Distress Asset Handbook

8/9/2019 Distress Asset Handbook

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Distressed

Assets Transfer

HandBook

Distressed Asset Transfer

Handbook:

General Guidelines for the Purchase and

Sale of Distressed Assets in the Financial Sector

IFC Advisory Services in Europe and Central Asia

IFC's Financial Markets Crisis Response Program

in Eastern Europe and Central Asia

In partnership with the Development Bank of Austria (OeEB)


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IFC, a member of the World Bank Group, creates opportunity for people to escape poverty andimprove their lives. We foster sustainable economic growth in developing countries by supportingprivate sector development, mobilizing private capital, and providing advisory and risk mitigationservices to businesses and governments.

The Handbook on Distressed Assets Transfer has been produced by PJSC Deloitte&Touche

USC by request of IFC through its Financial Markets Crisis Response Program. The IFCsProgram was launched in 2009 in partnership with the Development Bank of Austria (OeEB).

The conclusions and judgments contained in this report should not be attributed to, and do notnecessarily represent the views of, IFC or its board of directors or the World Bank or its executivedirectors, or the countries they represent.

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Distressed Asset Transfer

Handbook:

General Guidelines for the Purchase and

Sale of Distressed Assets in the Financial Sector


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Distressed Asset Transfer2

AMC Asset management company

ACBU Association of collection business in Ukraine

CBR Central Bank of Russia

CEE Central and Eastern Europe

CIF Corporate investment fund

CIS Commonwealth of Independent States

CIT Corporate income tax

Deloitte Deloitte Touche Tohmatsu Limited

DPD Days past due

DTT Double Tax Treaty

EUR Euro

FinCo Financial company (SPV that is licensed to providefinancial services)

FC Foreign currency (or currencies)

FX Foreign exchange

GAAP Generally Accepted Accounting Principles

IAS International Accounting Standards

IFC International Finance Corporation

IFRS International Financial Reporting Standards

LLP Loan loss provisionMAR Minimum acceptable rate

MBS Mortgage-backed security

NBU National Bank of Ukraine

NDF Non-deliverable forward

NPL Non-performing loan

NPV Net present value

NRV Net realizable valuePOS Point-of-sale

Glossary of terms


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Glossary of terms 3

PV Present value

SIC Standing Interpretation Committee

SPA Sale and purchase agreement between a bank and an SPV for the sale of loan claims

SPV Special purpose vehicle

UAS Ukrainian Accounting Standard

UK United Kingdom

USD, $ U.S. dollar

VAT Value added tax

VIF Venture investment fund

WHT Withholding tax

SPA Sale and purchase agreement between a bank and an SPV for the sale of loan claims

SPV Special purpose vehicle

UK United Kingdom

UIF Unit investment fund

USD, $ U.S. dollar

VAT Value added tax

WHT Withholding tax

UAS Ukrainian Accounting Standards

UIF Unit investment fund

VAT Value added tax

VIF Venture fund

WHT Withholding tax


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4 Distressed Asset Transfer


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5Contents

ContentsGlossary of terms ..................................................................................................................... 2

Contents .................................................................................................................................. 5

Guide to using this handbook ................................................................................................. 6

Introduction ............................................................................................................................ 7

Part I. Current NPL market trends ...................................................................................... 8

Chapter 1.1. Global NPL market............................................................................... 8

Chapter 1.2. Non-performing loans in Central and Eastern Europe ..................... 10

Chapter 1.3. Challenging NPL market in the CIS region ....................................... 11

Part II. Distressed assets transfer process ........................................................................... 17

Chapter 2.1. Strategy formulation .......................................................................... 17

Chapter 2.2. Loan portfolio review (nancial, tax and legal due diligence) .......... 21

Chapter 2.3. Segmentation of a loan portfolio to maximize value ........................ 22

Chapter 2.4. Valuation methodology ...................................................................... 23

Chapter 2.5. Elaborating the transaction structure................................................ 25

2.5.1. Tax and legal issues .......................................................................... 25

2.5.2. Financial and accounting issues ...................................................... 29

2.5.3. Value maximization ......................................................................... 31

Part III. Transfer structures: the CIS region specics .......................................................... 34

Chapter 3.1. Transfer to a Mutual Investment Fund .............................................. 34

Chapter 3.2. Factoring deals.................................................................................... 36

Chapter 3.3. Bad banks in Kazakhstan ................................................................ 37

Part IV. Case studies ............................................................................................................. 38

Chapter 4.1. Sale of SME NPLs to a third party Bank in Russian Federation ....... 38

Chapter 4.2. Sale of retail via off-shore SPV in Ukraine ........................................ 45

Appendices ............................................................................................................................ 50

Appendix 1 ............................................................................................................... 50

Appendix 2 ............................................................................................................... 56

Appendix 3 ............................................................................................................... 57


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Tis handbook has been written to brie on

the latest global trends at markets o non-

perorming loans (NPLs) and their reection

onto CIS markets (Part I), address issues

that may be aced by a lending institution

as well as potential investors on NPLs (Part

II), provide an insight to local specicso application common to NPL transer

structures (Part III) and study executed

transactions (Part IV).

We would like to draw your attention to Part

II which provides guidance on: (a) key aspects

in loan portolio review and ormulating o

general strategy in respect or NPLs (Step

1 and 2); (b) key considerations regarding

loan portolio segmentation and valuation

methodology (Step 3 and 4); (c) optionsavailable to management or transaction

structures or sales o NPL portolios (Step 5).

Guide to using this handbook

Strategyformulation

Step 1 Step 2

CIS trends

CEE market trends

Global trends of NPL market development

Case studies

Transfer str uctures

Step 5Step 3

Step 4

Keep

Sell

Write off

IssuesTax and legal

Financialand accounting

Tax, legal,&financial

Duediligence of

loanportfolio

Elaboration of

transaction

structure

Segmentationto maximize the

value

ValuationTransferfrom thebalancesheet


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7Introduction

IntroductionIn the years 2008 to 2011, loan portolio marketactivity in the world was subdued. Tis wasmainly due to the turmoil in the nancial sectorduring these years, as high levels o uncertaintyand volatility offered extraordinary returns oncomparatively sae investments, such as bank

bonds and hybrid capital or even sovereignbonds.

However, ongoing turbulence in the worldeconomy has uelled the growth o global

secondary debt markets. Falling asset prices,constrained liquidity and pressure on bankbalance sheets means that nancial institutionsare increasingly looking to trade distressedloans with well capitalized buyers rather thanpursue more traditional workout strategies.

Te market or distressed debt is complex butcan provide great opportunities or those thatunderstand it.


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Part I. Current NPLmarket trends

The global financial and credit crisis and thefailure or nationalization of large financial

institutions, put pressure on banks to focus on

core lending activities and exit non-core and

non-performing businesses. Per World Bank,

non-performing loans reached 12.6% of gross

loan portfolio in developing European and

Central Asia countries in 2011. NPLs have a

dual effect on financial institutions, as there

is no income from problematic loans and the

capacity of further lending is reduced due to

provisioning against NPLs.

There has been a growing trend, particularlyamong American and European banks, to

separate their non-core and distressed assets

into purpose-built business units, focused on

asset wind-down and disposal. In most cases,

this strategy has been applied to non-core

assets, including both performing and non-

performing, as well as markets and product

lines that no longer align with the banks

long-term business strategies, are capital or

risk-weighted asset intensive or mismatch the

current funding profile of the owner.

Eurozone banks are facing very difficult

financing conditions. The average NPL rate in

the region amounted to 6.1% in 2011. European

banks had in excess of 1.7 trillion of non-core

and non-performing assets on their balance

sheets, according to a research report by

Deloitte1. The report entitled, Deleveraging in

the European Financial Sector, assesses the key

challenges being faced by European banks and

the technical drivers behind asset deleveraging

and divestment in key territories including the

1 http://www.deloitte.com/assets/Dcom-UnitedKingdom/Local%20Assets/Documents/Industries/Financial%20Services/uk-s-deleveraging-in-the-european-nancial-sector.pd

3,5% 3,1% 2,7% 3,0%4,2%

4,0%3,5% 3,1% 2,7% 3,0%4,2%

4,0%3,5% 3,1% 2,7% 3,0%4,2%

4,0%

0%

5%

10%

15%

2005 2006 2007 2008 2009 2010 2011

Non-performing to gross loans trends

World Euro pean Un ion Europ e & Cen tral Asia (developing only) Un ited States

Chapter 1.1. Global NPL market


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9Part I. Current NPL market t rends

* Data for 2010

** The World Bank changed methodology of NPL rate calculation for some countries in FY12. Per previous methodology,

data for FY11 were the following: Ukraine - 40%, the Russian Federation - 10%.

