Ernst & young studie zum npl-markt 2011

European Non-Performing Loan

Report 2011Restructuring follows strategy — a review of

the European loan portfolio market

Cont

ents

Introduction

Foreword

The economic and political situation and a perspective on the financial environment•The economic and political situation in the Eurozone•Heavy turbulence in the banking sector•Basel III — reshaping the future landscape

Loan portfolio trading•Recent market developments•Future market trends

Country sections•Germany•United Kingdom• Ireland•Spain• Italy•Turkey•Greece•Portugal•Poland•Russia•Ukraine•Kazakhstan

Services

Contacts

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Ernst & Young European Non-Performing Loan Report 2011 5

Restructuring follows strategy The global financial crisis has exposed the weaknesses of the banking industry around the world and banks need to redefine their strategies to meet the challenges ahead. This has widened the pool of non-core loan portfolios and banks need to do more than sell their non-performing loans (NPL) to achieve their desired balance sheet structure.

Ernst & Young’s Strategic Portfolio Solutions team has been around in the “good old NPL years” before the financial crisis, being directly involved in a large number of loan portfolio transactions, and has been busy advising financial institutions and investors on their respective activities during the last few years.

We believe that the coming years will offer historic opportunities and rewards for both financial institutions executing their post-financial crisis strategy as well as investors in non- core and non-performing assets.

Nora von Obstfelder, Thomas Griess, Ana-Cristina Grohnert, Daniel Mair


Fore

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Much has happened since the publication of our European Non-Performing Loan Report 2008. Back in April 2008, the global credit crisis had already started with the bailout of Bear Stearns and was just picking up some speed, whereas significant events such as the demise of Lehman Brothers, the sale of Merrill Lynch to Bank of America, the conservatorship of Fannie Mae and Freddie Mac and the bail-out of AIG were just around the corner, but seemed unthinkable.

Ireland, Portugal and Spain were considered the growth engines of the Eurozone. Iceland and Greece were financing their national debt at similar interest rate levels to Germany or the UK. Sovereign risk was a political, not a financial term.

In the Eurozone and the UK, we saw the failure or nationalization of large financial institutions, the creation of “bad banks” and the arrival of multi-trillion euro stabilization schemes for the financial sector in countries throughout Europe.

Three years later, it appeared that the financial sector in Europe had stabilized and started to heal. High leverage and debt had moved from the private sector to the public sector. As most of the dust in the financial sector appeared to have settled, we decided to take a fresh look at the situation and the potential future development of the loan market in Europe.

At the time of publishing this report, European Union leaders are scrambling together with national governments to put in place a sustainable financial stabilization scheme for the Eurozone countries. Unsustainable levels of sovereign debt have already resulted in bailouts being agreed for Greece, Ireland and Portugal, and European institutions are collaborating to prevent the resulting contagion severely impacting Spain and Italy.

Compared to our 2008 report, we have broadened our perspective and our 2011 report covers non-performing, sub-performing and performing (non-core) loan markets. Whereas activity in the European NPL markets has been very subdued since our last report, as the market participants, especially sellers, have been focusing on managing their portfolios during the most challenging financial crisis since the Great Depression, we believe that the coming years will see a much higher level of activity, as transactions are a major step in deleveraging and repairing the financial system.

We completed our report in mid September and therefore have not covered the most recent developments after that date such as the fears of another freeze of the interbank lending market, the rating downgrade of several European banks and the recent rescue of Dexia. The potential impact of such developments on the non-core and non-performing loan markets in the short or longer term remain to be seen.

The economic and political situation

and a perspective onthefinancial

environment


The economic and political situation in the Eurozone

Economic overviewThe global economy was hit hard by the financial crisis and the recovery remains unbalanced with advanced economies growing at only 2.5%, while emerging economies grow at a much higher 6%.1 In the emerging economies, the crisis typically left no lasting wounds. Their fiscal and financial positions were generally stronger and hence, the negative impact of the crisis was less intense. High underlying growth has strengthened domestic demand and compensated a shortfall in exports. Better growth prospects and interest rate levels above that of advanced economies have turned capital outflows into capital inflows. Meanwhile, in a number of advanced economies the recovery shows signs of weakening.

In Europe, there is a growing divergence in economic performance between the north and south. While economic growth remains more reasonably robust in the northern part of the Eurozone — with the exception of Ireland — the south is suffering from pre-crisis excesses and crisis wounds: increasing borrowing costs, falling house prices, a crash in the construction industry and high unemployment rates led to a steep increase of NPLs on banks’ balance sheets, resulting in a deterioration of capital ratios and liquidity positions.

European governments placed a protective umbrella over their banks, expecting that, with the return of economic growth, bank profits would increase and balance sheets would improve to solve the problem. However, the post-crisis economic recovery is weaker than governments had hoped and, worse still, recovery is weakest where the debts are highest. The sovereign debt markets of the “PIGS” countries (Portugal, Ireland, Greece, Spain) are under strong tensions, indicated by a surge in government bond yields. A bank solvency problem thus turned into a sovereign solvency problem.

In 2010, the European Financial Stability Facility (EFSF) was created to provide liquidity to countries that struggle to refinance at the capital markets. But its remit remains restricted, particularly on the purchase of government bonds. A number of proposals on economic governance have been made, which go in the right direction but fall short of a significant move toward fiscal transfers. This underlines the fact that, as yet, there is no all-encompassing crisis resolution path. Individual member countries remain keen to limit their own financial exposure, but the multitude of solutions they offer do not constitute a coherent approach that could explain how and when debt sustainability is likely to be achieved in the Eurozone’s peripheral countries.

1 World Economic Outlook, IMF, April 2011.

Peripherals debt

Figure 1 | Source: Oxford Economics; Haver Analytics

Figure 2 | Source: Oxford Economics; IMF; Irish Dept. of Finance

Peripherals interest burden

Figure 3 | Source: Oxford Economics; IMF; Irish Dept. of Finance

Bond yields

20%18%

14%▬ Ireland

▬ Portugal

▬ Greece

▬ Italy

▬ Spain

16%

12%10%8%6%4%2%0%

Sep 08 Sep 09 Sep 10 Sep 11Mar 09 Mar 10Mar 08 Mar 11

▬ Ireland

■ Ireland

▬ Portugal

■ Portugal

▬ Greece Projections

■ Greece

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Gross government debt in % of GDP

Debt interest in % of government revenues

14.0

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16.1

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7.6%

15.6

%

16.1

%

8.2%

18.0

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19.6

%

8.6%

19.8

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25.1

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8.6%

22.0

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25.5

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8.5%

21.9

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25.1

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8.4%

Ernst & Young European Non-Performing Loan Report 2011 11Ernst & Young European Non-Performing Loan Report 201110

Forecast of the Eurozone economy (Annual percentage changes unless specified)

Figure 4 | Source: Oxford Economics

2010 2011 2012 2013 2014 2015

GDP 1.7 1.6 1.1 1.9 2.0 2.0

•Privateconsumption 0.8 0.5 0.7 1.3 1.5 1.6

•Fixedinvestment −1.0 2.3 1.8 3.7 4.0 3.6

•Stockbuilding(%ofGDP) 0.6 0.6 0.5 0.7 0.7 0.8

•Governmentconsumption 0.5 0.3 −0.2 0.5 0.9 1.1

•Exportsofgoodsandservices 10.6 6.4 4.6 6.0 5.9 5.3

•Importsofgoodsandservices 8.9 4.8 3.7 6.0 5.9 5.4

Consumer prices 1.6 2.6 1.8 1.8 1.8 1.8

Unemploymentrate(level) 10.1 10.0 9.9 9.6 9.2 8.9

Currentaccountbalance(%ofGDP) −0.5 −0.8 −0.5 −0.3 −0.3 −0.3

Governmentbudget(%ofGDP) −6.0 −4.2 −3.1 −2.3 −1.8 −1.4

Governmentdebt(%ofGDP) 85.5 86.9 88.0 87.9 87.8 87.6

ECBmainrefinancingrate(%) 1.0 1.3 1.2 2.6 3.5 3.9

Euroeffectiveexchangerate(1995=100) 120.7 121.1 120.4 119.4 115.4 113.5

Euro/USdollarexchangerate($per€) 1.33 1.41 1.38 1.33 1.27 1.24

Economic outlookThe opinion on the Eurozone’s immediate economic outlook is sharply divided. Earlier this year, confidence indicators painted an almost euphoric picture, with the Ifo Business Climate Index in Germany reaching an all-time high in February this year. In the wake of sovereign debt crisis and softening economic indicators in some key markets, economists have been lowering their expectations for economic growth and fears of a double-dip recession are rising.

In our Ernst & Young Eurozone Forecast2, we see a significant risk of the Eurozone economy slipping back into recession as the sovereign debt crisis shows no sign of abating. We revised our GDP forecast to 1.6% this year instead of previously projected 2%, before slowing to an “anemic” 1.1% in 2012.

Earlier this summer, our forecast was a fairly benign scenario in three main respects. First, our Ernst & Young Eurozone Forecast assumed no further escalation to tensions in the Middle East. Second, it assumed that the financial market environment is benign as fiscal adjustment proceeds further and governments take some decisions that reassure investors as regards their ability to avoid and deal with future sovereign debt crisis (however, during August, investors certainly did not afford governments such breathing room). Third, our forecast assumed that the Eurozone banking sector restructures gradually and avoids widespread disruptions. However, we now expect that the Eurozone sovereign debt crisis will worsen further, in turn undermining growth prospects.

Growing risk of disorder Markets remain unconvinced by the two bail-out packages agreed for Greece. It is possible that similar sentiment could spread and once again impact the borrowing costs of Ireland and Portugal.Without a rapid improvement in their competitiveness, all three economies, as well as Spain and Italy, will be challenged by low levels of economic growth, further hampered by unsustainable debt servicing burdens.

One of the most disturbing problems in this context is the unemployment among young people and how it affects the society and the younger generation’s ability to become established in the labor market. The latest available statistics are alarming: in Spain, nearly 45% of citizens under 25 are unemployed. The figure for Greece is 36% — this is far too many young people who are not using their insights, energy and ideas to build and develop future businesses and public services.

The economic and political situation and a perspective onthefinancialenvironment


Businesses prefer to reduce debt and banks keep credit tightThe recovery in domestic activity is forecast to continue at a slow pace. Strong export performance has not yet been sufficiently sustainable to make companies in the Eurozone as a whole confident enough to raise investment at a robust pace. Even in Europe’s recently top performing economy, Ernst & Young’s study of the German lending market3 supports this finding, as the majority of polled companies are still reluctant to invest. This is mainly attributable to the need for utilization of technical capacities, which were considered weak at that time. Nevertheless, given ample amounts of cash available to the business sector on aggregate, our Ernst & Young Eurozone Forecast sees Eurozone business investment to rise by 2.7% this year and 2.6% in 2012. This would leave the level of investment at the end of next year still around 10% below pre-crisis levels. In the UK, demand for credit is reported to be similarly weak.

We think that the corporate balance sheet restructuring and deleveraging that has been a main focus of companies over the past year will continue to weigh on investments for some time. Business investment is not expected to return to pre-crisis levels before 2014.

Moreover, Eurozone banks are keeping a tight lid on lending as they restructure their own balance sheets and reduce their exposure to the riskier sectors and countries. As banks continue to deal with a significant corporate refinancing burden, the outlook for new lending remains muted. The Q2 results of the ECB’s Bank Lending Survey show that only banks in core countries (Germany, France, Austria, Belgium, Netherlands) have started to unwind the tightening of credit standards imposed during the crisis and, even in these countries, this unwinding is slow.

Both the finance markets and the political leadership in Europe fear that after Greece, Portugal and Ireland, Italy and Spain might also fail and the deepening crisis would strike hard against European banks, especially in Germany and France.

This creates a potentially dangerous economic and political context for business over the next 12 months, and one that is not geographically limited to Europe either. We have seen that the voluntary participation of the private sector in the second rescue package for Greece has led to a downward rally of European stock markets, and diminishing confidence among banks is raising fears of a second credit crunch on the interbank market. A wider orderly sovereign debt restructuring could rock global financial markets and a deeper default than the one in July on Greek sovereign debt now looks unavoidable. Economic recovery in Europe falters as confidence in the euro and the solidity of the Eurozone weakens. Consumer confidence, by no means robust in the Eurozone at present, will be weakened further. Into this bleak outlook, we should also factor in growing uncertainty over the direction of US economic policy, doubts over the US economic recovery, the risk of oil prices remaining at current high levels and the possibility of even higher, and fluctuating, commodity prices.

The discussion about the best way of solving the Eurozone sovereign debt problem between the EU and the European Central Bank (ECB) has been hard and reveals a strong disagreement over what measures need to be taken. The Eurozone financial crisis is a great challenge for its governments and central banks, but this is not only about creating consensus at the EU level. All governments in the Eurozone and their political opponents have a great responsibility when it comes to finding common strategies to lift their countries out of the crisis and to secure Europe’s future as a strong single market.

2 For further information please refer to the full reports under www.ey.com/eurozone.3 A Study of the lending market — September 2010, Ernst & Young, http://www.ey.com/DE/DE/home/library.


Heavy turbulence in the banking sector

LiquidityThe global credit crisis was triggered by the US subprime mortgage crisis, followed by a liquidity shortfall in the US banking system. With the collapse of Lehman Brothers and other systemically important financial institutions, the bail-out of banks by national governments and downturns in stock markets around the world, this quickly emerged into a global financial and economic crisis, which exceeded all previous crises since the Great Depression.

Despite the fact that the Eurozone banking sector is gradually recovering from the global financial crisis and recession, the outlook remains challenging. As described in the first section of this report, economic growth in the Eurozone is expected to remain uneven; household and business balance sheets remain stretched in many member states. Ongoing sovereign debt crises and lingering uncertainty about the asset quality of many banks is hampering access to wholesale funding markets at reasonable cost (although the ECB is playing a crucial role in providing financing to certain banks). At the same time, banks’ profitability in the region is facing headwinds from a broad range of regulatory reform initiatives that are currently under way at both the EU and global levels. Against this background, the outlook for the Eurozone banking sector remains highly uncertain.

ECB lending to the periphery

Figure 5 | Source: Oxford Economics; Haver Analytics

Sovereign risk is casting a shadow over the banking sector …The sovereign debt crisis remains a defining theme for both the Eurozone economy and the banking sector. Credit default swap (CDS) spreads for Greece, Ireland, Portugal, and more recently Spain and Italy, have risen to new highs, which is translating to higher funding costs that banks are finding difficult to pass on to borrowers in these countries. Concerns about possible sovereign debt defaults have led to a sharp rise in the perceived counterparty risk of banks in the troubled countries, with banks elsewhere in the Eurozone and beyond reducing their exposures to banks considered to be most effected. Due to the interdependence of bank and sovereign creditworthiness, access to wholesale funding is likely to remain significantly restricted in these economies. This is illustrated by the forecast for 10-year government bond yields, which are expected to remain close to 4% in Germany and France this year, as opposed to 5.5% in Spain and more than 15% in Greece.

