Valuation of Non-Performing Loans under Discussion

In March 2018, the ECB published “Addendum to the ECB Guidance to banks on non-performing loans: supervisory expectations for prudential provisioning of non-performing exposures” in which it required non-performing loans originated after 1 April 2018 to be fully written down after 7 years, with unsecured loans to be written offer after only 2 years. In practice, this approach implies the use of a null value: i) after seven years for secured non-performing loans and ii) after two years for unsecured loans, with an accounting provision for an equivalent amount. European Banking Authority (EBA) statistics for 2019 show that provisions for non-performing loans in Europe were 44.9% (Note 1), corresponding to an NPL valuation of 55.1%, which is higher than the implicit value in the prudential provisions recommended by the ECB. The ECB's new guidelines on provision levels and the implicit value of such provisions creates serious doubt about banks' estimated fair values of NPLs, as per what they book in their accounts. This article aims to use the disclosures provided by listed Italian banks in their notes to the accounts from 2009 to 2019 to determine if the fair value for NPLs, as divided between the secured part and the unsecured part, is value relevant and the amount of any discount/premium applied by the financial market compared to the actual fair value that is booked. The results highlight the excessively prudential nature of completely writing off non-performing loans and justify a review of the approach adopted by the European Council and Parliament in August 2019 (and subsequently adopted by the European Central Bank) in which unsecured NPLs should be fully written off after 3 years (compared to 2 years before), NPLs secured by real estate after 9 years (compared to 7 years before) and NPLs secured by non-real estate guarantees after 7 years (confirming the previous approach) for all loans originated after 26 April 2019.