Source: World Bank, 17-Apr-2012

3,3% 4,2%4,6%

11,5%

7,8%

26,3%

15,4%

10,3%

8,0%

1,9% 1,1% 2,4%2,9% 4,7%1,1% 3,2%

0%

5%

10%

15%

20%

25%

30%

Ls to tota gross oans n

European Union

Average EU - 6.1% Averagein the region - 12.6%

Averagein the region - 2.6%

Averagein theregion -2.9%

Averagein theregion -2.4%

Developing countries in Europe &Central Asia

East Asia & Pacific NorthAmerica

LatinAmerica

UK, Germany, Ireland, Spain and Italy.

Data from Chinas Banking Regulatory

Commission showed that the non-performing

loan ratio for the countrys commercial banks

stood at 0.9% or $69.6bn as of 31 March 2012,

down from 1% at the end of 2011. Per public

sources, NPLs in Chinese commercial banks

are expected to grow in 2012.

The US and Brazil continue to be very active

debt sale markets in the Americas.

There are increasing signs of renewed activity

in other countries across the Americas region,

including Argentina, Chile, Colombia, Peru andMexico. For the Mexican market, in particular,

the semi-monopoly of the market by a handful

of investors has often resulted in lower prices

being offered to sellers. And while markets,

such as those in Peru and Mexico, are attracting

some regional investors, the potential flow of

deals available overall remains uncertain.

Other key trends

In certain markets, a number o commercialbanks are emerging with a mandate toexpand their client base and market throughportolio acquisitions;

Te increased market participation o newdebt-ocused investors is continuing acrossall debt classes, bringing in investmentbanks, pension unds, real estate investorsand sovereign wealth unds rom aroundthe world;

Increasing stabilization in deault rates

has been reported by both consumer andcorporate clients;

Many delinquent corporate loans are being

provisioned and losses updated to reect

a more positive economic environment,reducing book values and narrowing bid/ask spreads or deaulted loans;

Vendors, purchasers, advisors and auditorsare starting to overcome bid/ask challengesin light o the closing in 2009 and 2010o several large structured and vendor-nanced transactions;

Tere is rising ocus on the strategic valueo platorms attached to portolios or on

a stand-alone basis as transaction activityincreases and new market entrants shore upservicing options.


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Chapter 1.2. Non-performing loans in

Central and Eastern EuropeBoom and bust cycles caused high level onon-perorming loans (NPLs) in variouscountries in Central and Eastern Europe (CEE).Economies and lending growth during 2003-08 were the reason o an unsustainable creditboom that ended with the global nancialcrisis o 2008/09. Te deep recession, thatollowed all over the world brought many o the

accumulated underlying problems to the ore,including poor quality o some loans on banksbooks.

Moreover, data deciencies and possibleunderreporting o bad loans in some countriesmight mean that the true NPL problem is evenbigger than offi cial statistics suggest.

Financial crisis effects spread over severalyears leading to a relatively slow recoveryphase. From 2007 NPL ratios have more than

doubled in almost all analysed countries withno effective countermovement visible.

0%

2%

4%

6%

8%

10%

12%

14%

16%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

2007

2008

2009

2010

2007

2008

2009

2010

2011

2011

2007

2008

2009

2010

2011

2007

2008

2009

2010

2011

2007

2008

2009

2010

2011

2007

2008

2009

2010

2011

2007

2008

2009

2010

2011

Bulgaria Czech

Republic

Hungary Poland Romania Slovakia Turkey

NPLstogross

loans

LoanstoGD

P

Total loans to GDP and NPL ratio in CEE (except CIS countries)

Loans to GDP NPL to gross loansSource: World Bank, EIU

Tere is a clear relationship between a countrysNPL growth and the respective loans to GDPgrowth. Indeed, countries with the highest

NPL rates grew the most (with the exception oSlovakia and urkey).


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NPL ratios continue to increase in most CEEcountries, where the economic recovery hasbeen weak, and in Hungary, where in additionto subpar growth a large share o mortgagesis denominated in strongly-appreciated Swissrancs. Elsewhere, NPL ratios seem to havepeaked but any reduction tends to be small andis bound to ace headwinds rom the renewedslowdown o the global economy. Tis limitedprogress is despite considerable efforts by banks,most o which have set up internal dedicatedworkout units equipped with additional andmore senior staff.

Banks are exible in adjusting the paymentterms o cooperative distressed borrowers,

but generally avoid interest capitalization orrenancing. Te sale o problem loan portoliosand outsourcing o collection remain relativelyrare. A ew governments, such as those o Latvia,Romania, Serbia, Moldova, Russia, Estonia, andPoland have also undertaken to overhaul theircorporate or household insolvency regimes orencouraged out-o-court restructurings. Othershave opted or more direct intervention indealing with the NPL problem, although someschemes recently introduced (notably the earlymortgage repayment scheme in Hungary) haveimposed large losses on the banking system andare problematic.

Bulgaria

Czech Republic

Hungary

Poland

Romania

Slovakia

Turkey

0%

10%

20%

30%

40%

50%

60%

70%

80%

(100)% 0% 100% 200% 300% 400% 500%

Loans/GDP

growth(2008vs.20

05)

NPL rate growth (2011 vs. 2008)

Loans to GDP and NPL growth

* Bubble size reflects the NPL volume

Source: World Bank, EIU, Deloitte analysis

Similar to CEE, the CIS region showed high

growth rates beore the crises 2008. From 2009till 2010 the general trend show continued toseek speedy work-out o NPLs, with operationalsupport rom parent banks as necessary. In 2011

many banks ensured adequate provisioning,

capitalization, and valuation o collateral to NPLsas well as (partially) write down o NPLs i theirrecovery is unlikely. Te target or the nearestuture is to recover loans with good collateral.

Chapter 1.3. Challenging NPL marketin the CIS region


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Source: World Bank, 17-Apr-2012

2,5% 3,0% 3,7% 2,4% 1,9%

3,8%3,9% 5,1% 5,2% 4,4%

1,7%

9,5%

13,7%

21,2%

16,4%

4,8% 4,2%

8,2%

15,3%

23,8%

13,3%

3,0% 3,5%

8,0%

15,4%

26,3%

10,7%

4,2%

3,1%

0%

5%

10%

15%

20%

25%

30%

Russian Federation Ukraine Kazakhstan Moldova Armenia Belarus

NPLs to gross loans in CIS region

2007

2008

2009

2010

2011

n/a

NPL markets in Belarus and Azerbaijan arenot widely developed due to governmentoverregulation and non-transparency. Below we

provide insights on the largest NPL markets inthe CIS region Russian Federation, Ukraineand Kazakhstan.

Russian Federation

Due to the massive liquidity support by the

Government, Russian banks have emerged airlyunscathed rom the crisis and have activelycompeted or good quality corporate and retailloans despite the downturn.

Per CBR, the share o overdue loans haddoubled by the end o 2009 (rom 2.5% to6.0%), reaching a peak o 6.5% in 1H10 romwhich it then began to gradually decrease,mainly due to new lending.

NPLs are heavily concentrated, and this isinherent in the Russian banking system:

op 30 Russian banks (ranked in terms o

assets) accounted or c.85% o all corporateNPLs as o 31 December 2011;

Dominant portion o loans are RUB-denominated. As a result, only 11% o non-perorming loans were FX-denominated aso 31 December 2011;

Moscow-based banks accounted or alarge proportion o NPLs (c. 30%) as o 30September 2011.

9,3

23,9 24,2 25,130

5,1

8,0 9,29,0

10

2,5%

6,0%5,8%

4,9% 5,0%

0%

1%

2%

3%

4%

5%

6%

7%

-

5

10

15

20

25

30

35

40

45

1-Jan-09 1-Jan-10 1-Jan-11 1-Jan-12 1-Apr-12

Overdueloans,%

Overdueloans,$bn

Overdue loans dynamics in Russian Federation

Overdue corporate loans, $bn Overdue retail loans, $bn Overdue loans, %

Source: Cenral Bank of Russ ian Federation


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Te NPL market in the Russian Federation ismainly composed o retail portolio sales, sales

o corporate NPLs are rare. Average price arerange at 3-7% or consumer loans (largely c.5%) and 1-2% or SME loans which are believedto be attractive or buyers.