This drain of liquidity has left peripheral country banks increasingly reliant on the ECB for funding. In January 2011, banks from Greece, Ireland, Portugal and Spain borrowed around €320b from the ECB, down from €378b in July 2010, but still well above the typical levels of around €50b before the crisis.

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And in February 2011, two Irish banks, that had to sell assets to restructure their balance sheets, had to resort to the ECB’s overnight lending facility, pushing the amount borrowed by Eurozone banks to around €15b for a few days compared with only a few hundred millions usually. Total ECB lending to Portugal, Ireland, Greece and Spain amounted to around €350b in April. Within this total, lending to Ireland has expanded significantly over the past year due to the intensification of their banking crisis. By contrast, ECB lending to Spain had, until recently, been contracting in line with improved investor sentiment. But the intensification of the sovereign debt crisis has seen financing costs for Spanish banks rise again, forcing them to borrow from the ECB rather than access capital markets.

… underscoring the north/south divide in performanceBesides a funding squeeze, uncertainty remains about the asset quality of many of the banks in the peripheral economies, particularly their exposures to the depressed residential and commercial property sectors. The impact of ongoing fiscal austerity measures on economic growth, employment and credit quality will continue to represent a significant downside risk to the performance of banks in these economies for some time, where they have significant local exposure.

Persistently high NPL ratios in the periphery economies will mean that provisions for bad loans will remain at elevated levels, dampening earnings and profitability. In countries such as Spain, where we expect house prices to continue falling through to 2014, the negative collateral effect on bank balance sheets will be compounded, as mortgages will have to be written off net of much

Banks‘ NPLs

Figure 6 | Source: Oxford Economics; World Bank

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lower collateral values. This legacy of bad loans will hamper banks’ ability to normalize credit conditions to support the economic recovery in these regions.

In light of our underlying forecasts for subdued economic growth and multiyear deleveraging in the private sector, we expect lending and profitability to remain muted, with the likelihood that some banks will need to raise capital to meet new Basel III standards as well as address elevated asset quality risk. There is also a risk that margins will generally remain weaker than for banks in the core due to the higher cost of funds. On the other hand, our forecast for a gradual normalization of monetary policy by the ECB will see the yield curve flatten within the core Eurozone over the next few years, which is also likely to squeeze margins for banks in these economies.


CapitalThe financial crisis also revealed major shortcomings in the way the banks had been operating: the capital ratios were insufficient and the capital they held was of insufficient quality. What began as a credit issue on US subprime mortgages spread to several other asset classes as the recession took hold, leading to the significant impairment of banks’ balance sheets. To fulfill capital requirements and improve liquidity positions, banks had to raise new capital or reduce assets exposures.

Governments were required to intervene with massive and unprecedented rescue packages for both the economy and the financial sector, preserving both financial stability and the functioning of the internal markets. Globally, governments have adopted a variety of measures to achieve this, ranging from full-scale nationalization of financial institutions to providing insurance for impaired assets.

Government intervention schemes

Figure 7 | Source: Ernst & Young research

State guarantees • ► State guarantees were provided to selected financial instruments issued by financial institutions

• ► Typically, senior unsecured medium-term (three to five years) instruments were guaranteed

• ► State guarantees were provided across the majority of the countries researched — notably in Ireland, where around €440b of state guarantees were provided to the major banks

• ► France is the only case where guarantee was provided to a government-owned entity (Société de Financement de l’Economie Française) that further provided loans to financial institutions

Assumption of risk positions

• ► The scheme involved the acquisition of risk positions through purchase or guarantee of legacy assets

• ► Asset purchases involved acquisition of assets, securities, rights and obligations arising out of credit commitments and/or holdings; for example, the National Asset Management Agency (NAMA) in Ireland, that acquired toxic property assets of banks at a heavily discounted rate in return for government bonds

• ► Asset guarantees were also deployed to provide protection from potential losses. These programs were generally customized according to the beneficiary institution; for example, the Asset Protection Scheme in the UK, which provides RBS with protection against future credit losses in return for a fee

Recapitalization • ► Capital injection in selected financial institutions was provided to strengthen the capital base of these institutions

• ► Most of the government recapitalization during the financial crisis occurred through non-dilutive instruments such as preferred shares, non-voting securities, mandatory convertible instruments or subordinated debt securities

• ► Recapitalization measures were used widely across the EU Member States — in particular, in Germany

Nationalization • ► Nationalization is a special case of recapitalization under which the government becomes sole or majority owner of the financial institution

• ► This step was generally undertaken for severely distressed financial institutions to enable smooth restructuring and eventual re-entry into the market

• ► Key examples include the nationalizations of Northern Rock in the UK, Allied Irish Bank, Hypo Real Estate in Germany and Parex Bank in Latvia

Deposit guarantee • ► The scheme primarily involved increasing the limit for protection of retail and SME deposits in financial institutions

• ► The majority of countries researched increased the level of protection provided by depositor protection schemes

Across the EU over €2,800b capital was deployed by national governments to stabilize and support financial institutions. Of the support measures deployed, around €2,100b was provided in state guarantees (76% of total measures), 16% were deployed to assume risk positions and 8% were deployed to recapitalize financial institutions. The Irish Government dedicated the highest amount toward state guarantees, which accounted for 82% of the total value of support provided by the Government. Across the EU and Switzerland, funds allocated for state guarantee schemes were primarily used to provide guarantees for bonds issued by financial institutions.

In terms of country-specific measures, the UK Government provided the highest value of country support with a total amount of around €585b. The Irish Government deployed the second-highest value of measures — marginally behind the UK at ca. €540b and Germany at around €480b. In many countries, mainly Eastern Europe but also including Italy, governments



Total value government aid per country


were not required to introduce formal anti-crisis schemes; however, deposit guarantee schemes have been widely introduced by these governments.

Across the EU region, a total of 94 financial institutions received some form of government assistance. France supported the highest number of institutions — 13 in total. This is followed by Germany, Austria, Portugal and Greece who supported seven institutions respectively. In most of Eastern Europe, as well as Italy, no direct support was provided to any institution — primarily because, in most of the Eastern European countries, the banking industry is dominated by foreign players who received support from their respective home countries’ governments. During 2008, the US Government, along with the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and the US Treasury, launched various schemes, under the Emergency Economic Stabilization Act of 2008 and Troubled Asset Relief Program (TARP), to stabilize the financial system. Of the support measures deployed, more than US$1,000b was provided in state

However, progress on banking restructuring is slow and it is as yet uncertain as to whether these measures are enough to solidify the banking system and make it a contributor to growth rather than a restraint. Nevertheless, management boards, including those of banks owned by the state, are willing to rethink the bank’s business model, improve risk management and are keen to present their shareholders cleaned-up balance sheets.

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guarantees, around US$420b was deployed to recapitalize financial institutions, and around US$40b was deployed to assume risk positions.

Limited ratings migration to the benefit of most creditors of these banks, as well as the improvement of banks’ capital ratios, reflect the effects of these capital interventions in addition to profitability improvements and deleveraging efforts. The state aid measures were linked to major restructuring and reorganization requirements for banks in order to establish robust banking models that show higher resistance to shocks to the financial markets. Restructuring of the Eurozone banking sector is ongoing, with measures such as the consolidation of Spanish cajas (savings bank) or the split-up of German Landesbanken (federal state banks).

€ billion


Largest European listed banks4 that have not required governmental aid to date

Figure 9 | Source: Forbes 2000 list; Bloomberg; banks‘ interim financial

statements; www.oanda.com

* Market capitalization as of 30 June 2011 (Bloomberg)

** Total assets as of 30 June 2011 (interim financial statements)

*** Latest available rating Moody‘s/S&P/Fitch/

FX rates as of 30 June 2011 provided by www.oanda.com

€billion Market* capitalization

Total assets** Rating***

HSBC Holdings 122.7 1,870.0 Aa2/AA−/AA

Banco Santander 67.2 1,231.9 Aa2/AA/AA

Deutsche Bank 37.8 1,850.0 Aa3/A+/AA−

Barclays 34.8 1,661.9 A1/A+/AA−

BBVA 36.8 568.7 Aa2/AA/AA−

Credit Suisse 32.8 814.9 Aa2/A/AA−

UniCredit Group 28.2 918.8 Aa3/A/A

Nordea Bank 29.9 593.2 Aa2/AA−/AA−

Svenska Handelsbanken 13.2 244.1 Aa2/AA−/AA−

SEB 12.3 238.8 A1/A/A+

Swedbank 13.4 190.7 A2/A/A

Banco Popular Español 5.5 130.4 A2/A−/A−

Why are some banks more resilient to stress than others?The financial crisis has had far-reaching impacts on financial institutions across the globe. However, while numerous institutions failed or had to be bailed out by impressive governmental rescue schemes, other financial institutions maneuvered better through the crisis years and came out in much better shape.

The question as to what makes the difference between a successful and a less successful business model and whether there is a “best practice” business model in banking, has been addressed in various research papers and analyzed in recent years; yet, we find that the following key factors seem to play a role in most of the analyses:

Sound business model. A key factor enabling sustained financial success also in periods of stress is a sound business model. Key elements include a clear focus on product, markets and client strategy, established riskmanagement processes and last, but not least, an established set of values across the organization.

A key element differentiating performance of financial institutions has been the appetite for risk, which is closely linked to the business model. In general, we find that financial institutions lacking a solid, sustainable and competitive business model were more likely to take on excessive risks to improve profitability than others.

A recent study of US banks revealed that those banks that performed poorly during the Asian crisis of 1998, were harder hit by the global financial crisis of 2007 to 20095. This phenomenon seemed to be independent of the people in charge, and has been explained largely by sustained weaknesses of those banks’ business model.

A fundamental element of sound business models is a state-of-the-art risk management. Risk management practices of top performers have been summarized as combining various elements, such as effective firm-wide risk identification and analysis; consistent application of valuation practices; an effective management of funding liquidity, capital and the balance sheet; and informative and responsive risk measurement and management reporting.6 Those banks that priced risk appropriately, and/or took early action to reduce high-risk positions as the crisis unfolded, performed significantly better in the crises.

A high degree of non-interest income can drive profits, but does lead to higher volatility of income. However, if risks are rightly managed, a higher portion of non-interest income should not be viewed as a critical issue of a bank’s business model per se.

Underperforming business models, an increasing appetite for risk, coupled with inadequate risk management routines, may all have played a role in numerous banks’ accumulation of significant exposure to toxic assets in their credit books during pre-crisis years.



4 Largest private banks based on Forbes Global 2000 Leading Companies list.5 “This time is the same: Using the events of 1998 to explain bank returns during the financial crisis”, Swiss Finance Institute Research Paper No. 11–19,

Fahlenbrach, R., Prilmeier, R., Stulz, R. (2011). 6 “Risk Management Lessons from the Global Banking Crisis of 2008”, Senior Supervisors Group (2009).7 “A Spanish Bank Emerges as a Winner in Global Crisis”, Spiegel Online, Scott, M. (2008).8 “The German Banking System: Lessons from the Financial Crisis”, OECD Economics Department Working Papers, No. 788, OECD Publishing, Hüfner, F. (2010).9 “The Bank Lending Channel Lessons from the Crisis”, ECB Working Paper Series No. 1335, May 2011, Gambacorta, L., Marques-Ibanez, D. (2011).10 “Why did some banks perform better during the credit crisis? A cross-country study of the impact of governance and regulation”, Charles A Dice Center Working Paper

No. 2009–12, Beltratti, A., Stulz, R. (2009).

On one hand, institutions that limited their structured credit investments emerged as winners from the crisis. Spanish Banco Santander, today Eurozone’s largest bank by market capitalization, and BBVA, benefited from low exposure to such instruments, in part due to limitations imposed by the Spanish central bank, and instead focused on growing in retail banking and in international growth markets in Latin America.7 Likewise, French banks, in general, maneuvered better through the crisis than most peers, supported by their business models focused on traditional retail and corporate clients. Somewhat in contrast to the aforementioned study results on US banks, Swedish banks for their part seem to have learnt a lesson from their banking crisis in the early 1990s, and in general were in much better shape to address the challenges of the financial crisis.

On the other hand, those institutions that were particularly affected by the crisis often revealed shortcomings in their traditional business model. A high degree of non-interest income, an increasing appetite for risk, and inadequate risk management may all have played a significant role in leading to increased earnings volatility and an exposure to higher-risk assets. Regarding investment banks, the (near-) collapse of several Wall Street players hints toward excessive risk-taking partially incentivized by a business model focused too heavily on short-term profitability and inadequate risk-management techniques in light of new and complex financial products. As a second hard-hit group, several German Landesbanken suffered massive losses in the crisis as they had accumulated a significant exposure to toxic assets in pre-crisis years. In search of a viable (and more profitable) business model, several players invested excess liquidity heavily in seemingly attractive foreign securities.8

Robust funding mix. Many of the hardest-hit institutions relied too heavily on wholesale funding and short-term money markets or securitization activity as a funding source, in many occasions for longer-term, often illiquid assets (which increasingly were faced with uncertainty over value).

The crisis has revealed that even the most liquid funding markets can break down within days, making business models relying too heavily on non-deposit funding much more risky and non-resilient to stress. As a consequence, a key focus of Basel III has been rightly placed on funding liquidity risks.

Capitalization. Financial institutions with strong core capital positions are outperforming peers with weaker positions. Recent studies during the financial crisis indicate that highly leveraged financial institutions tended to limit their lending more substantially9 but also underperformed in terms of stock market price development.10 Financial institutions with excessive leverage tended to be viewed more critically by counterparties with respect to their business model and overall solvency. Again, Basel III has identified the core capital issue as a major focus area.

In summary, we view those institutions well-positioned to face future challenges that pursue a sound and viable business model, are sufficiently capitalized and have a robust and balanced funding mix in place. The Basel III initiatives do provide regulatory guidance and create additional momentum about banks’ focus on core capital and funding liquidity risks. Meanwhile, several institutions have taken steps to re-shape their business model and adapt to a more risk-averse environment, strengthen core capital and recalibrate their funding profiles to better manage funding liquidity risk going forward.


To improve banking supervision in the European Union, the European Banking Authority (EBA) was established as of 1 January 2011 and has taken over all existing and ongoing tasks and responsibilities from the Committee of European Banking Supervisors (CEBS).

The stress tests carried out by EBA in 2010 and 2011 constitute hypothetical (what if) analyses of negative shocks to the banking sector. Both stress testing exercises were focused on credit and market risks, including a specific focus on the exposures to sovereign risk (applied to the trading book). Liquidity risks were not specifically assessed during the stress testing exercise.

One of the major points of criticism was that no sovereign default is included in the stress test. Instead of a sovereign default, there is a significant sovereign stress, which affects the price of foreign debt and the cost of funding. For most critics this is not going far enough, especially with regards to the economic situation in the PIGS countries.

Furthermore, the banking book that contains those sovereign bonds that are held until maturity is not within the scope of the additional sovereign stress.

