans, one can ask the question for which loan portfolios the bank has to be careful about the allocation of their risk costs, such as:
- Forborne loans/restructured loans
- Modified or POCI exposures
- Loans classified as Stage 2 loans.
Additionally, increasing regulatory requirements will lead to further reflections on a bank’s sales strategy and “hold to sell” decision making.
To give an example, the following definitions or triggers have become crucial in the bank’s transformation of exposures from a performing to a non-performing status:
- the “unlikely-to-pay” criterion
- the “distressed-restructuring” flag.
Taking into consideration also the capital implications from the upcoming Basel IV reform, it is crucial to deep dive into the portfolio composition.
Portfolios with potentially increased capital requirements are the following:
- Bank portfolios
- Corporate portfolios
- Retail portfolios, mainly to SMEs
- Residential mortgage portfolios
- Project financing (as part of specialised lending)
- Exposures backed by income producing collaterals
- Listed and unlisted equity positions
- Mezzanine/equity tranches (e.g. as financing to SMEs)
Of course, this overview represents only a high level impact assessment. The concrete outcome depends on each bank’s business model, its geographical focus, etc. and requires thorough risk-return analysis and actions tailored to the individual bank’s circumstances.
Banks shall therefore examine their capital allocation to each client segment and geography to ensure that capital is preferentially allocated to areas that generate higher returns – adjusted for risk, funding, and increased capital costs. Not only the segment growth and economics but also the attractiveness of client segments should be evaluated by capital efficiency.
To sum up, considering expected gross recoveries for the individual loan portfolios over their lifetime, deducting respective cost positions and discounting with the applicable rate of return, one can calculate the reserve price of the portfolio from the bank’s point of view. This reflects the true economic value of the loan portfolio and provides the stakeholders with a good overview of how much return they are expected to achieve with the portfolio until maturity.
External value assessment
The value of a loan portfolio to an external party generally depends on her individual circumstances. Hence, different market players may assess the portfolios differently. Some investors are interested in special asset classes and might consider economies of scale or potential synergies in their value assessment. Others are ready to undertake more risk in hope for additional return over time.
Market value of a loan portfolio is calculated by discounting the expected net recoveries with an investor’s internal rate of return. The illiquidity discount might be considered as well, in order to reflect current market perception of the respective portfolio.
This external value assessment can be easily derived via a constant portfolio indicative market pricing.
In order to support banking professionals in their process to form strategic portfolio decisions, e.g. whether to keep or sell portfolios, we – within our PwC Portfolio IQ team – have developed an advanced analytical portfolio optimization methodology. With this approach, we contrast risks and rewards inherent to keeping a portfolio on the banking book to the expected proceeds from a transfer of loans to a 3rd party market participant. Thus, we compare the internal and external views on a portfolio’s value, reflected in the bank’s internal reserve price and an investor’s market price, respectively, in order to support bank management’s strategic decision making over time.
This comparison is an ideal decision making tool when searching for a well-balanced and optimized portfolio and helps define banks the optimal portfolio strategy.
In detail, such a portfolio strategy includes:
- Analysis of the historical and expected loan performance including:
- Accounting impact
- Capital impact (based on Standardised Approach as well as IRBA, including IRB floors)
- Scenarios/sensitivities (running different scenarios and evaluating the impact for e.g. different regulatory decisions or macroeconomic development)
- KPIs –impact assessment on risk costs, RWA, ECL and CET1 capital.
- Portfolio stratification/clustering – based on common characteristics
- Portfolio optimization – following the goal of maximizing loan recovery/sales proceeds, based on the comparison of reserve price and market price, leading to a “hold” versus “sell” strategy
- Execution of the “sell strategy” via:
- Portfolio deals – selecting proper investors, tranche loans, undertake pre-sale preparation, and managing the entire transaction process, e.g. in a true sale loan portfolio transaction.
- Transfer of portfolio risks (e.g. capital relief trades, securitization, synthetic loan transfers, etc.) – requiring more complex deal structures, including in depth accounting, tax, legal and regulatory impact analysis.
Understanding the banking environment and investors’ needs, banks will need to consider the following actions to increase their overall profitability:
- Scale back business with portfolios that do not add economic value (accounting for a big share of the bank’s RWAs without returning the cost of capital)
- Limit certain products
- Sell, run-down or transfer the risks associated with most negatively impacted portfolios
- Further reposition the business strategy on the “profitable” portfolios.
As a result, banks executing comprehensive and well-thought portfolio optimization activities will profit from a portfolio equilibrium ensuring higher levels of returns.
We at PwC have been advising various banks on their portfolio strategy, either as performing in-depth As-Is analysis or evaluating possible disposal solutions. We have been supporting several banks to dispose of their non-core performing or non-performing loans and we foresee increased numbers of such portfolio trades in the future. The earlier banks start with such a “value assessment”, the sooner they are ready to implement a fit & proper business strategy and position themselves better towards regulators, their peers as well as other market participants.
For more information please contact:
Senior Manager, PwC Austria, FS Deals