In 2011 average DPD in portolios sold grew upto 1260+ compared to 900+ in 2010 in RussianFederation. Now dominant portion o baddebts has completed court proceedings andhas enorcement decisions. Tis may increaseaverage prices up to 10% (Morgan&Stout

estimate) or certain portolios. Number obanks engaging 3rd party collection companiesis growing as well. Last year 85% o OP-50Russian banks (which is c. 81% o Russianbanking sector by assets) outsourced debtcollection (vs. 54% in 2009).

One o the specic weaknesses o RussianNPL market is that Rospotrebnadzor (Federalservice on customers rights protection andhuman well-being surveillance in RussianFederation), considers claim assignments andcollection activities as illegal actions. At the

same time, this risk could be covered by FederalLaw On collection activities, which is under

consideration o the Parliament.

According to the Resolution o the Plenum othe Supreme Court in Russian Federation #17rom 28 June 2012, the bank could transera loan to an individual only to a third partywith a special license issued by CBR. However,the transer can be done in case either a loanagreement contains special clause that allowssuch transer (which is considered as consento the borrower) or the transer is allowed

by the legislation. At the moment collectioncompanies have any licences rom the CBR andthere is no legislation regarding its obtainingyet. As such, i the entire loan agreement doesnot contain the appropriate clause, to transerretail loans to a collection company the bankwill have to obtain the borrowers consent onthat which is likely to complicate the processand to limit marketability o retail loans. TeResolution #17 has no impact on the loans thatwere transerred to the collection companies

beore 28 June 2012.

Ukraine

Ukraine is the second-largest country in Europeafer Russia by territory and is seen as a keyelement in economic and political stability inthe region. Prior to the global nancial crisis,Ukraine had one o the highest global GDPgrowth rates, oreign direct investment andconsumer spending levels. However, it hasbeen one o the worst-affected economies bythe global nancial crisis, recording a 15.1%contraction in GDP to $114bn over 2008 to2009.

Huge growth o NPLs started in 4Q08, whenUkraine experienced signicant currencydevaluation by 58.4% during 4Q 2008. Amajor portion o loans were denominated inoreign currencies (primarily due to lower

interest rates as compared to UAH loans)while borrowers income streams were

primarily UAH-denominated. As a result thedevaluation increased loan exposure whichalong with economic crisis made debt servicingchallenging.

According to the National Bank o Ukraine

(the NBU) as o 1 May 2012 overdue loanscomprised $10.3bn or 10.6% o gross loanbook. However, this does not reect truepicture o NPLs held by Ukrainian bankingsystem due to specics o NBU reporting rules.According to the latter only tranches or whichpayment terms expired, but not the entire loanexposure, are accounted or as overdue loans. Itis especially typical or retail portolios whichare generally repaid in many instalments.


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Per Association o collection business inUkraine (ACBU), during 2011 corporate NPLsdecreased rom 36% (end o 2010) to 30% (endo 2011), consumer NPLs rom 50% to 40% ogross book, respectively. Overall NPLs volumedecreased by $6.7bn and reached $30bn.

Over 2008-2009, NPL market was primarilyrepresented by unsecured retail loans with365+ DPD. In 2010-2011 there was a tendencytowards the diversication o the market drivenby sale o retail secured loans (mortgage,car loans), including loans with 180+ DPD.Generally, prices are not disclosed, but taking

into account the offers o market participants,prices uctuated within 5-16% (o the ace

value) or unsecured loans and within 10-35%o the ace value or secured loans dependingon the quality o the security.

Te volume o NPLs purchase market in 2011reached $1.5bn, according to the ACBU. Te

volume o NPLs that were written off and/or transerred by banks onto their SPVs iscurrently undisclosed. NBU Resolution #172simplies NPLs write-off against ormedprovision.

Kazakhstan

Te Kazakh economy grew signicantly between2003 and 2007, mostly driven by oreign directinvestment inows into geological explorationworks, crude oil and gas extraction, and rising

energy prices. Te global nancial crisis, as wellas a signicant decline in commodity prices,had an adverse effect on GDP growth as well asconcentrated banking sector were deteriorated.Te Kazakhstan banking system consists o 39banks and 6 largest banks by assets accountingor almost 74% o total banking assets as o 1May 2012.

According to projections published by theRegional Financial Centre o Almaty, theprotability o Kazakh commercial banks isnot expected to increase in the short term due

to low interest income growth. Te structure othe loan portolio is projected to respond to theanticipated changes in the overall economy.

Specically, the percentage share o the overallloan portolio or telecommunications, agriculture,logistics, gas generation or distribution and utilitysectors is expected to grow.

1,3

6,58,3

6,9 7,5

1,0

2,2

2,43,0

2,8

3,0%

9,9%

11,9%

10,2% 10,6%

0%

2%

4%

6%

8%

10%

12%

14%

-

2

4

6

8

10

12

-12

Overdueloans,%

Overdueloans,$bn

Overdue loans dynamics in Ukraine

Source: National Bank of Ukraine

1-Jan-09 1-Jan-10 1-Jan-11 1-Jan-12 1-Apr-12

Overdue corporate loans, $bn Overdue retail loans, $bn Overdue loans, %


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Te last tendencies on Kazakh NPL market arethe ollowing:

Te legislation or NPLs transer to AMCs(SPVs) was created in 2011.

As o 1 May 2011 total NPLs market thatcould be interesting or investors amountedto $24.1bn.

National Bank o Kazakhstan establishedProblem Assets Fund. It is expected thatthe Fund will repurchase corporate NPLswith nominal amount o $2bn with 50%discount.

Summary

A long list o obstacles in the legal, judicial,tax, and regulatory areas is holding up NPLresolution. A survey o international institutionsand banks operating throughout the region has

identied the ollowing issues, which do notnecessarily apply to every country:

In many CIS countries the legal rameworkor NPL transer and collateral withdrawhave not been created yet or were recentlydeveloped. Tere are a lot o judicialissues: or bank unpredictability o courtdecision, or investors possibility o courtresolutions nulliying by the court o thehigher instance.

Te court system is usually overloaded andjudicial process is long and costly or NPL

owners. Due to legal gaps the borrowercould ree the assets rom collateralobligations and sell it during the suits.

Collateral sale is ofen perormed underseveral auctions and requires execution withthe minimum price. Ownership o collateralmight be diffi cult to establish, or the rightso secured lenders might be underminedby retroactive bankruptcy declaration ordebtors ability to sell collateral duringenorcement procedures.

o achieve out-o-court and speedresolution on non-perorming loans,

CIS banks make restructurings with loanholidays. Serial loan restructurings mayindicate that viable rms try to avoid debt

5,7 2,1 8,7 0,9 2,1 1,8 2,8

36,0%

22,3%

61,5%

16,5%

37,3%

49,6%

14,7%

-

1

2

3

4

5

6

7

8

9

10

JSCKazkommertsbank

JSC NarodnyiBank Kazakhstana

JSC BTA Bank JSC BankTsentrKredyt

JSC ATFBank JSC Al'yans Bank Other

0%

10%

20%

30%

40%

50%

60%

70%

Non-performingloans,bn

Non-performingloans,%

NPLs by banks in Kazakhstan as of 1 May 2012

NPL volume, $bn NPL rate, %

Source: Committee for the control and supervision of the financial market and financial organizations of the National Bank of the Republic of Kazakhstan

6 largest banks present 74% of total

assets, incl. 88.5% of NPLs


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servicing and could perorm liquidation,which will cause low recoveries on loans or

the banks.

ax issues could arise around NPLresolution in some CIS countries. Creationo provision reduces taxable prot and thebanks tax obligation. From the other hand,banks operations could be limited dueto loss activity. In some countries assetssales/transer must be perormed with VAcreating deerred tax asset that could not bereceived.

Finally, the existing instruments on recentlycreated markets or distressed assets limit

the scope or NPL resolution but create agood niche or investors. Te banks could

not perorm all NPL work themselves andare willing to sell problem loans. Existingprice gap in the CIS region could decreasein answer to legislation creation and DPDincrease.

Per Financial imes2, investor interest indistressed debt is rising, with attention ocusingon Europe as companies in the region strugglewith their debt levels and banks step back romthe credit market to build up capital reserves.

2 http://www.f.com/intl/cms/s/0/5cd8b7a2-5e48-11e1-856-00144eabdc0.html#axzz1xmDQnEy


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17Part II. Distressed assets transfer process

Every bank decides its own approach to NPLmanagement. Te choice o approach dependson the banks development strategy and the

particularities o the loan products offeredby the bank, as well as on the availability o

undraising mechanisms or maintaining thebanks liquidity and the availability o reeunds, time, and skilled personnel to build their

own ramework or NPL workout and recovery.