For some critics, the applied capital definition and benchmark to pass the most recent stress test is not sufficient enough, although they are more stringent than in the 2010 stress test. Silent participations are no longer included in the capital definition, which is applied to all participants regardless of any specific national distinctions in banks’ capital definitions. This was especially criticized by some German Landesbanken.

The stress test is supposed to show a bank’s resilience against a worst-case scenario as well as increase the transparency of the institutions to investors. However, the release of the results by the EBA, on 15 July 2011, did not reassure the market and European bank shares recorded the biggest drop in 11 months. Only 8 out of 90 banks failed the stress test and fell beneath the threshold of 5% Core Tier 1 Ratio (CT1R). But the perceived positive outcome is somewhat misleading as there is still a severe need for banks to raise capital. The eight banks that failed the test alone need to raise a total amount of €2.5b to reach a 5% CT1R. Furthermore, under the adverse scenario, 33 banks are below the intended 7% CT1R and will need to raise capital to improve capital ratios as well.

Comparison of the 2010 and 2011 stress tests

2010 2011

Benchmark 6% 5%

Capitaldefinition Tier 1 capital Core Tier 1 capital

Forecast EU Commission Springforecast2010(worse) Autumnforecast2011(better)

GDP growth over stress testing period EU:−3%points EU:−4%points

Probability of occurrence of the adverse scenario Higher Lower

Stress tests



Introduction to Basel III The Basel III framework was endorsed by the G20 leaders in November 2010 in South Korea. The goal of this new set of regulations is to enhance bank and banking sector resilience to unexpected shocks and thereby promote financial stability. The combination of microprudential approaches and macroprudential measures to address procyclicality and systemic risk is a key element of Basel III. Therefore, Basel III does not replace the Basel II and Basel I frameworks. It complements the existing regulation, simplifies and strengthens areas left largely unchanged by Basel II and introduces components on a macroprudential level.

On 16 December 2010, the Basel Committee of Banking Supervision issued the Basel III rules, which represent the details of regulatory standards on an international level for financial institutions. This broad set of measures aims to:

• Improve the banking sector’s ability to absorb shocks from financial and economic stress, whatever the source might be

• Improve risk management and governance

• Strengthen banks’ transparency and disclosure11

The main thrust of the reforms involves raising the quantity as well as the quality of regulatory capital and enhancing the risk coverage of the capital framework.12 The reform package further includes a number of new instruments such as capital buffers, a leverage ratio and enhanced liquidity standards.

For the European market, the EU Commission adopted the Basel III framework as standard-setting guidelines and published a corresponding framework: Capital Requirements Directive (CRD) IV, consisting of a Directive and a Regulation replacing the current Capital Requirements Directives (2006/48 and 2006/49).

Basel III — reshaping the future landscape

11 www.bis.org12 Basel III: A global regulatory framework for more resilient banks and banking systems, BCBS (Basel Committee on Banking Supervision), December 2010.


Timeline for the new capital requirement


Basel III changes on capital requirementsThe current Basel minimum standard for bank capital of 8% of risk-weighted assets (with 4% Tier 1, equity and equivalent instruments, and 4% Tier 2, which includes subordinated debt) has remained largely unchanged since the original 1988 Basel Accord. But the crisis highlighted the need for banks to hold higher-quality capital. One of the key aspects of Basel III is the increased focus on equity with a new Common Equity Tier 1 (CET1) component that will be almost double the previous Tier 1 minimum. There will be two requirements for CET1, a floor level of 4.5% and then an additional capital conservation buffer of 2.5% bringing the total to 7%. If a bank is not able to meet the full conservation buffer, there will be limitations on pay out of earnings through dividends, share buy-backs and bonuses. A countercyclical buffer of up to 2.5% can, by national descretion, also be added in any national market that is overheating.

In addition to the higher CET1 requirements, a number of new deductions will be made from the accounting definition of capital. Examples include goodwill, deferred tax assets (DTAs) (where non- timing difference DTAs will have to be deducted and others will be subject to a limit) and intangibles. A new stricter approach to the inclusion of minority interests within consolidated capital is also being introduced.

Different elements of the current capital requirements will be phased out — this includes Tier 3 and innovative hybrid capital instruments with an incentive to redeem. The phase out period is 2013–2021.

The capital requirements for trading books are changing sharply with the introduction of stress models for market risk and counterparty risk, credit value adjustment (CVA) charges as well as large increases in requirements for exposures to large banks. Overall trading book capital requirements go up by between three and four times.

The timelines for adopting the new capital requirements are quite long — see below — and the phase out of the capital instruments will take place over an even longer period. But there are already market pressures on banks to comply. More than €500b additional capital may be needed across the European banking industry relative to end 2009 and, of this, around half has been raised to date.


From 2019201820172014 20162013 2015Until 2012

• Additional capital conservation buffer of 2.5%• Countercyclical buffer (0%-2.5%) in national discretion

T1

Total capital

CET 1

8%

4%4.5%

5.5%6% 6% 6% 6% 6%

2%

3.5%4%

4.5% 4.5% 4.5% 4.5% 4.5%

8% 8% 8%8% 8% 8% 8% 8%

2.5%1.875%

1.25%0.625%

0%-2.5%0%-2.5%

0%-2.5%0%-2.5%

Capital conservation buffer

Countercyclical buffer


Enhanced liquidity standardsThe introduction of minimum quantitative measures for bank liquidity represents a major departure from previous international prudential standards. The focus in the past has been on minimum levels of capital and Basel II represents the first internationally harmonized standard for liquidity. Under Basel III, two separate requirements will be introduced: the liquidity coverage ratio (LCR), which will require a liquid assets buffer to be held, and the Net Stable Funding Ratio (NSFR), which will limit longer-term lending unless it is fully backed by stable funding.

The LCR will prescribe a minimum level of high-quality liquid assets a bank must have at any given time. The minimum liquid assets buffer will be driven by a stress test calculation of cash inflows and outflows and must be sufficient to cover the net cash outflows over a 30-day period.

The liquid assets buffer must comprise of a proscribed set of assets:

• 60% must consist of “level 1” assets — high-quality sovereign instruments and cash

• Up to 40% can consist of “level 2” assets — a wider range of good quality liquid bonds after a haircut

The LCR is:

The NSFR is designed to provide incentives for banks to seek more stable forms of funding. It will be a monitoring tool initially but a decision will be taken in 2017 regarding its use as a minimum requirement. To meet the requirement, a bank would have to fund 100% of illiquid exposures with stable funding, unless the loan is a mortgage where the requirement would be reduced to 60% stable funding. To calculate stable funding, the liabilities of the bank would be weighted by different factors to reflect their relative stickiness.

The NSFR is:

Stock of high-quality liquid assets

Total net cash outflows over the next 30 calendar days≥100 %

Available amount of stable funding

Required amount of stable funding>100 %

Banks will have until 2015 before the introduction of the LCR and 2018 before the NSFR will be considered as a minimum requirement rather than a monitoring tool (see Figure 10). However, the capital market will impose pressure on banks to comply with these new regulations much earlier.

Liquidity timeline


European/national implementation

Bank reporting to regulators starts LCR minimum standard NSFR minimum standard

NSFR final amendments

Introduce LCR minimum standardLCR observation period

LCR final amendments2x further QIS

NSFR observation period Introduce NSFR minimum standard

Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Jan 16 Jan 17 Jan 18 Jan 19 Jan 20 Jan 21


Leverage ratioOne feature of the crisis was the excessive on- and off-balance sheet leverage in the banking system, which was not detected with the existing risk-based ratios. Therefore, the measures strengthening the quantity and quality of capital are underpinned by a leverage ratio that serves as a backstop to the risk-based capital measures. The leverage ratio is intended to constrain excess leverage in the banking system and provide an extra layer of protection against model risk and measurement error.13

The ratio will require a minimum percentage of Tier 1 to gross on- and off-balance-sheet assets. The minimum Tier 1 leverage ratio is set at 3% for the observation period. The quantitative impact study (QIS) carried out by the Basel Committee showed that many banks would not have been able to meet this requirement at the end of 2009. The higher capital buffers will make it easier but it will be a constraint when markets pick up.

13 Basel III: A global regulatory framework for more resilient banks and banking systems, BCBS (Basel Committee on Banking Supervision), December 2010.



Basel III and the strategic implications Banks are reassessing their strategies in the light of the crisis and changes to risk appetite, but also in response to the Basel III regime finalized at end 2010. The Basel III framework substantially increases the cost of different types of activity. Although the basic credit risk treatments for loans are largely unchanged (still based on Basel II) the quality of capital needed to cover the requirements and the total amount of capital required is radically changed by Basel III. There is a much greater focus on equity capital, with the phase out of other instruments as well as more deductions from accounting capital. In addition, the total size of the capital buffers is being increased. Overall, banks will need between 40% and 100% more equity capital. Other changes in Basel III also have a fundamental effect on the economics of different business units or loan portfolios. Basel III introduces liquidity requirements (which translate into the need for high, quality liquid assets buffers), which also increase costs. A further change under Basel III that will affect strategy is the introduction of a leverage ratio. Banks that are under a leverage constraint will have to consider the most profitable areas of business on which to focus.

Overall, Basel III will be a major change for the industry. The magnitude of the capital changes and the need to hold large liquid assets buffers will place considerable pressure on rate of return on equity. Many banks are already lowering their targets, and further downward revision will happen going forward. Basel III includes long timelines for implementation. However, the adjustment period is likely to be compressed because of pressure from the ratings agencies and the market to demonstrate early compliance.

Some banks will be winners and some will be left behind in the move to change business models and design an effective strategy. The changes being considered by banks are far reaching. Some have already announced that they will be leaving particular markets, many have identified portfolios that they wish to sell and others are streamlining legal entity structures to optimize use of capital. But this period of change could also give opportunities for some banks to gain a foothold in new markets — some banks will be affected more than others and not all will respond effectively to the challenges giving opportunities for takeover or merger.

Conclusion

Impact on costs Private sector estimates show that the capital and liquidity change could lead to a fall in ROE of as much as 40% if banks do not change business models. The size of the capital increases in some areas mean that banks will have to exit from some types of activity and it is almost certain that some proprietary trading will move to hedge funds.

However, widespread adjustment of balance sheets and strategies will be needed. The Basel Committee has calculated that, assuming an ROE of 15% going forward, each one percentage point increase in the capital required will require a 13 basis point increase in spreads to cover the cost, and the liquidity standard will require a 25 basis point increase in spreads to cover the cost. Overall, banks are looking at the margin on loans rising by between 1 percentage point and 2.5 percentage points. This will be achievable in some market segments but not in others. Retail customers and small companies have fewer alternative avenues for funding and an increase in margin is possible, but the same is not true of large corporates. A careful assessment of the likely profitability of each business line is needed and then a restructuring of the business to exit less profitable areas and portfolios.

Banks will have to scrutinize costs across the business and legal entity restructuring could play an important part in economizing on capital and liquidity as well as other costs. However, restructuring programs will have to weigh up carefully the different costs and benefits from a range of sources — tax, regulatory capital, liquidity requirements, regulatory intensity and business effectiveness.

Loan portfolio trading


Market activityIn the years 2008 to 2011, loan portfolio market activity in Europe was subdued. This was mainly due to the turmoil in the financial sector during these years, as high levels of uncertainty and volatility offered extraordinary returns on comparatively safe investments, such as bank bonds and hybrid capital or even sovereign bonds. A lot of trading occurred in CDOs, CLOs and called B-Notes of mortgage-backed securities (CMBS and RMBS) and therefore investing was often replaced by trading. Nevertheless, as the dust is settling, we believe that there will be a significant increase in investment market activity in the quarters and years to come.

Most European banks are quite advanced in defining their strategy for the future after the financial and debt crisis, both concerning the regional footprint as well as the focus customer groups and solutions and products. We expect that institution after institution will assess non-strategic and non-core business segments, which will be offered for sale or run down and liquidated, as well as analyze which non-performing or sub-performing assets are better held onto and worked out, or monetized through a sales transaction. This continuing strategic reassessment will create ample supply of loan portfolios and other assets to come to market. It is our expectation that the restart of the market will take place in early 2012.

From a demand side, there are a large number of newly raised private equity, opportunity, debt, mezzanine and distressed debt funds that are starting to deploy and invest their capital. As the last two years did not see a sufficient supply on the market, we expect the appetite of investors to grow quarter by quarter and provide a significant demand for loan portfolios.

As a consequence of the strategic realignment and the financial and debt crisis, European banks currently hold in excess of €1,000b of non-core loan assets. In addition, NPLs held by banks throughout Europe have grown to over €750b. This will result in financial institutions increasing the supply of non-core assets and loan portfolios over the coming years. As regulatory changes, especially Basel III, will require institutions to keep more capital against assets, it is to be expected that a large range of restructuring and sales activity will take place across the entire sector, including banking, principal investments, insurance or investment management.

Non-core loan portfoliosThe global financial and credit crisis, and the failure or nationalization of large financial institutions, put pressure on banks to focus on core lending activities and exit non-core and non-performing businesses. Despite this, transaction activity in the European loan portfolio markets has been very slow as financial institutions have focused on wider run-off or restructuring plans in place of wide-scale disposals. In general, this strategy has been applied to non-core and non-performing assets as well as non-core markets and product lines. And while this has resulted in financial institutions being ahead of plan on their NPL targets, they are facing increasing challenges with their plans for non-core but performing loans. There still remain significant barriers to investment in performing loan portfolios, primarily funding requirements and leveraging limitations, resulting in vendors being offered unattractive discounts to book value from potential investors.

Current market activityWe are seeing early market activity, such as US investment banks actively selling non-standard UK mortgage loans. Limited activity in sales of small portfolios of commercial and residential mortgages is picking up as well.

In addition, we see that European banks, which have decided to exit certain markets, are starting to offer loan portfolios to the market, such as Irish banks offering US loan portfolios, UK banks offering continental European exposure, Dutch banks offering German loans and similar assets. If these transactions prove to be realizable, we expect the market activity to pick up speed and to see Spanish banks exiting non-core and NPL portfolios as well as German banks exiting activities both domestically and abroad.

We see a large quantity of refinancing and restructuring activity in the market, both originating from balance sheet lenders, as well as CMBS and RMBS platforms. More and more banks are enforcing on non-performing real estate loans and are subsequently selling the loans or the security collateral.

Recent market developments


Pricing gapPricing has often been cited as the main barrier to loan portfolio trading, whereby a significant gap exists between buyer valuation and that required by a seller for transactions to be capital accretive or even neutral. This pricing gap is due to a combination of factors, such as:

Low yields on assets written in very competitive markets• Margins on newly originated business are significantly higher than those earned on

historical portfolios (generated before the financial crisis). In many cases, margins on historical portfolios are not even sufficiently high enough to cover operating costs and credit losses and therefore are not contributing to overall retained earnings.

