FAIR III – Session V BANK OF ITALY Maximising Value of Non-Performing Assets Performance and Resolution of Non-Performing Assets: the Importance of Hard Evidence by P. Grippa, S. Iannotti, F. Leandri (Bank of Italy) Seoul - 11/11/2003

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Measuring recovery rates of bank loans is relevant: to assess the performance of workout procedures to feed internal portfolio models and the Basle II Advanced-IRB ‘regulatory function’ (LGDs) to correctly determine the value of loans transferred through securitization

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Recovery rates can be measured by: using the market prices on defaulted bonds or marketable loans soon after default (“market method”) discounting the future cash flows resulting from workout from the date of default to the end of the recovery process (“workout method”) extracting the recovery rate from non-defaulted risky bond prices by means of an asset pricing model (“implicit method”)

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  The workout method is particularly relevant since portfolios of banks consist mainly of non- marketable loans Calculating workout recovery rates requires a discounting methodology of the cash flows default close-out time t0t0 t1t1 t2t2 T 2°recovery cash flow discounting 1°recovery cash flow Final cash flow

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks In the years the Bank of Italy conducted a survey on workout procedures and recovery rates in the Italian banking system It addressed commercial banks (foreign bank subsidiaries and mutual banks excluded): around 250 banks, representing > 90% of total loans as of December 1999 It collected data on bad loans “closed” in 1999 (loans for which a specific event or board decision has determined their cancellation from the bank’s books)

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Structure of the quantitative survey Province Type of obligor (household, company, public entity, etc.) Economic sector Default date (when classified as ‘bad loan’ for the 1st time) Exposure at default (with evidence on collateral & guarantees) Legal expenses Cancellation date Total amount of recoveries (capitalized at cancellation date)

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  A vast majority of banks was able to respond to the quantitative part of the questionnaire …  … but by different degrees of detail  After controlling for data quality, the database showed the following figures:

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Time length of workout procedures in years

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  % of utilization and mean recovery rates by procedure

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Average time to recovery, by province in years (the darker the color, the lengthier the time to recovery)

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Evidence on costs of workout procedures Labour costs plus external services costs in 1999 amounted, on average, to 2.3% of each bank’s total operating expenses These costs varied with the location of the bank (northern banks seem to be more efficient) Weighted average total costs of workout procedures in 1999 amounted to 1.2% of bad loans

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Considerations The nature of data required was considered a compromise between: the high detail required by advanced risk measurement methodologies and future regulatory rules (Basle II) and the current state of the art of workout databases (critical, as for most banking systems) Even so, the degree of detail required proved to be too demanding for many banks

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Considerations The survey was useful, but could not, by itself, address the basic problem of delays in the way the banks address the workout function … but things, at least in Italy, are changing: some banking groups have created legal entities devoted to restructuring and workout procedures on the loans originated by other intermediaries within the group... … other groups have created internally workout divisions which are assigned a budget and are assessed as profit- centers

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Considerations Overall, it seems that the attention on workout procedures has increased This should prompt better internal data collection at banks in the next future On its side, the Bank of Italy is planning to realize a centralized national database to foster the collection of data at banks and to provide, as a feedback, a national benchmark for recovery rates

FAIR III – Session V BANK OF ITALY The Importance of Hard Evidence: Results from a Survey on Workout Procedures in Italian Banks  Considerations The degree of detail needs to be much higher than the one adopted for the 2000 survey This represents a challenging task for many banks, but it looks as the only way to collect sensible data on recovery rates and on the length and costs of workout procedures It could help banks wishing to move towards the Advanced IRB approach under Basle II