Part II. Distressed assetstransfer process

Step 1 Strategy formulation

Chapter 2.1. Strategy formulation

Te general ramework or an NPL settlement strategy is presented below.

Process

Drivers

N

N

Y

N

Y

Y

Y

N

Step 1

Gather

Information

Step 2

Basic (primary)

viability assessment

Step 3

Secondary viability

assessment

Step 4

Identify restructuring

or exit options

Step 5

Structure deal based on

the least cost option

Good loan no actionnecessary

Loan current butdefault anticipated dueto future negative events

Viable ?(Y/N)

Liquidate:Determine thebest exit option

Liquidate

Other legal recourse

Monitor loan

Determine debtservicing abilityof the borrower

Pre-emptiveaction

necessary?

NPL?(Y/N)

Reschedule Financially and

OperationallyRestructure

Transfer

Assess options:Additional securityGuaranteesChange managementOthers

Select leastcost Option -pursue optionand monitor

On occurrenceof futurenegative event,return toStep 1

Borrowers financialposition

Total debt burden

Operating environment

Commitments

Risk grading

Compliance withcovenants

LTM repayment

Significant variance incash flow forecast

Qualified audit report

Deterioration in financialposition

Working capitalrequirements

Tough operatingconditions

High employee turnover

Managements attitudetoward creditors

Companys potential andlongevity

Client relationship

Public pressures

Reporting systemimplemented

Free cash flow generated

Budget vs. actual

Define

restructur-ing options

Key area of focusof this handbook


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Banks have three main options or dealing withNPLs:

Keep loans on the balance sheet andcontinue working out the solutions (mainly

via restructuring or legal collection).Workout may be done either by an in-house collection department or throughoutsourcing;

Sell to a third party. Te vendor maycontinue servicing the portolio on the basiso a service agreement;

Write NPLsoff the balance sheet and ceaseormal collection efforts.

As there is no predetermined optimal solution,a bank should establish the criteria or the

strategic decision-making process. Below isa typical scheme or NPL option selectionwith the net present value (NPV) o proceedsrom NPL recovery used as the basis or thedecision. Te bank may establish the minimumacceptable rate (MAR) o recovery as apercentage o the total exposure or a specicabsolute amount.

Loan portfolio

Performing loans

NPV/Recovery analysis

NPV>0 NPVMAR NPV


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Tere are two key ways in which NPLs can betranserred rom a banks balance sheet:

Sale1. via a closed tender, an open tender, oran outright sale;

Securitization of assets2. .

Reer to step 5 Structure the transaction ormore details on transer options.

a. Keep strategy

Statistics show that up to 60% o overdue loansare repaid within 90 days. I the DPD periodis more than 90 days the probability and the

amount o recovery decline signicantly and theloans usually are subjected to the ollowing:

A loan is treated as distressed and istranserred to a special division that dealswith NPLs.

I negotiations with the borrower ail (hardcollection), the division commences legalcollection, which is a time-consuming andcostly procedure and may last several years.

Foreclosure o collateral seems to be a bettersolution in comparison to the expensive andofen ineffective court enorcement option.However, in this case tax issues may affectthe recoverable amount.

Reasons to keep NPL on the balance sheet couldbe inuenced by:

No budget or collection companies;

No discount at sale;

Deductibility o created reserves or prottax purposes.

Despite their relatively high costs, bankstend to keep NPLs on their balance sheets aslong as there is at least a slight chance o theoutstanding amount being recovered, providedthat the borrower cooperates with the bank.

b. Sell

Sale option could be perormed via tender,outright sale or securitization. An outright saleo NPLs to a third party is a common global

practice. Te ollowing underlying actorsindicate that a bank should consider sellingNPLs:

A lack o experience in NPL collection as1.well as insuffi cient time to develop and ne-tune relevant internal procedures.

A lack o skilled and experienced staff to2.effi ciently address the existing volume ooverdue debts.

Te NPL portolio is largely composed o3.a large number o small loans: a situationwhich is made harder to deal with due toan absence o a call centre and requiredsofware, etc.

Te estimated recovery ratio o NPLs rom4.internal efforts o the bank alls below aparticular level (some experts suggest 30%o exposure, as a rule o thumb, yet thissituation may indicate not only an ineffi cient

collection system, but also signicant issueswith loan and collateral documentation andaulty loan origination procedures).

Te gross NPL portolio is close to a certain5.proportion o the banks total assets (30% onaverage, based on international practices).

Te bank has a liquidity decit and/or NPLs6.that weigh heavily on equity.

Te required provisions exceed the7.

maximum allowable tax deductible amount.


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Strategy Advantages Disadvantages

Keep No expenses for collection1.companies

No discount at sale2.

Deductibility of created reserves for3.profits tax purposes

Expenditure of the banks money1.and employees time withoutguarantee of debt repayment

Eventual need to create a 100%2.provision (if outstanding amount isnot recovered)

Negative impact of NPLs on the3.

quality of the loan portfolioRequirement to accrue interest4.income on NPLs for profits taxpurposes

A typical sale process is illustrated below.

Situational andstrategic option

analysis

Market analysis andconsiderations

Portfolio analysisand selection

Pricing approach andstrategy

Financial,structural, legal andtax considerations

Sale processdefinition and

transaction timeline

Preparation ofinformation teaser

Data analysis,cleansing and datatape preparation

Management of datatape logistics

Investor screeningand targeting

Approaching andliaising withinvestors

Virtual data roomand confidentiality

management

Sale and purchaseagreement review

Q&A andinformational

meetings

Bid evaluation andselection

Closingcoordination

Transfer of assetsand servicing

StrategyDevelopment

SalePreparation

Execution oftransaction

Closingand Transfer

c. Write-off

One o the ways to clean the balance sheeto non-perorming loans is to write themoff. Tis is usually done i there is no hope oeffi cient debt collection, or the anticipatedrecovery amount is less than the expensesalready incurred and required or the recovery.However, there are number o actors why a

write-off might be chosen (e.g., increase o core

capital adequacy, avoidance o costs relatedto administration o the written-off NPLs, taxbenets).

Each o the methods or processing non-perorming loans has advantages anddisadvantages or a bank, as outlined below.


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Sell No need for funding or human1.resources to process NPLs,

allowing focus on profit-generatingsegments

Possibility of circumventing2.collection of NPLs, thus avoidingconflicts with the borrower

Enhanced loan portfolio quality due3.to transfer of NPLs

Possible improvement in currency4.position if currency loans aredisposed of

Ability to recognize losses when5.assigning claims for profits taxpurposes (however, amount oflosses recognized is subject tocertain limitations)

A proportion of portfolio value is lost1.due to a discounted sale

Release of reserves (or provisions)2.by the bank upon assignmentresults in taxable income

Write-off Increase of core capital adequacy1.

No need for input of bank funds and2.human resources to process NPLs,which allows for focus on profit-generating segments

Enhanced portfolio quality due to3.

NPL write-offsExecution of CB instructions4.

No transfer back to balance sheet1.

Possible tax disincentives2.

Chapter 2.2. Loan portfolio review(nancial, tax and legal due diligence)

Step 2 Conduct due diligence

Distressed loan portolios have become anestablished asset class or many internationaldistressed debt investors. o diversiy theirexposure, investors are beginning to lookoutside traditional and established NPLmarkets. However, these investors have come toexpect sales processes and legal documentation

to be reasonably consistent rom countryto country. Given that one o the key valuedeterminants or an investor is the speed withwhich they can start working with the portolio,the inormation prepared and presented toinvestors as a part o due diligence is critical tothe success o any transaction.


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Area Key quest ions

Legal Are there any provisions in the loan agreement and security agreement(collateral, surety) that may impede the transfer of loans?

Are there any issues with the loan and collateral documentation that mayweaken the banks (or investors) position in case of legal collection?

What is the legal prospect of enforcing collection and what legal actions havealready been taken?

Financial What is the current debt servicing in relation to the loan, and is there anyprospect of recovering of the outstanding amount?

What is the current provision level and is there any need for additionalprovision?

How is the loan secured? Does collateral exist? What condition is it in? Whatis its value? Is the valuation up-to-date and robust?

Tax Not usually performed in relation to the portfolio, but tax structuring of thetransaction is required refer to step 5 in this section.

Given that one o the key value determinantsor an investor is the speed with which they canstart working with the portolio, the inormation

prepared and presented to investors as a parto due diligence is critical to the success o anytransaction.

Chapter 2.3. Segmentation of a loan portfolioto maximize value

Step 3 Segment the portfolio

Te loan portolio usually undergoes a processo high segmentation during the loan review and

strategy ormulation stage. Afer the decision tosell a portolio is made, a bank should dividethe portolio into appropriate clusters/baskets tomaximize the portolios value.