Higher funding costs• Despite some recent improvements in the availability of finance (i.e., there are

some initial signs that securitization markets are returning), liquidity remains scarce and expensive for most institutions outside of central bank liquidity facilities (which themselves will need to be scaled down and removed in time).

Lack of leverage available to investors• Due in part to limited access to leverage, loan portfolio buyers often have to bid with

equity, offering a price below the value of the asset on the vendor’s balance sheet.

• Banks could offer leverage to the buyer (and this has enabled some deals to be completed); however, often this option does not, in whole, allow a vendor to reduce risk-weighted assets.

Vendor’s reluctance or inability to realize losses on sales through P&L• Vendors are often capital constrained and are unwilling or unable to crystallize loan

portfolio losses, without eroding their capital base.

If buyers and sellers can bridge this price gap, significant volumes of loan portfolio transactions could be unlocked. As described above, there are a number of triggers that will move the expectations of buyers and sellers, which will result in a larger supply coming to market, where it will meet an enormous demand for investment opportunities. As the two sides are currently moving in each other’s direction, it can only be a matter of quarters before supply and demand will meet and result in a long-lasting wave of loan portfolio transactions.

Loan portfolio trading


Although recent market activity has been restricted, there are promising signs for future activity, with the following transaction drivers expected to fuel transactions in the sector in the coming years.

Bridging the price gapTransaction activity has been minimal to date, despite a pressing need for government-funded institutions to reduce their balance sheets and the desire of independent banks to dispose of low margin lending generated during competitive pre-credit crisis markets.

The lack of disposals is largely explained by the price expectation gap, as detailed earlier in this report. We expect that this pricing gap, which we believe to be on average 10%–20%, will be bridged by both buyers and sellers lowering their pricing expectations over time, as they come under increasing pressure to respectively invest funds raised and execute disposal programs.

EU-mandated disposals Several European financial institutions have been set aggressive disposal mandates, focused on deleveraging their balance sheets. These targets were set with the aim of ensuring fair competition, with the potential effects on capital not fully considered. In order to reach their disposal targets in the timescale specified, there is a danger that financial institutions will be forced to accelerate asset sales in place of asset restructuring or run-off strategies.

Ireland has recently demonstrated the impact this can have on a bank’s capital base. We expect to see a renegotiation of these targets in the next few years, with a potential option allowing financial institutions to move these assets into a non- core area where they must either sell or run-off, but over a longer period of time.

Future market trends

Basel IIIEuropean banks are preparing for the implementation of the new Basel III rules, which will radically affect the banks’ costs of doing business. Financial institutions are being forced to reassess their strategies in response to the new capital and liquidity requirements set out in the Basel III framework. This requires the adoption of a new approach to strategic planning and optimization of strategy across capital, liquidity and leverage. In order to strengthen regulatory capital and funding positions, a greater focus will fall on optimizing portfolio structures and the development of credible strategies for non-core operations. We are already seeing banks take decisions to concentrate on core business, exiting certain markets or sectors, and this will intensify. To get the strategy right, banks will need new, more sophisticated, planning tools.

Recovering economiesOver the medium term, when economies begin to recover, banks will need to raise and generate more capital to fund the recovery. It is likely that, as this capital could be released directly from non-core assets, banks will increase their willingness to sell at a discount in order to increase their ability to focus on growth.

We also expect that the drag on earnings from legacy run-off books, driven by increased servicing costs and instability of servicing platforms, will make raising fresh capital more challenging. As bank’s turn to shareholders to raise further capital to lend in a recovering economy, banks will become more active in disposing of non-core assets in order to mitigate this risk.

Market outlookIn our opinion, we believe the loan portfolio market is beginning to gather momentum and, particularly in light of recent EU-mandated disposals and Basel III capital requirements, expect to see a significant increase in both the volume and size of transactions in the coming years.


Germany

While the outlook for the German economy was very positive until mid 2011, with an expected average GDP growth of 2% per year in the five years ahead, major economic research institutes have lowered their forecasts for GDP growth significantly as the turbulences on the global financial markets threaten to spill over to the real economy.

Contributions to GDP growth (GDP: Germany vs. rest of Eurozone)

Figure 12 | Source: Oxford Economics

▬ Germany ▬ Other Eurozone

0%

2%

4%

6% Forecast

−2%

−4%

−6%

−8%2012 2014201020082006200420022000199819961994

The German economy grew faster than the world’s other major economies last year and, with GDP growth at 3.5%, enjoyed its strongest performance since the 2000 IT boom. The main drivers behind this growth rate, despite the extreme fall in 2009, are the strong export situation and a surge in domestic demand for capital goods. In a globalized economy, Germany’s supplier countries are also profiting as imports increase at a similar pace.

Germany is reaping the benefits of the structural reforms implemented during the previous decade, which have greatly improved the competitiveness of its business sector. But the turnaround in the German economy remains surprisingly imbalanced between a buoyant business sector and a muted consumer sector.

Sustainable, strong growth in Germany requires that some of the benefits of the strong recovery are passed on to households. With rapid improvement in the labor market, one could expect wage increases to add to energy and food price pressures to push up headline inflation. However, recent pay settlements have been remarkably moderate given the strength of economic activity. In this context, we expect inflation to drop below 2% while the energy effects disappear. Furthermore, the opening up of the labor market to Eastern immigrants may relieve many of the economic tensions that could otherwise emerge in the German labor market.


Germany

The global credit crisis, which started to spill over to Germany in mid 2007, hit the German banks hard and relentlessly pointed out existing weaknesses in the German banking system. The aftermath of the financial crisis calls for changes in the German banking system, and the European Union is imposing pressure on Germany to take the necessary steps for change.

Germany’s post-war banking system relies on three pillars, namely the commercial sector, the savings bank sector and the cooperative bank sector.

Thefirstpillar includes big commercial banks, which combine retail and corporate banking business with investment banking activities, regional private banks, which often specialize in industry financing and wealth management, and foreign bank subsidiaries. Since the acquisition of Dresdner Bank by Commerzbank in 2008 and Postbank’s by Deutsche Bank, which became effective end of 2010, the three major commercial banks in Germany are Deutsche Bank, Commerzbank and UniCredit.14 These big banks account for around two-thirds of the commercial sector, while the remaining sector is quite fragmented with specialized local banks that are very often niche players. Those banks that relied heavily on wholesale funding, i.e., the pure interbank market, and those with direct exposure to the US real estate market and its related structured credit products, tended to be most affected by the financial crisis.

The second pillar comprises the public and free savings banks (Sparkassen) and the Landesbanken, which are mainly owned by the respective federal states and the savings banks. With limited regional activity and a core business in retail banking and relationship banking mainly to SMEs, the savings banks generate more than two-thirds of their profit from lending and deposit business and are thus particularly reliant on maturity transformation income. Hence, they benefited considerably in 2009 from the increasing spread between short- and long-term capital market rates, which resulted in higher margins. Savings banks were not that strongly affected by the turbulences on the financial markets because only a few invested heavily in complex financial products that turned toxic. However, as some savings banks are significant shareholders of the Landesbanken, they were indirectly affected by their exposures.

The role of the Landesbanken has notably changed from being a central institution for the savings banks and serving as main bank for the respective federal state, to operating in similar ways to private commercial banks on an international scale. Even though the approach of the Landesbanken has been traditionally more

reserved and risk averse, many of them have been affected heavily by the financial crisis through investing in the US subprime mortgage markets and other structured financial products. As investments turned toxic, many of them lost billions of euros and, as a consequence, some of them required bailouts or billion euro state guarantees.

According to Bloomberg, German banks accounted for around 7% of global write-downs on toxic structured credit securities in the period January 2007 to October 2009. Even though almost all groups of banks have been affected, the Landesbanken have been hit hardest.

The third pillar comprises the largest number of individual institutions of all three pillars. Led by their head institutions DZ BANK and WGZ Bank (Genossenschaftliche Zentralbanken), the cooperative sector comprises over 1,100 credit cooperatives, which together account for around 17% of the lending market to non-banks. The ownership shares of the credit cooperatives are mostly held by depositors and creditors. The organization of the cooperative sector is similar to the savings bank sector, with local institutes covering regions of differing sizes, and the two head institutions taking a similar role as the Landesbanken.

In addition, the statistics of Deutsche Bundesbank separately group mortgage banks, building and loan associations and special purpose banks, which come from all three pillars.

Overview of the banking sector

435

407

107

441

478

67 160

214

52Loans to non-banks

Figure 13 | Source: Deutsche Bundesbank, June 2011

600

400

500

300

200

100

0Commercial bank sector Savings bank sector Cooperative bank sector

■ Corporate loans ■ Housing loans ■ Consumer loans

€ billion


14 Formerly Bayerische Hypo- und Vereinsbank (HVB).15 Deutsche Bank, Dresdner Bank (until 2008), Commerzbank, Unicredit (formerly

Bayerische Hypo und Vereinsbank), Postbank.

Total assets of banks in Germany according to Deutsche Bundesbank

Figure 14 | Source: Deutsche Bundesbank, June 2011

* The assets of foreign branches, of money market funds (which are

also classified as MFIs) and of the Bundesbank are not included

€billionNº of reporting institutions Total assets*

Commercial banks 286 2,809.9

•Bigbanks15 4 1,858.3

•Regionalprivatebanks 169 743.7

•Branchesofforeignbanks 113 207.8

Landesbanken 10 1,362.5

Savings banks 428 1,068.5

Cooperative head institutions 2 264.9

Regional institutions of credit cooperatives 1,138 706.1

Mortgage banks 18 630.7

Building and loan associations 23 197.5

Special purpose banks 18 893.7

Total 1,923 7,933.8

Overall, the number of banks in Germany has seen a decline over the past few years; especially in the fragmented savings bank and cooperative sector where the number of institutions has reduced significantly. The consolidation process was fueled by the financial crisis and we have seen a number of prominent deals, such as the acquisition of IKB by US investor Lone Star (2008); the acquisition of Dresdner Bank by Commerzbank (2008); the acquisition of Sal. Oppenheim by Deutsche Bank (2009); the merger of DEPFA and Hypo Real Estate before the nationalization of HRE (2009); the purchase of the insolvent Düsseldorfer Hyp by Lone Star; the acquisition of the German retail operations of SEB by Banco Santander (2010) and the acquisition of a majority stake in Postbank by Deutsche Bank (2010).

The consolidation of the German banking sector continues in 2011 but at a slower pace. However, there will be further bank transactions to come as the EU has imposed certain restructuring requirements on banks such as WestLB to sell real estate bank WestImmo; Commerzbank to sell Eurohypo, which was acquired only in 2006; and several Landesbanken to dispose of non-core assets and non-strategic subsidiaries, such as the proposed sale of LBBW’s billion euro real estate portfolio.

Savings and cooperative banks still dominate the market for residential construction loans to private individuals, but in the consumer credit market, the commercial banks have taken the market leadership. The retail lending market sees increasing price sensitivity and decreasing customer loyalty with increasing but still limited competition through foreign players with lean operating models and aggressive pricing strategies.

Since the beginning of the financial crisis, the commercial banking sector has suffered from a significant loss in reputation with a shift of customers and assets to savings banks and credit cooperatives.


Germany

In addition to the Eurosystem’s extensive stabilization measures, the German Government introduced further measures to keep the German financial system operational during the financial crisis. In October 2008, the Financial Market Stabilization Fund (SoFFin) was set up, which was controlled by the Financial Market Stability Agency (FMSA16), and was equipped with funds of up to €480b (€400b for guarantees and €80b for recapitalization measures) to directly support banks to strengthen their capital base and bridge liquidity shortages.

SoFFin’s purpose was the restoration of mutual confidence among banks and the confidence of society at large and business in the financial sector. During the financial crisis, SoFFin supported numerous financial institutions with guarantees and recapitalization measures. At the end of 2010, SoFFin ceased to grant new benefits. However, it continues to assume responsibilities and control the measures’ conditionality with regard to existing stabilization measures. In addition, the funding of existing resolution agencies can be replenished. Since 2010, several banks have already reduced or repaid the funds received from SoFFin through capital market measures.

The Financial Market Stability Agency

16 The FMSA is a federal public law agency that was established in October 2008 as an instrument for resolving the financial market crisis. The FMSA reports to the Ministry of Finance. It manages the SoFFin and oversees the two German resolution agencies, EAA and FMS.

Figure 15 | Source: www.soffin.de

Instruments of SoFFin

Guarantees Guarantees by the fund up to an overall maximum of €400b for bond issues and other liabilities of financial institutions in return for a fee of 0.5% to 2%.

Recapitalization Instruments to strengthen the capital base of financial institutions through newly issued shares, silent participations or other equity instruments up to a maximum of €10b for any single financial institution. The fund obtains remuneration at market prices for deposited capital.

Assumption of risk Assumption of risk positions by the fund to obtain a balance sheet relief at the financial institution up to a maximum of €5b for any single financial institution.

In addition to the below instruments, the FSMA introduced the possibility for banks to spin-off structured securities as well as other risk positions — such as non-performing or sub-performing loans — and non-core business units into a separate resolution agency (sometimes referred to as “bad bank”), to provide balance- sheet relief for the remaining bank and to allow an organized run- off of such assets. Two institutions have seized this opportunity, namely Hypo Real Estate Group (HRE) and WestLB, and have transferred large amounts of their non-core portfolio to such resolution agencies.

These resolution agencies are public law entities, held by the same shareholders as the transferring entity. Due to the loss compensation and liquidity guarantee by its shareholders, both resolution agencies have top ratings from all three rating agencies, allowing the resolution agencies to refinance at the capital market at favorable conditions. The resolution agencies do not hold a banking license because their focus is solely on the run-off of the existing portfolios. They have hired highly skilled workout specialists, who are working out the portfolios by standardized resolution strategies “hold,” “restructure” and “sell.”


FMS Wertmanagement was established in 2010 and has acquired risk positions and non-strategic business units with a total nominal amount of €174.3b18 (€60b loans and €114.3b bonds) from HRE Group:

Portfolio overview

Figure 17 | Source: www.fms-wm.de18 As at 31 December 2010.

50%

11%

4%25%

10%

15.9%

32.7%

27.5%

20.2%

52.8%

25.2%

■ Real estate■ Real estate workout■ Public sector ■ Infrastructure■ Structured products

■ USA■ Italy■ UK■ Germany■ PIGS■ Other

Erste Abwicklungsanstalt (EAA) was established in 2009 with the task to wind up WestLB’s risk exposures and non- strategic businesses or assets originally with a total (nominal) volume of ca. €77.3b:17

Portfolio overview

Figure 16 | Source: www.aa1.de17 As per December 2009 — reduction from originally €85b in June 2009.