In order to increase the selling price, a bank mayconsider adding a portion o perorming loans

that generate stable cash ow or other non-coreassets which may be o interest to investors. Anexample o segmentation drivers are presentedbelow.

Level Basis

1 Terms of origination: maturity, products, industries, availability and type ofsecurity, etc.

2 Days of delinquency

3 Currency


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Tere is no optimal solution or portoliosegmentation and it is necessary to take main

value drivers into account each time.

Corporate loans have a wide range opeculiarities, making standardization morediffi cult than or loans to individuals. Tis isone o the reasons or the underdevelopment othe corporate NPL market.

Afer segmentation is completed, a qualitativeanalysis o all sub-portolios obtained is

conducted. In qualitative analysis, the ocusshould be on the assessment o recoveryprospects.

Chapter 2.4. Valuation methodology

Step 4 Value the port folio

One o the major actors constrainingdevelopment o an NPL market is the absenceo an effi cient methodology or determiningthe assets air value. Tis value is based on theamount that is likely to be collected and takesinto account the period necessary or collection,as well as nancial expenses and the required

return or an investor.

Portolios o retail and corporate NPLs areusually evaluated separately because theactors affecting their value are undamentallydifferent.

Borrower profile

Borrowers assets

Debt servicing

Type of loan

Behavioralcharacteristics

S

c

o

r

e

= =

P

R

I

C

E

RecoveriesWeightedaverage

score

Recovery ratio

Delinquency days

Other

Retail portfolio

Analysis o the loan portolio quality covers the

ollowing actors:

Age, social status, and nancial capacity oa borrower (i.e. his/her prole);

Availability o other borrowers assets (i.e.those which do not secure this exposure),especially the liquidity and reliability oproperty securing the loan, and availabilityo valuation reports relating to the security;

Availability o a solvent guarantor and/or

security;

Recent history o payments/date o the

latest payment, and amount o the loan

already repaid;

Factors that have led to poor debt servicing;

Actions already taken towards debtrecovery;

Potential to exert inuence over theborrower;

Availability and other behavioralcharacteristics;

Completeness and quality o inormationon the borrower and the borrowers relativesand guarantors.


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Each o the actors listed above is assigned ascore. Tese actors are then combined into

complex indicators and the scores are totaledand weighted, usually or rst-level sub-portolios. Tan, a recovery ratio is derivedby discounting cash ows that are expectedto be received rom the recovery o the NPLs.Te discounting period is selected based on

available statistical data on the time spent ondebt recovery o sub-portolios o differing

quality. Te discounted cash ows are thencompared with the outstanding exposure o theNPLs to determine the ratio. Te ratio is usuallycalculated or days past due (DPD) clusters (e.g.1-30, 31-60, 61-90, and 91-180 DPD, etc.). Reerto Appendix 2 or details.

Corporate portfolio

Existence andvaluation of collateral

Reasons for poordebt servicing

Borrowers businessprospects

Legal position

Other sources fordebt repayment

Actionsalready taken

Estimated recovery

Te main principals behind retail loanvaluations are also generally appropriate orsmall corporate loans. Te majority o mediumand large corporate loans, though, usually haveimportant eatures that are very individual.Tis, together with a lack o representativestatistics on their recovery, makes a loan-by-

loan assessment approach more appropriate orthese types o loan.

Te importance and priority o different aspectso the analysis are contingent on the processingstage o the troubled loan. It is extremelyimportant to know what measures have alreadybeen taken to collect the loan. I the NPL is atthe litigation stage, it is necessary to understandthe borrowers legal position and assess thebanks chances o receiving a avorable decision.

In addition, the actors that led to poor debtservicing should be investigated as well as theborrowers management plans regarding theuture o the business. Sometimes, a ailure tomeet commitments on the agreement is not theresult o eroded nancial perormance, but is a

deliberate policy implemented in which priorityis given to payments other than debt servicingpayments. Tis requires an assessment o theborrowers capabilities o generating cash ow.

Finally, it is essential to analyze the value andmarketability o the security, the quality and

completeness o loan documentation, andthe importance o the pledged assets to theborrowers activities.

oday, behavioral scoring is used by banks tomeasure customer behavior, and to improvecredit portolio management and customermanagement. When applied to NPL andcollateral portolio processing systems,behavioral scoring helps automatically segmentand rate accounts, customers and portolios;

thus allowing the credit account o a particularborrower to be effi ciently managed as well asthe entire credit portolio.


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Chapter 2.5. Elaborating the transaction

structure

Step 5 Structure the transaction

Te ollowing general considerations should be taken into account when choosing the appropriatestructure or a transaction:

Legal Legal form of the transaction (sale, factoring, assignment)

Availability of litigated NPLs, stage of litigation

Issues regarding assignment of collateral to an SPV and subsequentrepossession

Transferability of FX-denominated loans

Disclosure of bank secrecy and personal data information

Tax Debt/equity mix in SPV

Deductibility of tax losses in SPV

Tax inefficiencies related to repossession of collateral by SPV

Personal income tax consequences related to work-out of retail loans

Taxation of forex gains/losses

Transfer pricing issues

Exit strategy

Financial True sale treatment of the transaction

IFRS consolidation issues in case of captive sale to SPV

Forex risk management

Limited hedging tools, forex gain/losses arise

Fair value accounting

Effect on the banks regulatory compliance

2.5.1. Tax and legal issues

Distressed loan portolios have become anestablished asset class or many internationaldistressed debt investors. o diversiy theirexposure, investors are beginning to lookoutside traditional and established NPLmarkets. However, these investors have come toexpect sales processes and legal documentationto be reasonably consistent rom countryto country. Given that one o the key valuedeterminants or an investor is the speed withwhich they can start working with the portolio,

the inormation prepared and presented toinvestors or due diligence is critical to thesuccess o any transaction.

Legal due diligence

Legal due diligence o the loan portolio is oneo the key steps in preparing the assignment oNPLs. Te purpose o this stage is to determinethe possibility o assigning loans and estimatingthe quality o the loan portolio rom a legalperspective.

Key areas o concern or this stage are asollows:

Are there any issues with a loan andcollateral documentation that may weakenthe banks (or the investors) position in theevent o a legal collection?


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I a bank ails to obtain corporate approval ora transaction, the bank or its shareholders are

eligible to le a lawsuit to claim the transactionvoid.

Negative obligations

Attention should be paid to the contractualobligations o the assignor (or its parentcompanies). Tese agreements may include

various provisions which restrict the right othe assignor to dispose or pledge its property

and conclude certain types o transaction,etc. (such restrictions are ofen stipulated insyndicated loan agreements and some otherdebt agreements).

Tese obligations should be reviewed by a duediligence team which should include specialistsqualied in any applicable oreign law(s).

Summary: legal DD of a loan port folio (key issues)

Loanagreement

Notification/consent of the debtor

In general, a debtors consent is not required unless otherwise stipulated in acontract or in the relevant law(s);

Failure to notify (or improper notification of) the debtor may increase the riskof debt non-performance.

Set-off

Offsetting debtor counterclaims may increase the risk of debt non-performance;

A loan agreement should include provisions that limit or disable the rights of

the debtor to offset his or her counterclaim(s).Direct debit clauses

In general, the rights to directly withdraw the funds from debtors bankaccount are not automatically transferred when a loan is assigned;

A loan agreement should include provisions which allow direct debittransactions to be performed in favor of the assignee.

Commissions

Negatively perceived by regulators and the courts, commissions increase therisk of potential disputes with debtors;

It is recommended that commissions are assigned under a different

transaction;Some types of commissions are non-transferable;

Best practice is that commission fees should be eliminated from the scope ofan assignment agreement.

Collateralobligations

Collateral obligations should clearly refer to the primary obligation;

It is advisable to check the sustainability of collateral obligations (subsequentpledge restrictions, succession of obligations under a surety agreement, etc.)

Bankscharter

A banks charter may stipulate specific provisions for corporate approvals(e.g. major and related party transactions).

NegativeObligations Contractual obligations of the assignor may include restrictions which maynegatively affect an assignment transaction.


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Tax and legal structuring considerations

Specic tax and legal issues may arise whilestructuring the sale o NPLs.

Potential legal issues

Dening legal orm o sale (actoringagreement, sale and purchase agreement,claim assignment agreement)

Te legal orm o the agreement should bedriven by the legal capacity o a purchaser(nancial or non-nancial institution) and scopeo rights being transerred (i.e. whether onlyreceivables or the whole contractual position istranserred).

Availability o litigated loans

Te procedural legislation has to be analysed asto the possibility or a purchaser to succeed abank in court litigation with a borrower.

Potential inability to charge interest

Te transerability o rights to charge interestrom the seller to the buyer should be examined.

Risk o assignment under the collateralagreements and possibility o subsequentassignment

Te registration o transer o rights to thepledge and mortgage in the respective stateregisters is normally required unless automatictranser o rights to the security is expressly

envisaged by the legislation.Possibility o assignment o loan claimsdenominated in oreign currency

In certain countries, specic legislation mayexist impeding the sale o oreign currencyloans (e.g. licensing requirements). For suchcountries, the solution may be to concludeservicing (collection) agreement between a bankand SPV or collection o proceeds denominatedin oreign currency, which should generally

allow to avoid licensing o the SPV.

Disclosure o bank secrecy and borrowerspersonal data

Banks is bound by data protection and bankingsecrecy that may limit or even prevent the ull

disclosure o data to potential buyers and theiradvisors.

Te above list o issues is not exhaustive andcareul legal structuring o the transaction isthereore required.

Potential tax issues

ax consequences should be consideredby the buyer at the stage o nancing SPV

(thin capitalization rules, withholding taxon interest and dividends) to decide onthe optimal debt/equity mix and SPVsownership structure;

Deductibility o bad debt provisions / taxlosses incurred by SPV rom debt work-out should be considered (e.g., in certain

jurisdictions, losses rom debt work-out areallowed or loan originators only);

Personal income tax consequences should

be analysed in relation to work-out o retailloans (whether haircuts or discontinuedinterest accrual are included as taxableincome o the borrower, whether oreclosureo collateral is taxable to the borrower);

axation o oreclosure o collaterals isalso important (or example, in certain

jurisdictions oreclosure is a VA-abletransaction);

Forex issues may have impact in case ounbalanced oreign currency position o SPV(in case o SPV unding in oreign currencyor NPLs denominated in oreign currency);

Movement in loan loss provisions o theseller may be either taxable or deductibledepending on whether the loans are sold atthe price above or below net book value);

Debt collection and loan administrationactivities, i retained by the selling bank, may

become subject to VA;

ranser pricing issues may be relevant orcaptive transactions;


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Permanent establishment issues have tobe analysed in case o purchase o NPLs

by offshore SPV (especially as a result ocollateral oreclosure);

Other tax issues may be relevant depending onthe tax jurisdiction o the seller and/or buyer.

2.5.2. Financial and accounting issues

In accordance with applicable local accounting standards additional accounting and nancialissues which inuence both banks and investors nancials are arising. Te major issues by optionsare presented in the table below.

Major nancial and accounting issues by options

Issue Keep Sell Write-off

Banks financials and ratios(banks viewpoint)

Influence of the option implementation on regulatory ratios

Managing the banks currency position

Consolidation and true sale issues - -

SPV Financials(investors viewpoint)

Accounting for FX-denominated loans - -

Loan loss provisioning for FinCo - -

Forex risk and hedging considerations - -

Te ransaction may affect the ollowing ratioso a selling bank:

Equity capital. Most likely, sale o NPLswill ultimately result in improvement o theBanks capital. However, this may not be thecase i proceeds rom disposal o NPLs arelower than net outstanding amount.

Capital adequacy. Te transactioneffects the amount o risk assets and thecapital adequacy ratio increases. Tis ratioshould be careully considered when thebank transers NPL to a new SPV owneddirectly or indirectly by a bank. For thepurpose o regulatory capital calculation,all investments in subsidiaries decreasethe banks capital and in accordance with

the CBR denition o banking group, allcompanies under substantial control areconsidered as subsidiaries.

Liquidity position. Te Banks liquidityposition most likely will change signicantlyas a result o ransaction due to the act thatthe loans o different maturity clusters willbe replaced by cash rom the purchaser.

Credit risk per customer is likely to beimproved as a result o likely improvedequity capital and potential disposal omaterial loans.

Currency risk. ranser o FX-denominatedloans off the balance sheet will result inshortening o the Banks FX position by theamount o loans transerred.

Modelling exercise is required in order toquantiy the effect o the ransaction on

required bank ratios and the uture Banksnancials.


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Normally accounting standards require theconsolidation o entities that are controlled by

the reporting entity. For example, based on IAS27, control over another entity requires havingthe ability to direct or dominate its decision-making, regardless o whether this power isactually exercised. Local accounting standardsmay also contain other criteria.

Generally, standards indicate severalcircumstances which result in control even incases where an entity owns one hal or less othe voting power o another entity. Similarly

(like IAS 27, or instance), control may existeven in cases where an entity owns little or noneo SPVs equity. Te application o the controlconcept requires, in each case, judgement in thecontext o all relevant acts and circumstancesas covered by applicable GAAP.

It is likely that there will be elaborated theguidance on the consolidation o SPVs (like SIC123in IFRS).

In order to decide on the necessity to

consolidate SPV into IFRS nancials o theBank, the ollowing questions may be requiredto get answered:

Is there a control presumed to exist romthe side o the Bank, directly or indirectlythrough subsidiaries, o more than hal othe voting power?

Which entity will have a power over morethan hal o the voting rights by virtue o an

agreement with other investors in SPV?Which entity will have a power to govern thenancial and operating policies o the entityunder a statute or an agreement?

Who will have a power to appoint orremove the majority members o the boardo directors or equivalent governing bodywhich would control SPV?

Who will have a power to cast the majority

o votes at meetings o the board o directors

3 Effective 1 January 2013 SIC 12 will be replaced with IFRS 10Consolidated nancial statements which will put under oneroo requirements o IAS 27 and SIC 12

or equivalent governing body which wouldcontrol SPV?

In substance, would the activities o SPV beconducted on behal o the Bank accordingto its specic business needs so that theBank obtains benets rom SPVs operation?Is SPV principally engaged in providing asource o long-term capital to the Bank orunding to support the Banks ongoing majoror central operations? Does SPV provide asupply o goods or services that is consistentwith the Banks ongoing major or central

operations which, without the existence oSPV, would have to be provided by the Bankitsel?

In substance, who will have the decision-making powers to obtain the majority othe benets o the activities o SPV eitherdirectly or, by setting up an autopilotmechanism, through delegation o thesedecision-making powers? Who will have apower to unilaterally dissolve SPV? Whowill have a power to change SPVs charteror bylaws? Who will have a power to vetoproposed changes o SPVs charter orbylaws?

In substance, who will have rights to obtainthe majority o the benets o SPV andthereore may be exposed to risks incidentto the activities o SPV? Who will have therights to a majority o any economic benetsdistributed by SPV in the orm o uturenet cash ows, earnings, net assets, or othereconomic benets? Who will have the rightsto majority residual interests in scheduledresidual distributions or in a liquidation oSPV?

In substance, who will retain the majorityo the residual or ownership risks related toSPV or its assets in order to obtain benetsrom its activities?

Will the Bank guarantee a return or credit

protection directly or indirectly throughSPV to outside investors?

Will the Bank perorm any services or SPV?


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Option Typical Scheme

open or closed tender

outright sale

1- Cash

3- Cash

4- NPL

2- Equity

Buyer Seller

SPV

For a tender, the buyer is the bidder who proposes thehighest price compared to other tender participants.

securitization

Selling bankServicer (couldbe Selling bank)

Investors

Trustee

2- CashInvestorservicing

2- Assettransfer

1- Assettransfer

3- Cash

SPV

A sale o NPLs to a third party is a common global practice and is still the most widely-usedpractice. Te other options are poorly developed in the legislation o many i not most jurisdictions.Te major advantages and disadvantages o the various NPL transer options are summarizedbelow.

o a specic loan to structuring the transero loan portolios, returns may be improved

by considering various alternative structures.

Te most viable o them are the ollowing:Sale;1.

Securitization.2.


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Option Advantages Disadvantages

Tender Wider base of professional1.investors may be reached,which should lead to valuemaximization

Reasonably quick, one-off2.process

Greater management efforts1.Significant amount of information2.needs to be collected to satisfyinvestors

Will not reach all potential3.investors

Outright sale May be relatively quick1.

Information supplied and2.transaction structure arespecifically tailored to investor

Confidentiality easier to maintain3.

Information requirements may be1.too specific

More time and efforts may be2.required in some instances,

especially where there are failednegotiations

Consolidation requirements for3.the investment funds organizedby the bank

No competition: lower price4.

May not reach those who might5.make highest bids

Limited investor base6.

Securitization May diversify and target funding1.

sources, investor base, andtransaction structures

Value maximized2.