39.6% Loans Structured and project financing, non-strategic international syndicated and bilateral loans (e.g., shipping, aviation, hospitality, banking, leasing, leveraged finance)

29.5% Phoenix Refinancing notes

22.9% Other securities Government and municipal bonds as well as debentures and bank bonds with good credit rating

4.4% Other ABS Securitizations

3.6% European Super Senior Super senior tranches of securitizations

29.5%

39.6%

22.9%

4.4%3.6%


Germany

As a direct reaction to the global financial crisis, new regulations for the financial services sector have been put in place to avoid future crisis with such large-scale effects on the financial system and to strengthen the resilience of the financial system to systemic shocks. In November 2010, the G20 leaders have endorsed the new regulatory framework — Basel III — on capital and liquidity requirements. Setting standards for the EU, the EU Commission adopted a legislative package to strengthen the regulation of the banking sector in July 2011. The Directive and the Regulation replace the current Capital Requirements Directives (CRD), entailing more conservative capital requirements, higher requirements on risk and liquidity management and harmonized reporting requirements.

At present, German regulatory supervision is focusing on Basel III/ CRD activities, establishing new capital requirements and capital ratios, capital buffers, leverage ratio, higher-risk weights for selected exposures and central counterparties, increased reporting requirements, a harmonized liquidity framework and further risk management requirements. Deutsche Bundesbank expects an additional capital demand of approx. €50b until the end of 2018 due to the new regulations. Large internationally active and systemically relevant banking institutions will require the biggest share of such additional capital demand.

New requirements on OTC and other derivatives have been put in place in the US (Dodd-Frank Act), having impact on internationally active German banking institutions. In the EU, a similar Directive — the European Market Infrastructure Regulation (EMIR) — is expected to be adopted for 2011. The impact of these new regulations on German banking institutions depends on its respective derivatives portfolio and its activities on foreign (US) markets.

The failure of large international banking institutions, such as Lehman Brothers, exposed the far-reaching effects of a collapse of system-relevant banks to the global financial system. With the bank levy (Bankenabgabe) and expected living wills requirements, new regulations have been developed to allow a restructuring or an orderly liquidation of troubled institutions and hence to limit spill-over effects to the banking system.

Overall, increasing regulatory constraints as well as governance, transparency and reporting requirements for financial institutions are expected to lead to a more competitive environment within German banking institutions.

Regulatory aspects

Capital. The implementation of the requirements of CRD II in 2010 results in substantial changes to the German Banking Act (KWG) with regard to hybrid capital instruments, securitization instruments and the definition of borrower units. Furthermore, the changes were made to the German Solvency Regulation (SolvV) with regard to securitization instruments, increased trading book exposure and reporting requirements; and to the German Large Exposure Regulation (GroMiKV) with regard to credit risk mitigation techniques, reporting requirements and fund exposures. CRD III, also implemented in 2010, addresses trading book risks and introduces further capital requirements — stressed value-at-risk (VaR) and incremental risk charge (IRC) — as well as higher reporting requirement for such assets. With the new CRD IV framework, the Basel III framework is being transposed into EU regulation. The definition of own funds will be changed dramatically, increased risk-weighted assets and higher requirements for capital ratios will lead to increasing competition for capital instruments. The new introduced leverage ratio is expected to embank leverage on the balance sheets.

Liquidity. Liquidity requirements in Germany had already been in place through the Liquidity Regulation (LiqV), which required a liquidity ratio of larger than one, calculated as the one-month ratio of receivables and liabilities. With Basel III, this will be changed dramatically and banks are expected to increase their holdings of liquid assets, especially with regard to government bonds.

Risk management. The Pillar 2 requirements in Germany are transformed into the Minimum Requirements on Risk Management (MaRisk). Changes to the MaRisk have been made in December 2010 as a result of international developments: e.g., the European Banking Authority has published the CEBS Guideline on Stress Testing (26 August 2010) and the High Level Principles for Risk Management (16 February 2010). Furthermore, increased reporting requirements have been put in place as a result of the ongoing supervision of BaFin and Bundesbank, which increase the importance of a sound risk management, especially of economic capital management.



Germany

The last major recession, the global economic downturn following the collapse of the IT bubble in 2001, resulted in a steep increase in corporate and private insolvencies in Germany. At the same time, the housing market in Eastern Germany collapsed, leading to a peak in default rates for mortgage loans.

As a consequence, banks experienced a surge in NPLs and especially credit cooperatives and mortgage banks saw an immediate need to resolve their NPL problem. By disposing of their NPLs, German banks were able to reduce their non-performing mortgage loans substantially and clean their balance sheets.

From 2003 to mid-2008 Germany was the most active NPL market in the world, with over 60 major portfolio transactions and a total volume in excess of €50b of face value. The market was fueled by large amounts of liquidity and strong demand for German NPLs mainly from international investors, which had come over from Asia, where the big NPL markets were maturing.

Loan market

The German Financial Supervisory Agency BaFin has historically defined the term NPL in their statistics as the gross exposure of impaired loans. In 2009, this definition was changed and has been aligned with international definitions of NPL — it now includes overdue loans not yet impaired. Hence, BaFin reports a steep increase in NPLs to €204b in 2009.

In our 2008 European NPL Report, we estimated the German NPL market at €200b, including problem loans not covered by the BaFin definition. Given the effects of the financial crisis on the banking sector and the economy as a whole, we believe that the German NPL market has grown to around €250b.

In addition, we estimate the magnitude of performing loan portfolios, which have been deemed non-core by their current holders, at €500b, bringing the magnitude of the German loan portfolio market to a total of around €750b.

During the global credit crisis, the NPL market in Germany froze and close to no loan portfolio transactions were noted. Many investors were caught by the turmoil in the financial markets themselves and sellers were concentrating on surviving and keeping their banks operating.

Now the dust has settled and we see investors’ interest in German loan portfolios returning. At the same time, the volume of NPLs on banks’ balance sheets have increased as a result of the economic downturn and large volumes of non-core loans have been identified as a result of the banks’ restructuring efforts in the wake of the financial crisis.

However, no material loan portfolios have traded in Germany and banks are still reluctant to bring portfolios to the market. The preparation and planning of NPL portfolio transactions are rather time and cost intensive for the selling institutions. Consequently, as long as no breakthrough transaction occurs — which can persuade other potential sellers that the market is back — we expect the market to remain subdued for another two to three quarters. As in other markets, the main reason for transactions to fail, or not even to get offered in the market, is the expected or perceived large gap between bid prices and banks’ price expectations. Since the beginning of this year, we have seen transaction activity slightly increasing — although very quietly — with smaller

portfolios being traded via electronic platforms as well as a few larger transactions. These larger transactions have not yet been the breakthrough transaction in the German market as they all had rather specific backgrounds that relate to the respective transaction parties. There were purchases of three NPL portfolios by Colony Capital from IKB, Shinsei and BAG Hamm; Apollo’s acquisition of a €2.8b European NPL portfolio from Credit Suisse; and the recent acquisition of a €370m syndicated CRE portfolio by Colony Capital. These recent transactions have received much attention in the market and can be considered the overture to the starting point of a NPL 2.0 wave in Germany.

195

.7

215

.7

226

.9

210

.6

190

.3

157

.7

135

.5

141

.7

204

.0

210

.0(e

stim

ate)

250

.0(e

stim

ate)

NPL market potential

Figure 18 | Source: BaFin; Deutsche Bundesbank; IMF

250

200

150

100

50

0

2%

1%0%

4%

3%

6%

5%

8%

7%

10%

9%

2009 2010 201120082007200620052004200320022001

€ billion

■ NPL volume ▬ NPL ratio

4.6%5.0% 4.9%

4.0%3.4%

2.6% 2.8%3.3%

5.2%

Ernst & Young European Non-Performing Loan Report 2011 37Ernst & Young European Non-Performing Loan Report 201136 Ernst&Young European Non-Performing Loan Report 2011 37

As discussed, we expect a large NPL 2.0 wave of transactions that could start as early as the beginning of 2012. We expect that NPL 2.0 will surpass the nominal €50b traded in Germany during the years 2003 until 2007 by a number of magnitudes. We expect the following sources of transactions:

Foreign banks active in the German market. The partly politically motivated strategic shift of UK, US and other foreign banks toward their home markets, and decisions to pull back from foreign markets, will result in the sale or wind down of their German loan exposures. We expect those banks to be among the first to offer large German loan portfolios on the market.

CMBS/RMBS Special Purpose Vehicles. There are more than €25b in securitized loans (CMBS/RMBS) related to the German market, many of which are either sub-performing or non-performing, or will face performance issues during their fixed lifetime. There is already a high number of loans in restructuring and one restructuring strategy can be a sale of the loans. We expect the number of transaction opportunities resulting from non-performing CMBS/RMBS to increase quickly, as the number of loans in special servicing is accelerating from quarter to quarter.

Commercial banks and real estate banks. The new Basel III regulations impose pressure on banks to reassess their strategies across capital, liquidity and leverage. Banks will concentrate on core business, exiting certain markets or sectors — we expect an increasing number of transactions in this market. As most of the commercial and mortgage banks have not fully agreed on the details of their future strategic footprint, we expect it to take at least until mid-2012 before we will see significant disposals of non-core or non-performing assets by this group of banks.

Landesbanken. The EU has imposed pressure on Landesbanken to reduce their balance sheet and to dispose of non-core assets. We expect Landesbanken to exit and dispose of exposure in certain international markets or certain sectors (shipping, aviation, etc.) in the near future. We also expect to see NPL portfolios to come to the market, as the Landesbanken are not only under pressure from the EU, but just as much from their shareholders, who expect the return to profitability as quickly as possible. Therefore, they should also be among the early seller groups.

Savings banks. Due to their role in the German retail market, savings banks have not been an active seller in the last NPL wave and are not expected to bring major portfolios to the market this time.

Resolution agencies. Whereas resolution agencies in theory could be the natural born sellers of non-core and non-performing assets, we expect sales activities to remain subdued for a prolonged period of time. The setup of FMS and EAA as triple and double A-rated “non-banks” with extremely low cost of capital and a resolution time horizon of 15 to 20 years, give incentives toward “hold and workout” strategies, rather than quick disposals. Unless there are assets where the resolutions agencies’ management decides that earlier is a better time than later to dispose of certain specific or opportunistic assets, we do not expect significant disposals in the short term. As, in the end, the German taxpayer will have to cover any losses from the wind-down, we don’t expect the resolutions agencies to sell portfolios at a discount in the short to medium term. These agencies have hired top work-out specialists who are successfully running down the books, and there is currently no urgency to sell in the absence of Basel III and other regulatory pressure.

Outlook


United Kingdom

The United Kingdom is the sixth largest economy in the world and the third largest in Europe (after Germany and France). Prior to the global financial crisis in 2008, the UK experienced a prolonged period of growth since its last recession in 1991, driven by booming financial and property markets. The global financial crisis had a significant effect on the UK economy leading to the UK being the last of the major global economies to emerge from recession in the final quarter of 2009.

For over a decade, the UK had been one of the strongest EU economies and recorded 60 consecutive quarters of growth from the fourth quarter of 1992 to the third quarter of 2008. This growth was driven by a rapidly expanding financial sector that, in conjunction with lax lending, fueled an unstable property bubble. The onset of the financial crisis hit the UK particularly hard, beginning with the collapse of Northern Rock in September 2007 and the initial £37b part nationalization of The Royal Bank of Scotland (RBS) and Lloyds Banking Group (LBG) in October 2008.

Although the UK exited recession in the final quarter of 2009, its recovery is delicately poised, with the expectations of forecast GDP growth reduced to 1.1% in 2011, remaining sub-par next year at 1.8%, but accelerating to 2.3% in 2013. Despite £200b of quantitative easing by the Bank of England to date, the financial sector remains vulnerable and not in a position to support the recovery, forcing the UK Government to stake its reputation on restoring the public finances to balance the economy. However, with austerity measures now being implemented, this leaves the economic recovery totally dependent on exports and business spending, which are now threatened by developments in the Eurozone. Provided the problems facing the global economy can be resolved, the outlook for UK exports and investment remains encouraging, with business spending forecast to grow by 7.6% this year and 12.1% in 2012.

2,23

0.8

Real GDP and real GDP growth rates

Figure 19 | Source: Global Insight

2,500

2,000

1,500

1,000

500

0

−10%

−15%

−5%

0%

5%

10%

15%

2004 20152014201320122011201020092008200720062005

3,000

US$ billion

■ Real GDP (US$) ▬ Real GDP growth rate, year-on-year

2,27

9.3

2,34

2.9

2,40

5.8

2,40

4.2

2,28

7.0

2,31

8.0

2,34

2.5

2,38

4.3

2,43

8.3

2,50

0.0

2,56

8.2

3.0% 2.2% 2.8% 2.7%

−0.1%1.4% 1.1% 1.8% 2.3% 2.5% 2.7%

−4.9%


United Kingdom

The severity of the financial crisis has led to substantial changes in the UK banking landscape leading to the disappearance of some players and the restructuring of others.

The first victim of tighter capital markets was Northern Rock, which after receiving emergency liquidity support from the Bank of England in September 2007, was eventually taken into state ownership in February 2008, following two unsuccessful bids to take over the bank. As the crisis unfolded in July 2008, Banco Santander agreed to acquire Alliance & Leicester, who also relied heavily on wholesale lending markets. This was closely followed by the nationalization of the Bradford & Bingley in September 2008 by the UK Government, with the simultaneous sale of the deposits and branch network to Banco Santander, putting the mortgage lending book into run-off. These events culminated in October 2008, when Lloyds TSB announced its acquisition of HBOS and the UK Government had to inject a total of £37b into the newly formed Lloyds Banking Group (£17b) and RBS (£20b), as a result acquiring initial 40% and 58% stakes, respectively.

As a result of the nationalization of Northern Rock, the bank was separated into two entities: a “good bank” that still underwrites loans and accepts deposits (currently the subject of a sale process), and a “bad bank” Northern Rock Asset Management that was put into run-off, and which holds largely NPLs. Northern Rock Asset Management, together with Bradford & Bingley, is currently held by UK Asset Resolution Ltd, a subsidiary of UK Financial Investments Limited (UKFI), which was set up by HM Treasury in November 2008 to manage its shareholdings in banks subscribing to its recapitalization fund.

The aftermath of these events was a reduced number of market participants, who adopted more stringent and conservative lending criteria, resulting in a substantial reduction of lending levels. The UK banking sector has emerged from the crisis with a reduced number of lenders, heavily reliant on state aid and with a substantial reduction of new business written.

The emergence of new entrants, such as Virgin Money, Metro Bank, Aldermore, Whiteaway Waidlaw and Walton & Co. has been as a direct consequence of this reduction in competition. The UK Government will be looking to the imminent sale of Northern Rock and LBG’s Project Verde to do more to foster competition in the UK market.