Very complicated and time-1.

consuming process (requiresrating; there are extensiveinformation requirements)which eventually leads to hightransaction costs

Consolidation requirements for2.the investment funds organizedby the bank

Highly regulated3.

Lowest confidentiality4.


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Part III. Transfer structures:the CIS region specics

All countries have almost the same generaloptions o NPLs transer (reer to the Chapter2.5.3 o the Section Distressed assets transer

process): a tender, an outright sale and asecuritization. At the same time, some regionalspecics o options implementation exist.Generally, market participants in developingcountries lack established and clear regulationon bad loans management and thus have toadjust global practices to local specics:

Investment fund in the orm o ClosedMutual Investment Fund (CMIF) in RussianFederation and in the orm o Mutual

Investment Fund (MIF) in Ukraine can beconsidered as a orm o securitization or

operations with hedge unds.

An outright sale o NPLs to a third party

usually perorms in the orm o a factoringtransaction with a actoring company or abank in the CIS countries.

Claim assignment transactions are not verypopular in the CIS countries and are widelyused or captive transer o loans.

In Kazakhstan bad banksare created by thenancial regulator, the National Bank oKazakhstan, in the orm o Problem AssetFund and commercial banks in the orm o

SPVs.

Chapter 3.1. Transfer to a Mutual Investment Fund

Option 1 Cession to a Closed Mutual Investment Fund (Russian Federat ion)

Te investment fundmay be an external party that

intends to generate prot rom recovery o theacquired distressed assets, or a special purposevehicle established by the bank exclusively or

holding its NPLs. When the bank transers debts

to its own CMIF, the structure o its balancesheet can be enhanced in accordance with localreporting standards only in certain cases.

Option Advantages Disadvantages

Cession to aCMIF

Likely to be more tax1.effective

High liquidity of certificates2.

More time and funds may be required1.for establishing the CMIF

Consolidation requirements for the2.investment funds organized by the bank

Lack of information transparency.3.

Te legislative ramework which regulatesinvestment und activities was adopted in 2001

(Federal Law On investment unds No. 156-FZ dated 14 November 2001).


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35Part III. Transfer structures: the CIS region specifics

At present, Russian closed mutual investmentunds (CMIFs) are classied according to

investment objectives: rent, real estate anddevelopment (real estate or proessionalinvestors). Growth in the level o NPLs andnon-core assets on bank balance sheets givecause or the establishment o a CMIF, as doesthe need or managing NPLs.

Banks can establish a CMIF and transer assetsin our ways:

Te bank transers non-core assets to a1.CMIF and receives securities in return

Te bank invests unds in a CMIF in2.

exchange or securities, and then the CMIFbuys the banks non-core assets

Borrowers transer non-core assets to the3.CMIF and repay outstanding loans bymeans o the securities they have receivedrom the CMIF

Te bank transers or sells non-perorming4.loans (not collateral) to the CMIF, and laterthe CMIF repossesses the pledged assetsand manages them

Te ollowing operating scheme is used i a

bank creates an SPV in the orm o a CMIF orthe purposes o NPL transer:

ManagementCompany

CMIF

Loan portfoliomanagement

Investments(deposits, stock market, etc.)

Investors

Funds

Shares

Claimson NPLs

Funds

Bank

Russian legislation allows CMIFs to classiycertain claims as receivables. Please reerto Appendix 3 or details on aspects oaccounting.

According to Federal Law On consolidatednancial statements #208-FZ dated 27 July

2010, IFRS reporting must be used by credit,insurance and all other public entities in theRussian Federation rom 2012.

Option 2 Transfer to a Mutual Investment Fund (Ukraine)

Te legislative ramework which regulates theinvestment unds activities was adopted in 2001(Law o Ukraine On collective investment

vehicles (unit and corporate investment undsNo. 2299-III dated 15 March 2001).

As o today Ukrainian unds are not classiedbased on investment objectives. Althoughthere are no direct prohibitions or transerringloan portolios to such unds, underdevelopedlegislation and insuffi cient knowledge o

market participants impedes the use o undsor managing bad assets. So ar, bad assets inUkraine are mainly sold to actoring companiesaffi liated with debt collection companies,and the practice o establishing MIFs hasnot become widespread. Tere are virtuallyno legal procedures, and, to the best o our

knowledge, the general banking community isnot considering MIFs as one o the preerredoptions or managing bad assets.


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Tat said, currently, the National Commissionon Securities and Stock Markets (hereinafer,

the NCSSM) is developing methodologicalregulations which will govern the acquisitiono loans by Asset Management Companies(hereinafer, the AMC) into the venture unds(hereinafer, the VIF). NCSSM intends tosolve core problems in this area. In particular,execution o assignment o loan claims byAMCs at the expense o VIFs assets, currencylicense to assign FX-denominated loans

valuation methodology or banks distressedassets and accounting o claim rights under

loan agreements, etc.

In case a bank creates SPV in the orm o MIFor purposes o transerring the NPLs, theollowing steps will have to take place: the bankacquires venture investment certicates [1],the venture investment und uses these undsto acquire non-perorming bank assets [2].According to Ukrainian law, bank will have tocreate a provision in the amount o 100% o

venture investment certicates. As such, rom

perspective o banks balance sheet, investmentcerticates may create a higher pressure thanoriginal NPL portolio.

However, i the investment und is ounded by athird party, no consolidation is required as well

as no need to acquire the und participationsecurities which are 100% provisioned.

Alternatively, to prevent the provision, theBank may sell certicates o a venture undto a Diversied Investment Fund in exchangeor its certicates which do not generallyrequire provisioning [3]. Tus, the Bank avoidsprovision requirements and the diversiedinvestment und avoids prohibition o investingin loan claims rights.

According to the Ukrainian accountingstandards, loan claim rights are accounted oras receivables. For accounting details pleasesee point 5 o Guidelines on accounting basicoperation of mutual investment funds approvedby Ukrainian association o investmentbusiness. Te Guidelines prescribe that assetsare accounted or as nancial investmentsaccording to UAS 12 Financial investments. Inancial investment is purchased in exchangeor other assets, its cost is determined accordingto a air value o the assets purchased. Allreceivables (i.e. principal, interest, penalties,etc.) on nancial investment are recorded asnancial income.

Bank

[1]

[2]

[3]

Venture IF

Diversified IF

Chapter 3.2. Factoring deals

In the CIS countries banks usually use actoringagreement with the bank or nancial institution(actoring company) or sale o NPLs.

According to the actoringagreement (nancingagainst assignment o monetary claims), one

party (actor) shall transer or undertakes totranser unds to the other party (client) or aconsideration (payable in any manner speciedin the agreement), and the client shall assign

or undertake to assign to the actor its right omonetary claim to a third party (borrower).

Only monetary claims can be assigned. Certainde jure limitations exist on assignment o othernon-property rights, which are connected to

principal monetary obligations (e.g. obligationto provide nancial statements, noticationobligation, keeping o secured property, etc.)


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37Part III. Transfer structures: the CIS region specifics

Chapter 3.3. Bad banks in Kazakhstan

o segregate o a banks good assets rom itsbad assets, thereby improving the overallquality o the banks credit portolio, two typeso vehicles are established in Kazakhstan:

the Problem Assets Fund (PAF) a und,created by the National Bank o Kazakhstan(the NBK), or a limited period o timewhich will purchase bad assets o one ormore Kazakh banks;

the SPV creation or acquisition by abank o a subsidiary which will acquire thebanks bad assets.

Problem Assets Fund

Te Problem Assets Fund, known as JointStock Company Fund o Problem Loans,was registered on 11 January 2012 effectivelyreplacing the Distressed Assets Fund (controlledby the Government through the NationalWealth Fund Samruk-Kazyna) which wascreated in 2008. Te Problem Assets Fund isexpected to acquire bad corporate loans and thesecurity associated with those loans (except ormortgage loans), and it will manage those loansand the attached security until they can be sold(by way o securitization or otherwise) to thirdparties.

Te Fund will acquire loans with the associatedsecurity at a carrying value or at a negotiateddiscount. o nance its operations, the Fundmay issue bonds which are expected to beplaced among pension unds, banks and theNBK.

SPV in Kazakhstan

Te Banking Amendments4 also authorize abank to establish or acquire a SPV (subsidiary)which will then acquire the banks bad assets.