6,79

05,

311

6,98

1

7,12

45,

527

Total banking assets

Total loans

Figure 20 | Source: Bank of England

Figure 21 | Source: Bank of England

8,000

8,000

6,000

6,000

4,000

4,000

2,000

2,000

0

0

0%

0%

1%

1%

2%

2%

3%

3%

4%

4%

Dec 09

Dec 09

Jun 11

Jun 11

Dec 10

Dec 10

£ billion

£ billion

2.8%

2.0%

3.3%

0.8%

■ Total banking assets ▬ Growth rate

■ Total loans ▬ Growth rate

5,48

6


In September 2011, the UK Independent Commission on Banking (ICB) published its final report that sets out recommendations on regulatory changes in the UK banking sector. The new rules would force banks to boost their capital and separate their core retail operations from riskier trading and investment banking activities. The main objectives of the regulatory changes are to ensure that:

• Banks’ resilience to market fluctuations is improved by having a greater loss absorption capacity

• It is less costly and easier to bail-out banks that are experiencing financial difficulties

• Excessive risk-taking is discouraged

• Retail depositors are protected from banks‘ failures

• Competition among banks is encouraged, affording more choice to consumer

Although the ICB in principle favors a separation of retail and investment banking, banks will be allowed to continue to operate a universal banking model as currently used by HSBC, Barclays and RBS, as long as retail operations are ring-fenced. The final recommendations afforded banks one concession by allowing them to keep their corporate lending activities inside the ring-fenced retail operations and by responding to bank concerns around a “one-size-fits-all” ring-fence by allowing a degree of flexibility in what banks can place in the new entity. Retail and SME deposit taking and overdraft provision are the only strictly mandated services that have to be in the ring-fence, while most investment banking activities are prohibited from being in the ring-fence. That leaves significant retail, commercial and corporate operations (including lending, trade finance, project finance) at the banks’ discretion regarding inclusion. The deadline for implementing the reforms is 2019 and the Financial Times estimated that the costs of compliance is likely to reach between £4b and £7b.

Regulatory aspects


United Kingdom

• EU remedy program for banks that have received state aid and consequently are required to reduce the size of their operations due to competition concerns. RBS and LBG have already commenced their non-core assets disposal programs.

• There are a number of other banks who have not been required to restructure but which are undergoing strategic reviews aimed at raising returns on equity over the medium term.

• An anticipated impact of Basel III may encourage banks to sell assets that are more capital intensive.

• After raising capital for emergency stabilization purposes, and then to comply with increasing regulatory capital demands, banks will at some point have to raise capital to provide credit to a recovering economy (albeit unfortunately not a short-term concern). To attract capital, they will seek to provide a compelling argument around how legacy non-core loan books will not act as a drag on the returns expected on this additional capital.

• The recent emergence, albeit at a limited level, of third-party debt for portfolio acquisitions will help to bridge the funding gap that has subdued portfolio trading activity in many sectors.

• Pressure on margins arising from the low profitability of historic loan portfolios originated in 2006–2007 will lead to banks selling assets that do not meet their targeted return requirements.

The recent financial crisis and the failure or nationalization of large financial institutions has put pressure on banks to focus on core lending activities and exit non-core and non-performing businesses. Despite this, transaction activity in the UK loan portfolio market has been very subdued, as financial institutions have focused on wider run-off or restructuring plans in place of disposals. However, in many cases, the decision has been taken because the price on offer in the market was unattractive. As the value gap between run-off versus sale narrows, we expect activity to increase.

Over the last 18 months, there has been a number of publicly announced loan portfolio transactions in the UK.

The financial crisis and more stringent regulatory environment have created a significant portfolio of non-core loans in the UK banking system. It is a different scenario to traditional NPL markets we have seen emerge in the past, which will be resolved through numerous mechanisms, including loan portfolio sales. Key drivers have, and will continue to be:

Loan market


Recent transactions


Date Target snapshot Seller Buyer Portfoliosize(£million)

Sep 11 Loanportfolio(pendingcompletion) Bank of Ireland Kennedy Wilson 1.500

Jul 11 Commercial real estate loan portfolio RBS Group Blackstone 1.400

Apr 11 Credit card loan portfolio MBNAEuropeBank(BankofAmerica) Barclays Group 130

Mar 11 Creditcardportfolio(pendingcompletion) EggBanking(Citigroup) Barclays Group 1.800

Jan 11 SinglecorporateloanofMaximScheme LBG Cerberus Capital Management 95

Jul 10 Retail portfolio LBG Legal & General 150

Oct 10 Mezzanine loan portfolio RBS Group Various hedge funds 220

Sep 10 Commercial real estate loan portfolio Unknown Westcore Europe 85

Aug 10 Leveragedfinanceloanportfolio RBS Group Intermediate Capital Group 1.164

Apr 10 PL/NPLmortgageloans:US$1bloanportfolioandUS$11bsecuritizations Ally(formerlyGMAC) Fortress Investment Group 7.800

The non-bank lending sector has been the most active source of NPL transaction activity over the last two years. GMAC RFC was a major seller in the market until it was acquired by Fortress in April 2010; Credit Suisse has disposed of the majority of its mortgage exposures (performing and non-performing) over the course of 2010; and other investment banks have offered portfolios to the market but have not accepted the bids due to low prices. We see this area of sale activity reducing going forward.

Following the publication of the Financial Measures Program in March 2011, some Irish banks, e.g., Allied Irish Bank and Bank of Ireland, have announced their intention to sell or run-off portfolios of UK assets. There are numerous other non-UK banks and lending institutions that closed to new business over the past number of years but they have, to date, largely elected to run-off their legacy portfolios rather than sell them.

Several investors have reviewed assets at banks and other lending institutions that are in administration. However, very little has been sold due largely to the large gap between the cost of capital of investors and the underlying creditor groups behind these administration situations.

44

United Kingdom

Of the UK lenders RBS has been the quickest to come to market with its disposal program selling leveraged finance portfolio and mezzanine loan books of a total value in excess of £1b in the second half of 2010. In July 2011 it sold £1.4b of commercial real estate to Blackstone at a 30% discount.

LBG has announced two loan disposal transactions in the UK in the last 12 months.

Otherwise, UK banks and building societies have been slow to take loan portfolios to market. We attribute this limited activity to the following factors:

• A persistent pricing gap, which has in turn been caused by:

• A scarcity of capital causing potential vendors to have limited room to accept further losses on the sale of loan portfolios

• Tight margins on legacy books, often rendering them unprofitable on current market cost of funds

• A lack of funding capacity available to buyers to leverage their returns

• There is a view that the level and quality of data available on many loan portfolios would have significant pricing implications or would add to overall transaction costs.

• Banks have invested heavily to build up their internal work-out units.

• At the smaller end of the market, a number of servicing companies have emerged providing a long-term third-party run-off option for banks.

Outlook

Notwithstanding the various limiting factors that have constrained activity to date, we do expect the volume of portfolio sale activity to increase over the next two to three years.

Transaction activity has been minimal to date, despite a pressing need for government-funded institutions to reduce their balance sheets and the desire of independent banks to dispose of low- margin lending generated during competitive pre-global credit crisis markets.

From our discussions with many vendors, a reduction in gross assets is often the paramount objective in their non-core loan strategies. As the focus on capital, rather than balance sheet size, becomes a more prominent strategic driver, we see this also becoming the increasing focus for non-core loan strategies.

We envisage a shift in the relative importance of these triggers away from mandated restructuring toward a capital strategy. As banking sector profits recover, banks will need to raise and generate more capital to fund the recovery. It is likely that, as this capital could be released directly from non-core assets, banks will increase their willingness to sell at a discount in order to increase their ability to focus on growth.

We also expect that the drag on earnings from legacy run- off books, driven by increased servicing costs and instability of servicing platforms, will make raising fresh capital more challenging. As bank’s turn to shareholders to raise further capital to lend in a recovering economy, banks will become more active in disposing of non-core assets in order to mitigate this risk.

Interest rates are finally expected to rise over the short to medium term. We have seen evidence of the sensitivity of borrowers to rate rises and would expect that this will put renewed pressure on impairment levels.

From our conversations with a number of investors, we can see an increasing tendency to consider teaming up to bid for non-core portfolios. NPL buyers are seeking to team with buyers of performing loans in recognition that vendors are often very focused on balance sheet reduction and selling performing loans, as well as non-performing, is the leading way of making a significant impact. We also expect a greater incidence of financial investors partnering with lending institutions (as well as servicers) to make portfolio purchases and extract more out of the book than a pure run-off.

Specialist alternative investment firms have been traditional major buyers of NPL portfolios, which is a trend that is set to continue. We also see investment firms that are new to loan portfolio acquisitions creating transaction capabilities to enable them to take advantage of the opportunity created. The firms’ appetites vary vastly depending on the nature of the underlying assets. In addition, smaller lenders and new market entrants into the banking market have been expressing interest in specific potential acquisition opportunities that will allow them to grow in a particular market segment. A selected number of debt collectors have also been looking to benefit from the current market condition and actively seeking out specific consumer asset-backed NPL books.

In our opinion, we believe the loan portfolio market is beginning to gather momentum, and particularly in light of recent EU-mandated disposals and Basel III capital requirements, expect to see an increase in both the volume and size of transactions in the next few years.


Ireland

Once described as the Celtic Tiger due to its unprecedented growth up until the global financial crisis in 2008, Ireland was the first Eurozone member to enter into recession. The crash in the property market and construction industry, along with recent concerns over its sovereign debt, has left the Irish economy in a precarious state.

Between 2000 and 2008, the Irish economy grew significantly, driven by a boom in its construction industry and rising domestic demand. The global financial crisis had a severe effect on the Irish economy, resulting in a respective 3% and 7% decline in GDP in 2008 and 2009 and a 0.4% decline in 2010.

In response to the financial crisis, Ireland injected close to €50b into the financial system to prop up the banking and property markets and ease the impact of construction and developer loan defaults. With borrowing costs pushed to record levels, the Irish Government was forced to agree a €85b bailout rescue package with the IMF in November 2010. Although the Irish economy returned to growth, with GDP increasing by 0.6% in the first quarter of 2011, GNP decreased by 4.3% over the same period.

190.

2



250

200

150

100

50

0

−10%

−15%

−5%

0%

5%

10%

15%

2004 20152014201320122011201020092008200720062005

300

US$ billion


201.

7

203.

5

214.

0

207.

6

193.

1

192.

2

193.

5

197.

0

201.

5

206.

8

213.

4

4.6%6.0%

0.9%

5.2%

−3.0%

−0.4%0.6%

1.9% 2.2% 2.6% 3.2%

−7.0%


In September 2008, the Irish Government guaranteed the covered liabilities of all Irish banks to ensure the survival of the Irish banking system following the collapse of Lehman Brothers and the subsequent freezing of global wholesale capital markets.

In January 2009, Anglo Irish Bank (Anglo) was nationalized by the Irish Government due to its continuing weak funding position and questions pertaining to the Chairman’s personal loans with the bank and the reporting of deposit transactions (totaling €7.5b) between Anglo and Irish Life and Permanent (IL&P). In February 2009, the Government decided to recapitalize Allied Irish Bank (AIB) and Bank of Ireland (BOI) to the tune of €3.5b each for a 25% stake, as the economic conditions continued to deteriorate and the funding markets remained closed to the Irish banks.

As part of the conditions outlined in the budget in April 2009, the National Asset Management Agency (NAMA) was established as a mechanism to take the non-performing property loans off the balance sheet of the Irish banks and therefore cleansing their balance sheet to enable them to provide much needed credit into a contracting economy. NAMA has currently received between €70b to €80b of property assets from the Irish banks at an average haircut of 60%. NAMA will look to work these loans out on behalf of the taxpayer over the next 10 years.


Following the announcement in March 2010 of the prices paid by NAMA for the first tranche of property loans, the following capital injections were made by the Government. Anglo was recapitalized to the tune of €10.4b. Irish Nationwide Building Society (INBS) was recapitalized with €2.7b and nationalized through the provision of a special share to the Government. In May 2010, Educational Building Society (EBS) was also provided with additional capital requirements and given some time to secure outside investment to address these needs. Throughout the summer months the performance of the economy deteriorated and subsequently the impairment losses at the Irish banks continued to rise.

In September 2010, AIB was nationalized through the Government increasing its shareholding in the bank as management recognized they were not able to raise funds in the private marketplace. Taking into account the deteriorating performance of the Irish banks and the impact of the sovereign debt crisis on the debt markets, the Government was finding it increasingly difficult to raise money in the bond market to fund the budget deficit. As this situation continued to deteriorate further, the Government agreed a bailout package with the IMF/EU for €80b, €35b of which was earmarked to recapitalize the Irish banking sector.

Ireland

Notional loan balances as at December 2010

140

5.6

1.72.033.9

15.90.8

29.7

3.5 2.00.50.1

2.6

17.1

40.0

31.0

59.9

40.1

20.4

5.4120

100

80

60

40

20

0

€ billion

BOI EBS Anglo INBSAIB ILP

■ CRE loans

■ Corporate loans

■ Consumer and other loans

■ Residential mortgages

Figure 24 | Source: Central Bank of Ireland — The Financial Measures Programme Report


Regulatory aspects

The recent financial crisis has had a profound impact on the banking system and the regulatory environment. Since his appointment in October 2009, the new regulator Matthew Elderfield has been working hard to increase the resources at his disposal to bolster his team’s enforcement capabilities. The regulator has also been incorporated into the CBI structure under the authority of the governor of the CBI. The new regulator’s main area of focus is to replace the existing bank boards and to increase the enforcement capacity of the regulator.

Liquidity. From a liquidity perspective, the Irish banks have been heavily reliant on the ECB for funding. At 30 June 2011, the ECB has provided €103b in short-term liquidity funding to the Irish banking sector. As part of the bailout program, the Irish banks are required to deleverage €70b worth of assets to ensure they achieve a loan-to-deposit ratio of 122.5% by 2013.

Capital requirements. As a consequence of applying conservative assumptions based on the stress test work performed by Black-Rock Solutions, Irish banks were required to raise a significant amount of additional capital to cover their projected losses. The minimum amount of capital the banks were required to raise was a total of €18.7b to ensure they achieve Core Tier 1 targets of 10.5% in the base case and 6% in the stress case scenario.

In addition to these capital requirements, the CBI has added a further capital “buffer” of €5.3b.

Operating activity. The banks have had their ability to collect residential mortgage debt impacted by government forbearance policies, which require banks not to commence legal action until a year after a customer has fallen into arrears on their mortgage. The Government has set the bank’s targets on SME lending, but they are struggling to achieve these targets.

Deleveraging. In response to the stress test results, the Irish banks are required to identify core and non-core assets in order to dispose or run-off non-core assets and achieve a target loan- to-deposit ratio of 122.5%.

Consequently, banks have been undertaking a lot of detailed work to split their balance sheets between core and non-core assets. It should be noted that the Irish banks have already transferred €71.4b of commercial property assets to NAMA.

This was followed by the collapse of the Government and a general election was held in March 2011. A new government was formed between Fine Gael and Labor. On 31 March 2011, the Central Bank of Ireland (CBI) announced the results of the stress tests on the Irish banks performed by BlackRock Solutions. The results of the stress tests identified that the Irish banks required an additional €24b in capital under a stressed scenario. The new government also announced their plan to create two pillar banks, which involved EBS being merged with AIB to form one pillar and BOI to be the other stand-alone pillar. Anglo and INBS were merged together and put into run-off. In July 2011, the Government injected €2.3b into IL&P, effectively nationalizing that institution.