4 Law On Making Changes and Amendments to CertainLegislative Acts o the Republic o Kazakhstan on Regulation oBanking Activity and Financial Organizations in Furtheranceo Minimization o Risks dated 28 December 2011 (theBanking Amendments)

Tus, the SPV will act as an affi liated badbank to the parent bank. Such SPV may beestablished only with the permission o theNBK, and the parent bank will not need tocomply with the general no-loss/nancialstability requirement which ordinarily applieswhen a bank creates a subsidiary.

A bank may establish any number o SPVs.While the Problem Assets Fund will acquire

primarily corporate loans and the relatedsecurity (except or loans secured by mortgageo real estate), it is intended that SPV willacquire primarily mortgage loans. As withthe Problem Assets Fund, SPV will managethose loans and sell them to investors (bysecuritization or direct sale). SPV will not berequired to oreclose on the mortgaged security.Proceeds received by SPV rom the sale o thebad assets will be transerred urther to thebank.

SPV can be created only or a given period otime within which it must either sell the assets(loans and associated security) acquired romthe parent bank or transer them back to thebank. Afer that, the bank must liquidate theSPV or otherwise dispose o its shares in theSPV.

Special status o the Problem Assets Fund andSPV

Te Problem Assets Fund and a banks SPVcreated under the Banking Amendmentshave special status. In particular, they arenot required to obtain a banking license inconnection with their acting as the lenderunder loans transerred to them by the banks.Further, the Fund and SPV are exempted romcorporate income tax on income rom theircore operations rom 1 January 2012 until 1January 2018.


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Part IV. Case studiesTe ollowing case studies illustrate the practical implementation o the disposal o NPLs on

Ukrainian and Russian market.

Chapter 4.1. Sale of SME NPLs to a third party

Bank in Russian Federation

4.1.1. Purpose of the project

Te purpose o the project (the SME Program)was to set out the mechanics, economics andlegal arrangements involved in the purchaseo sub-perorming and/or non-perormingloans granted to small and medium businessenterprises (hereinafer SME NPLs). TeBank-Purchaser acquired the SME NPLs roma selected bank (hereinafer Originator) undera pilot transaction to help build a platorm orrenancing a new SME Program.

Te purpose o the pilot transaction was togain experience o the processes involved,the operational implications, and the detailedpractical capabilities o the Originator.Afer completion, the arrangements canbe standardized and a scalable operationalmodel can be developed (leading to theimplementation o a ull SME Program).

Te objectives o the SME Program are to:

oster the development o urther SMElending in the Russian Federation;

provide a template and standardized set o

lending criteria representing best practicethat banks may then go on to adopt (tobecome eligible to participate in a Bank-Purchaser program);

provide nancing in a manner that isacceptable (and undable) by the CentralBank and potentially (i markets improve) inthe securitization market;

design a structure that provides effi cienciesto participating Originators by:

reducing their regulatory capital needs(which involves the Bank-Purchaseraccepting some risks);

allows the Bank-Purchaser to take overthe unding o the SME loans, relievingthe Originator o this responsibility;

providing economic incentives (throughthe payment o servicing ees and thesharing o residual protability in theSME lending with the Originator);

does not involve tax ineffi ciencies or taxrisks or the Originator.

4.1.2. Project summary:

Originators are selected to participate in1. the program based upon the quality o theirlending and standing within the Russiannancial market. Such banks are then

Case A

Sale of NPLs issued to Small and MediumEnterprises to a third party Bank


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39Part IV. Case studies

reviewed in terms o their lending standards,quality o servicing and quality o lending

documentation.

Selected banks are then invited to sell SME2.NPLs to the Bank-Purchaser, either once oron a regular monthly basis. I the NPLs solddo not match the promised criteria, then thepurchase o these particular loans rom theOriginator is cancelled. Te Originator alsoassumes a limited buyback obligation inrelation to uncollectable SME loans.

Purchased NPLs are owned by the Bank-3.

Purchaser. Servicing o the loans issubcontracted back to the Originators. TeOriginators also retain responsibility or

enorcing the NPLs on behal o the Bank-Purchaser under a power o attorney. In

certain circumstances, loans may be soldback to the Originator as well.

Each day, the Originator pays over cash4.received (collected) rom the borrowers tothe Bank-Purchaser.

Each month, the Bank-Purchaser will pay a5.servicing ee to the Originator. In addition,an assessment is made o the protability othe NPLs (afer deducting unding costs atan agreed rate, losses, and servicing ees).

Te surplus is then divided between theOriginator and the Bank-Purchaser.

4.1.3. Deal Structure

Te ollowing diagrams set out the structure o arrangements to be put in place.

OriginatorBank-

Purchaser

Initial Purchase Price (outstanding loan balance)

Cash Flows

Principal, interest, fees and commissions

Servicing Fee

Payments for loans bought back

Bank-Purchaser Recoveries(and reporting on Originator Recoveries)

Vendor share of rewards (Differed Purchase Price)

Deposit installments

Interest and repayments on Deposit Account

Depositaccount

Payment for loans whose purchase iscancelled, penalties

1

4

9

10

11

3

2

6

5

8

7

Principal, interest,fees and commissions

Cash flows that arise in relation to normal performance of the loans

Cash flows that arise to deal with allocation of risks and if problemsarise with loan performance

Cash flows that arise in relation to security for Originator credit risk

On enforcement,Recoveries (Bank-Purchaser and

Originator)

Clients


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Tere are some undamental principles that areollowed in designing the structure:

o keep administration simple, all cash owspaid in relation to the SME loans ownedby the Bank-Purchaser should be paid tothe Bank-Purchaser. Tis means all ees,commissions, interest and principal receipts,recoveries (direct, rom the realisation o asecurity and through ormal enorcementprocedures).

When recoveries are made rom borrowersto the Originator under NPLs bought back

by the Originator (dened as OriginatorRecoveries), the Originator has to report thereceipt o this cash to the Bank-Purchaser.Te Bank-Purchaser keeps track o theOriginator Recoveries or the purpose ocalculating the allocation o income and loss.

Te Originator should pay over cash receivedevery working day to the Bank-Purchaser (ona next day basis).

Administratively, the Bank-Purchaser will

divide up cash receipts into several types:

Principal (reecting repayments oprincipal on the loans purchased) andreceipts in respect o the principal balanceo loans sold back to the Originator;

Income (interest, ees and commissions)and receipts in respect o any accruedincome included in the sale price o NPLssold back to the Originator;

Bank-Purchaser Principal Recoveries(principal received on NPLs not sold backto the Originator);

Bank-Purchaser Income Recoveries(income received on NPLs not sold backto the Originator) and;

Originator Recoveries (amounts receivedon NPLs afer they have been transerredback to the Originator).

Te distinction between different types o income (i.e.: ees, commissions or interest)is not required to be maintained or thepurpose o administering the arrangements

(it may be required or legal, accounting and/ or regulatory reporting purposes but this

is subject to separate discussion).Te ollowing basic cash ows arise within thestructure:

When a NPL is acquired by the Bank-1.Purchaser, the Bank-Purchaser will pay theinitial purchase price or the NPL which isbased on the loans estimated market valuecalculated by an independent appraiser.

Tereafer, the Originator will collect amounts2.in respect o the NPL in the usual way (as theOriginator remains the administrator andservicer o the loan).

Te Originator is obliged to pay all amounts3.it then receives in respect o the NPL to theBank-Purchaser. Tis includes principalrepayments, and payments o interest eesand commission payments and any otheramounts.

Te Bank-Purchaser will keep track o the4.

amounts that it receives in respect o NPLspurchased rom the Originator. At the endo each month, the Bank-Purchaser willdetermine how much cash has been received,how much o the cash is principal and howmuch is income, and the Bank-Purchaser willaccount back to the Originator or a servicingee based upon the NPL portolio principaloutstanding balance at the end o the month.

NPLs may continue to be owned by the5.Bank-Purchaser, or (subject to certain limitsand restrictions) the Bank-Purchaser may sellNPLs back to the Originator.

NPLs will then, periodically, generate6.recoveries. Tese will also be collected bythe Originator either through regularenorcement processes or through ormalactions (with the Originator acting on behalo the Bank-Purchaser and under suchguidance as the Bank-Purchaser chooses toprovide pursuant to a power o attorney or

on its own behal regarding the loans boughtback by the Originator).

For NPLs which still belong to the Bank-7.


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41Part IV. Case studies

Purchaser, all recoveries are the property othe Bank-Purchaser and the Originator will

be obliged to pay all the amounts receivedto the Bank-Purchaser. Where recoveriesarise on NPLs that are bought back by theOriginator, the Originator will retain this cashbut report its receipt to the Bank-Purchaser.

Occasionally, NPLs may be sold to the Bank-8.Purchaser which on urther examinationprove to be outside th

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