Also, in July 2011, BOI raised capital from a group of institutional investors, securing its independence.


Ireland

The majority of loan portfolio transactions that have taken place in the Irish market relate to the €71.4b of assets transferred to NAMA from all the Irish guaranteed institutions. As the banks commenced their deleveraging plans, the transactions below have taken place:

Loan market

Recent loan portfolio transactions

Figure 25 | Source: Press and restructuring of Irish banking system

Institution Transaction Size Buyer

AIB Sale of Bank Zachodni WBK SA €3.1b Banco Santander SA

AIB Sold22.4%stakeinM&T(USretailBank) €2.6b Banco Santander SA

BOI Sale of BOI asset management €57mState Street Global advisors

BOI Sale BOI Security Services €60m Northern Trust Ltd

BOI Sale of 50% in Paul Capital Investments LLC n/a Management Team

Anglo/INBS Merger initiated by Irish Government

AIB/EBS Merger initiated by Irish Government

At the time of writing, a number of loan portfolio transactions involving the overseas assets of Irish banks were taking place.


The outlook for the Irish economy is weak in the next few years as the Government implements the austerity measures as agreed with the Troika. The slowdown in the global economy will have a negative impact on the Irish economy given the reliance on the export market. Consumer demand will remain weak as households manage with decreasing disposable income and increased unemployment.

There has been a limited number of loan sale transactions in Ireland since the beginning of the financial crisis. However, all Irish banks are currently looking to dispose of non-core assets as they execute their deleveraging strategies. At the time of the report, there is significant interest in the assets of the Irish banks notably from international private equity investors and trade buyers but the concern over the future performance of the loan portfolios and current valuations has ensured a depressed level of activity.

The Government will implement their banking strategy and then aim to sell their stakes to foreign owners if possible. Hence, we expect the trends over the next two years to be that of increased transaction activity as the Irish banks execute their deleveraging strategies. With regard to various loan books, they will either be run-off or sold to prospective buyers.

Outlook


Spain

Spain experienced strong economic growth from 2000 to 2007, mainly driven by a booming construction industry as well as increased tourism. The economic crisis had significant impact on the Spanish financial system as well as the economy as a whole, resulting in a steep decline in GDP and a surge in the unemployment rate to as high as 21%, the highest in Europe.

Spain has recently started to recover and expects a GDP growth of around 0.7% in 2011 and in 2012. However, the economic landscape remains fragile, with a rapid turnaround unlikely amid ongoing fiscal tightening, together with deleveraging in the private sector. Spain made good progress with its fiscal consolidation last year, cutting the budget deficit by 1.9 percentage points to 9.2% of GDP. Even more aggressive tightening is planned for 2011. Nevertheless, such achievements are threatened by political uncertainty, the surfacing of more deficits from local governments and slow progress with reforms. The economic outlook for Spain is still behind expectations by the EU and deteriorating financial conditions could further add to pressure on sovereign and bank funding costs.

1,08

9.7



1,000

800

600

400

200

0

−3%

−2%

−4%

−1%

0%

1%

2%

3%

4%

2004 20152014201320122011201020092008200720062005

1,200

1,400

US$ billion


1,12

9.1

1,17

4.5

1,21

6.4

1,22

6.9

1,17

9.5

1,18

7.6

1,19

5.4

1,20

7.4

1,22

6.1

1,25

2.3

3.3%

4.0%3.6% 3.6%

0.9%

−3,7%

−0.1%

0.7% 0.7%1.0%

1.6%2.1%

1,18

1.3


After almost a decade of unprecedented growth, driven by a housing market boom and European interest rates geared toward the slower growing core nations of Germany and France, the Spanish banking sector has been hit by the economic crisis. Due to the traditional retail banking model, the financial crisis had a very limited effect on most financial institutions, but impacted liquidity due to global problems in the wholesale funding markets.

The economic crisis also had a significant impact on impaired asset quality, leading to further problems in the wholesale funding markets and structural imbalances in the Spanish financial system. This in turn has led to a sovereign debt crisis caused by an increasing lack of confidence in public finances, despite austerity measures having been implemented, and led to a substantial increase in funding costs and access to wholesale funding markets.

Confidence in the Spanish banking system has improved over the past few months, in part due to the major restructuring process under way to consolidate Spain’s numerous cajas, which has been aided by the introduction of the Fund for Orderly Restructuring of the Banking Sector (FROB) in 2009. These new initiatives are likely to have an increasingly active role in implementing the much-needed restructuring of the Spanish banking market and will be a key factor for Spain returning to prosperous growth.

In mid-2011, two of Spain’s cajas raised capital in an IPO to avoid partial nationalization by the Spanish Government. The action was seen by the Government as an important step to reforming Spain’s damaged banking sector. Both IPO s were succesful though, due to the escalation of European debt markets, valuation and prices were in the low range. Accessing private investors is seen as the preferred way to raise capital.

After the failed merger of Caja de Ahorros des Mediterraneo (CAM), Spain’s 10th largest lender, with three smaller banks earlier in 2011, the bank received a €2.8b capital injection from the FROB and Bank of Spain took a controlling stake in CAM. Bank of Spain is expected to sell CAM to another lender, as it has done with two other nationalized cajas in recent years.

The FROB has been a key instrument in the consolidation and recapitalization process in Spain. According to the Bank of Spain, of the initial estimate of the Spanish financial system capital needs, €5,8b has been met through private investment and the remaining €7,5b will be invested by FROB.


Spain

Market share of the Spanish banking sector (by number of institutions)

Figure 27 | Source: Bank of Spain

■ Savings banks

■ Credit cooperatives

■ Specialized credit institutions

■ Spanish limited liability companies

■ Branches of foreign banks

21%

26%

18%

24%

11%


From 2009 to 2011 a fundamental change process was initiated to restructure part of the Spanish financial sector. Royal Decrees 9/2009, 11/2010 and 2/2011 created FROB, enabled savings banks to exercise banking activity through banking license, changed the governance structure of savings banks and established new capital requirements in Spain.

Regulatory aspects

Specifically RD 2/2011 set new capital requirements for institutions (8%-10% according to risk profile) and set an strategy and calendar for the recapitalization of these institutions which needed to strenghthen their capital base. The process is set to finish in autumn 2011.


Spain

Loan market

Across the Spanish banking sector, the amount of NPLs as at December 2009 was €93.3b and rose to €107.2b at December 2010, representing a 14% increase. The NPL ratio surged from 0.9% in 2007 to 5.8% in 2010, a significant increase caused by the financial crisis. It is expected that the increase in NPLs will continue, though at a slower pace, for the next two years. The majority of NPLs on the Spanish banks’ balance sheets relate to construction and property development loans. In this sector, the NPL ratio is increasing significantly faster than that of other industry sectors.

The local market for NPL portfolio transactions is still immature and far from the activity levels seen in neighboring countries. The market has started to pick up with a few transactions happening, but on the whole there is only limited information available with respect to these loan portfolio sales. Transaction activity is still well below the expectations of trade players, and the main obstacle remains the price gap between sellers and buyers.

However, market participants remain cautiously optimistic about the prospect of increased investment opportunities, given the Spanish macroeconomic environment and recent regulatory measures taken by Bank of Spain and the Spanish Government that will impose additional pressure on local banks and cajas to strengthen their capital, by looking for capital increases and/or reducing risk-weighted assets.

The necessity of the financial sector to restructure its capital basis and improve its solvency ratio will probably fuel the divestment of non-core and NPLs especially by savings banks. The correction of housing prices continues and could need another adjustment resulting in further foreclosures an increase in NPLs.

2008

1,80

763

3.4%

2009

1,74

493

5.1%

2010

1,73

710

7

5.8%

2006

11

0.7%

2007

16

0.9%

NPL development

Figure 29 | Source: Bank of Spain

2,500

2,000

1,500

1,000

500

0

2%

3%

4%

5%

0%

1%

6%

7%

8%

■ Performing loans ■ Doubtful loans ▬ NPL ratio

€ billion

1,74

4

1,49

8Recent NPL transactions in the Spanish market


Seller Buyer Asset type Face value Completion date

RBS PERELLA Commercial Real Estate €280m Mar 11

BBVA Confidential Retail Portfolio €200m Jan 11

Orange Confidential Telecoms Portfolio €250m Jan 11

Santander LINDORF Retail Portfolio €600m Jan 11

MBNA LINDORF Retail Portfolio €100m Sep 10

Taking into consideration the deflated property assets when calculating the quality of loan portfolios, the NPL ratio would be closer to 9% according to IMF estimates. Beyond that, the NPL ratio is expected to rise and the pressure on existing loans to the construction and property development industry will again increase.


Outlook

The macroeconomic recovery in Spain is expected to continue in 2011. Although below the European average, the Spanish economy expects a slow upward trend, but is unlikely to recover before 2012. Spain is currently starting several reforms to achieve GDP growth such as the labor market reform, fiscal consolidation, cost cutting and the restructuring of the financial sector. Focusing on the credit market, the downward trend of credit toward all sectors has persisted. This development is driven by the economic situation and the tightening of credit standards by the Spanish banks due to customer credit liability.

NPLs, as mentioned earlier, grew dramatically in the past two years and, especially in the areas of construction and property development, this is a significant risk for the banking sector. Looking at the funding of the Spanish banking sector, institutions mainly issued medium- and long-term debt in order to lower debt refinancing risk. Smaller institutions unable to access the senior debt market are instead obtaining funds from the Government and the ECB. Unfortunately, the profitability of the banking sector is offset by the impact of increasing loan loss provisions. On the whole, solvency remains good due to the high quality of own funds.

We are confident that transaction activity in the NPL market will increase over the coming months, given the current deal volume in the savings banks space and increasing pressure from both new potential investors and Bank of Spain.


Italy

Since joining the Economic and Monetary Union (EMU) in 1998, Italy has consistently struggled to bring its budget deficit under the 3% ceiling set by the EMU and has continued to grapple with high public debts, which reached 120% of GDP in 2011. Italy was one of the worst-affected European countries by the global financial crisis, recording a 5.2% decrease in GDP in 2009, the largest decline since World War II.

Italy’s economy grew an average of 0.8% over the period 2001 to 2008 and recorded a decrease of 1.3% in 2008 driven by the impact of the global financial crisis on exports and domestic demand. 2009’s record fall in GDP was followed by a steady increase in the unemployment rate, which totaled 8.5% in the fourth quarter of 2010. Since then, owing to support from budgetary policies, unprecedented injection of liquidity to sustain markets and international cooperation among authorities, Italy’s economy has begun its gradual path to recovery. During Q1 2011, a small acceleration in production has been recorded, as indicated by the slight recovery in industrial production, increased exports and a general increase business confidence.

Italy’s slow recovery is projected to continue, driven by increasing world demand stimulating Italy’s export sector. Unemployment rates are expected to only decrease marginally, primarily due to initial improvements in labor demand being met by reduced use of short-time working. However, significant concerns still remain over the state of the Italian economy, in particular its high government debt (120% of GDP in 2011) and low growth rates. The Government’s National Reform Program contains an extensive list of priorities for reform; however, this must be effectively implemented to enhance the economy’s potential to reduce the debt burden and return to growth.

1,76

2.5



2500

2000

1500

1000

500

0

−4%

−6%

−8%

−2%

0%

2%

4%

2004 20152014201320122011201020092008200720062005

3000


1,77

6.6

1,81

4.1

1,83

9.0

1,81

4.6

1,71

9.6

1,74

1.1

1,75

3.4

1,76

5.0

1,78

2.0

1,80

2.5

1,82

9.7

1.4%0.8%

2.1%1.4%

−1.3%

1.2%0.7% 0.7% 1.0% 1.2% 1.5%

US$ billion

−5.2%


The Italian banking system was relatively unscathed by the global financial crisis in comparison with other European countries, due to its conservative lending culture and strong retail deposit base. Direct exposure of Italian banks to US subprime products was also limited, further enabling Italy’s banking sector to emerge from the crisis in good shape.

During 2009, Italian banking activities declined by 0.7% compared with the previous year. This was mainly driven by a lack of liquidity in the banking system and a reduction in domestic demand resulting from a downturn in the property market but also from a decline in production and a reduction of investments. In the period 2008 to 2009, bank deposits continued to decline with only marginal growth recorded in 2010, mainly due to the prolonged decline in disposable domestic income triggered by the crisis.

According to the publicly available financial reports of the five largest Italian banking groups in 2010, bank profitability was broadly in line with the previous year, and ROE increased by an average of 4% compared with 2009. However, net interest income remained weak, decreasing by 7% compared with the previous year.

There still remains significant concern within the Italian banking sector in relation to contagion risk from the Greece sovereign debt crisis, which has led to 10-year government bond yields rising to 5.5%, and has prompted fears that Italy may also be forced to seek emergency funding from the IMF in the near future.

The new bodies envisaged by the reform of the European financial architecture became effective on 1 January 2011: the European Systemic Risk Board (ESRB), responsible for macroprudential supervision, and the three microprudential European Supervisory Authorities (ESAs), one each for the banking, securities and insurance sectors. The reform lays the basis for closer coordination between national authorities and greater convergence on supervisory rules and practices.

Work is under way for the transposition of the Basel III prudential rules at European level. According to a research presented at the Italian Bank Association (ABI) conference,19 the impact of Basel III on the Italian banking system is estimated to be between €20b and €25b, i.e., additional capital to be raised, which should be lower than in the rest of Europe, as the Italian system is characterized by a high liquidity and lower leverage compared with other European banking systems.

To improve liquidity risk management, two quantitative rules will be introduced: a liquidity coverage ratio requiring banks to hold enough high-quality liquid resources to cope with situations of severe stress lasting 30 days without recourse to the market; and a net stable funding ratio to prevent structural imbalance in the composition of liabilities and assets for maturities up to one year. The instruments for monitoring liquidity were strengthened from the early months of 2010 onward with a view to maintaining strong safeguards against liquidity risk. Discussions with banks’ cash management and risk management units were intensified.

Targeted inspections were often followed by calls for prompt corrective measures in view of, among other reasons, the new rules established by the Basel Committee. A new format for reporting banking groups’ liquidity position was prepared, to acquire additional information on structural characteristics and facilitate comparison among intermediaries.

Large Italian banks’ capital ratios continue to be generally low by international standards, partly owing to the very substantial public recapitalizations of the leading European banks. Basel III will have a significant impact on the Italian banking system. However, the lengthy transition envisaged by the authorities will spread its effects over time, allowing the banks to move gradually into line with the new standard, attenuating the possible restrictive effects on lending to firms.


Regulatory aspects

3,33

2

3,63

5

3,75

0

+9.1%

+1.5%+2%


Figure 31 | Source: Central Bank of Italy — Annual reports 2008, 2009 and 2010

4,000

3,000

2,000

1,000

02007 2008 2009 2010

€ billion

19 Meeting ABI “Markets & Investment Banking Conference,” Milan, 7 June, 2010.


2%

3%

4%

5%

0%

1%

6%

7%

8%

9%

10%

3,69

1

Italy



1,38

0

163

387

321,42

4

96513

21 1,28

6

139

378

28

In recent years, the NPL market was important for banks’ performance, but the Italian banking system experienced a series of significant changes, such as sector concentration, increased competition, the impact of new regulation on capital requirements and concentration on core activities.

Italian banks typically manage NPLs by resorting to legal action, irrespective of the type of credit, with progressively reduced recovery rates and a lengthy average recovery time of several years. Out-of-court settlements, which carry a much better recovery ratio and faster recovery times, are normally obtained only at the debtor’s request. To address this problem, major Italian banks have spun off their collections process, creating specialized companies for servicing intermediaries and keeping the management of the bad debts under control, and for checking the costs of the credit portfolio.

In the past two years, credit quality has significantly worsened. In 2009, this resulted in an increase in delinquent debtors, which saw the overall NPL ratio rise from 6.5% to 9.1%.20 With reference to defaulted debtors only, the share of bad loans within total loans increased from 1.4% at March 2009 to 2.4% at December 2010.21 Furthermore, the ratio of new bad debts to outstanding loans remained high in 2010 (1.9%) but in line with the average of 2009–2010 (average of 1.1% in 2007 to 2008).22 The outlook on credit quality appears to be still uncertain and only a few signs of improvement can be detected, but these are not evenly reflected across all types of credit classes (corporate, retail, etc).

Looking at 2010 figures for the Italian banking system and comparing these with the previous year, NPL positions — past due loans and overdrafts breached for more than 180 days (€12.1b), restructured loans (€16b), substandard positions (€60b) and bad debts (€106.9b) — increased from 9.1% to 9.9% of total on-balance sheet exposures to customers. Around 82% of total bad debt was related to private individuals. At the year-end of 2010, write-downs on non-performing exposures amounted to 40.5% of face value.

Loan market

20 Annual Report, Bank of Italy, 2009.21 ABI Monthly Outlook, Economics and Financial and credit Markets, May 2011.22 Economic Bulletin n° 64, Bank of Italy, April 2011.

Italy

2008

Companies Companies Companies IndividualsIndividualsIndividuals

Loans to non-banks

Figure 32 | Source: Bank of Italy; Ernst & Young research

2,000

1,500

1,000

500

0

10%

20%

0%

30%

40%

50%

2009 2010

■ Performing ■ Non-performing ▬ NPL provision rate (%)

€ billion46.2%

40.5%40.2%


Outlook

Prior to the global financial crisis, Italy had an active NPL market. This activity is continuing, but at a much slower pace.

During 2012, a change in trend is expected and NPL deals could become more attractive. This is likely to depend on banks’ profitability, new high-quality capital and liquidity requirements, the adoption of internal ratings and risk-adjusted pricing models and adjustments to provisions on NPL portfolio accounted for in the banks’ financial statements. These factors would be expected to trigger banks to dispose of their NPL portfolios or seek operators specialized in credit recovery.

Currently, there are some significant deals in the pipeline. Furthermore, certain foreign players could try to enter the Italian NPL market either directly or through the acquisition of (or partnership with) Italian specialist players.


Turkey

The Turkish economy has undergone a transformational process through economic, political and social reforms in response to the financial and economic crisis in 2001. Turkey recorded an average annual GDP growth of nearly 7% over the period 2003 to 2007 and the reforms put in place in response of the 2001 crisis ensured that the effects of the recent global financial crisis were limited. Turkey has established itself as Eurasia’s rising tiger and, among others, was identified as a suitable destination for foreign investments. Capital inflows to Turkey increased, the economy continued to grow on the back of domestic demand, and unemployment rates declined while industrial production and capacity utilization increased. However, the rapid recovery in the economy has raised concerns about excessive borrowing in Turkey. With the capacity utilization rate still at low levels, and production volume hovering below its potential due to weak external demand, there is increasing pressure on inflation.

Although there is currently no overheating in the economy in terms of aggregate demand, the divergence of growth rates of internal and external demand along with short-term capital inflows causes concerns over financial stability. In this context, the Central Bank of the Republic of Turkey (CBRT) implements a new policy mix consisting of low policy rates, a wide interest corridor and higher reserve requirement ratios, with a view to contain the rise in credits and current account deficit and reduces short-term capital inflows to ward off concerns over financial stability. However, key concerns still remain over the medium term, with a current account deficit indicating possible overheating of the economy. The current account deficit declined to 2.3% of GDP at end-2009 due to the global turmoil, and economic contraction started to rise again with the economic recovery reaching 6.6% of GDP by the end of 2010. Increasing further in 2011, the current account deficit climbed from US$48.4b in 2010 to US$60.5b year on year in March 2011. GDP growth came in at 8.8% in Q2 2011, surprising once again on the upside, stronger than the market consensus of 6.4%.

444.

9



1,000

800

600

400

200

0

−10%

−15%

−5%

0%

5%

10%

15%

2004 20152014201320122011201020092008200720062005

1,200

US$ billion


482.

3

515.

5

539.

6

543.

2

517.

0

563.

2

605.

0

632.

7

661.

4

694.

2

728.

1

9.4%8.4%

6.9%4.7%

0.7%

8.9%7.4%

4.6% 4.5% 5.0% 4.6%

−4.8%


Turkey’s recent growth has been underpinned by a robust banking sector, which has shown great resilience during the global financial crisis, announcing record profits during 2009 and 2010. Major Turkish banks overcame the crisis by maintaining relatively low levels of debt and following a conservative asset allocation strategy. In addition, their liabilities are significantly weighted to a traditional deposit structure and levels of external leverage have been kept within a sustainable range. Turkish banks are generally well capitalized, with average capital adequacy ratios of 18.9% as at December 2010. The current position of Turkish banks makes the country’s banking system comparatively more stable than other emerging European countries. In addition, Turkish banks did not have material exposures to US subprime mortgages, or associated structured assets and, as a consequence, the Turkish banking sector has not experienced the level of loan impairments and value adjustments seen in other economies.

Although the Turkish banking system proved to be resilient, the global financial crisis affected the banking sector in two ways. Firstly, deteriorating external markets have put pressure on both the Turkish export sector as well as foreign capital inflows, which have traditionally been a primary driver of economic growth over the past few years. Secondly, in addition to the decrease in demand for banking products, the supply of capital in the banking sector decreased and, coupled with low domestic consumption due to high interest rates, further dampened growth.


Turkey

Total banking assets in Turkey increased to TRY1,008b (€488b) in December 2010, a 20.8% growth on the previous year, and represented 80.4% of the total financial sector assets as at September 2010. However, when compared with Eurozone countries, Turkey’s total asset to GDP ratio remains well below average.

As at December 2010, the total number of banks in Turkey totaled 49. While 32 of these are deposit banks, 4 are participation banks and the remaining 13 are development and investment banks. Total loans increased by 31.7% compared with the previous year and amounted to TRY546b (€265b) in December 2010. The growth in loan portfolio was mainly driven by recovering economic activity, a low interest rate environment, increased deferred consumption demand and increasing competition between banks. The macroeconomic recovery in Turkey is expected to continue into 2011 and beyond.

The well-capitalized Turkish banking sector is in a good position to cope with Basel III legislation and it is expected to expand customer credit further, and force private consumption and capital investments significantly over the short term.40

7

500

582

733

834

1,00

8


Figure 34 | Source: Turkstat; Turkish Banking Association

1,000

800

600

400

200

0

10%

0%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 20102009200820072006

1,200

TRY billion

■ Assets ▬ Assets/GDP

62.7%65.9% 69.0%

77.1%

87.5%91.2%

170.1185.0

234.1

88.990.2

131.6

122.5 139.3

180.1

600

500

400

300

200

100

0

TRY billion

20092008 2010

■ Retail ■ SME ■ Corporate/commerical

Figure 35 | Source: BRSA Turkish Banking Sector Interactive Monthly Bulletin

Share of loans by business line


Prior to the changes in Banks Act No. 4389, which came into force on 23 June 1999, the Treasury Under Secretary and the CBRT had been the two main regulatory and supervisory pillars in the banking sector. With this act, the Banking Regulation and Supervision Authority (BRSA), with financial and administrative autonomy, was formed and became operational as from 31 August 2000.

The BRSA is the sole authority in charge of the supervision, surveillance and regulation of 174 institutions, comprising Turkey’s 49 banks, 47 financial leasing companies, 78 factoring companies as well as 9 consumer-financing companies. In order to enhance competition within the financial industry, minimize risk, reduce the costs of operation and intermediation, harmonize with other financial market regulations and practices, and to foster a more active and transparent financial system through more active markets, a new Banking Act (5411) was issued on 1 November 2005. BRSA’s mission is defined as being “to safeguard the rights and benefits of depositors and create the proper environment in which banks and financial institutions can operate with market discipline, in a healthy, efficient and globally competitive manner, thus contributing to the achievement of the country’s long-term economic growth and stability.” With the establishment of BRSA, the Savings Deposits Insurance Fund (SDIF), previously under the authority of the CBRT, started to operate under the administration of BRSA. Later on, with the enactment of Act No. 5020 on 26 December 2003, the management of the SDIF was separated from the management of BRSA. Banks in Turkey are subject to general controls under the provisions of the Turkish Commercial Code and of various tax laws and are also subject to special oversight by BRSA. BRSA exercises its supervisory authority on a direct and ongoing basis in terms of legal considerations and financial soundness. Additionally, banks are required to submit quarterly internal audit reports to BRSA.

Associated with governmental measures to control the current account deficit, the CBRT has started to introduce several measures to moderate lending growth. One of the most important developments is the CBRT‘s decision to change required reserve ratio on deposits and cut interest rates further on such deposits. In August 2011, required reserve ratio on foreign currency denominated deposits are determined as follows: 11.5% for demand deposits up to one year, 9.5% for time deposits up to three years and 8.5% for time deposits over three years.

Regulatory aspects

On 7 January 2011, required reserve ratio on Turkish Lira denominated deposits started to be calculated by using variable ratios depending on different time deposits. Valid from 21 April 2011, required reserve ratios on TRY-denominated deposits are 16% for demand deposits, 16% for time deposits up to one month, 13% for time deposits up to three months, 9% for time deposits up to six months, 6% for time deposits up to one year, 5% for time deposits for more than one year. Also, according to the CBRT announcement in September 2010, the remuneration of required reserves for both TRYand foreign currency has been terminated. These changes will directly impact the cost of funding for banks, and coupled with the strong competition in loan and deposit market shares, net interest margins are expected to contract as the reflection of such reserving costs may not be fully recovered from customers.


Turkey

Loan market

The top five banks comprise 55.3% of the all banking sector gross loans. Isbank and Garanti are the leading banks in terms of total loans with over TRY64b (€31b) loans provided by each bank as of December 2010. Retail banking activities in the Turkish banking sector is quite new and accordingly retail loans comprise a limited portion of the total loan portfolio.

During the last couple of years, with the introduction of new regulations regarding capital adequacy requirements and potentially upcoming Basel III requirements, banks in Turkey were urged to limit their credit exposure in line with their equity. The total NPL portfolio of banks in Turkey is reported as TRY20b (€9.7b) as of December 2010. Together with the portfolio held by SDIF,23 the total NPL market is estimated to be more than TRY28b (€13.5b). The NPL ratio has increased from 3.1% in September 2008 to 3.6% as of December 2008, and further increased to 5.3% as of December 2009. Since then, the NPL ratio

23 The SDIF holds TRY8.8b of NPL in its balance sheet, as of December 2010.

3.1%

4.8%

3.7%

3.6%

7.6%

6.0%

2.8%

4.5%

4.1%

NPL dynamics

Figure 36 | Source: BRSA Turkish Banking Sector Interactive Monthly Bulletin

6%

4%

5%

3%

2%

1%

02008 2009 2010

7%

8%

■ Corporate/commercial banking loans ■ SME loans

■ Retail loans

% of total loans

has decreased to 3.7% as of December 2010 due to recovering financial markets and the sale or write-offs of elements of NPL portfolios. Due to strict BRSA regulations, Turkish banks have a conservative provisioning policy on NPLs, with coverage ratio of specific provisions of approximately 84.1% as of December 2010. Nineteen percent of banks’ NPL portfolios stem from non-performing credit card loans, which amount to TRY3.8b (€1.8) as of December 2010. Consumer loans, excluding credit cards but including housing, automobile and other retail loans, constitute 18.0% of the total NPL portfolio of banks as of December 2010.

The ratio of loans to deposits of 88.5% is below the European average, with only Slovakia and Belgium having slightly lower ratios. The low loan-to-deposit ratio shows that there is room for the Turkish loan market.


İşBa

nkas

ı

Garan

tiBan

kası

TCZi

raatB

anka

sı

Akban

k

Yapı

Kred

i

Vakıfl

arBa

nkas

ı

Halk

Bank

ası

Finan

s Ban

k

Denizb

ank

ING Ban

k

NPL ratios of major banks in Turkey as of December 2010


50

40

30

20

10

0

1%

2%

0%

3%

4%

5%

6%

7%

8%

60

70

80

TRY million

■ Total loans ■ NPL volume ▬ NPL ratio

64,2

322,

407

52,1

89

57,1

61

44,0

03

18,2

03

64,4

76

44,8

36

52,8

96

24,6

27

12,0

36

3.6%

2.9%

1.5%

2.4%

3.4%

4.8%

3.8%

7.1%

4.8%

3.1%

1,93

9

855

1,28

0

1,86

1

1,75

8

1,75

8

922

390

2,26

6


Recent transactions in the Turkish NPL market

Figure 38 | Source: SDIF announcements; ISE; public information

Bid date Vendor NPL amount on sale

Portfolio Offer Purchaser

Jun 11 Isbank TRY88.4m Not disclosed TRY13.9m StandardVarlıkYönetimA.S.

Apr 11 Denizbank TRY111.3m Credit cards, retail and commercial loans TRY10.6m GirişimVarlıkYönetimA.S.(FIBAGroup)

Mar 11 Sekerbank TRY143.2m Not disclosed TRY12m GirişimVarlıkYönetimA.S.(FIBAGroup)

Mar 11 TEB TRY39.9m Not disclosed TRY4.1m StandardVarlıkYönetimA.S.

Jan 11 TEB TRY55.5m Not disclosed TRY4.3m LBTVarlikYönetimiA.S.

Dec 10 Alternatifbank TRY34.5m Not disclosed TRY1.3m AnadoluVarlıkYönetimŞirketiA.S.

Dec 10 Isbank TRY300.4m Not disclosed TRY50.8m GirişimVarlıkYönetimA.S.(FIBAGroup)

Dec 10 Isbank TRY41.9m Credit cards, retail and commercial loans TRY6.5m LBTVarlikYönetimiA.S.

Dec 10 Fortis Bank TRY33.9m Commercial loans LBTVarlikYönetimiA.S.

Nov 10 YapıveKrediBankası TRY427.8m Credit cards, retail and SME loans TRY56m LBTVarlikYönetimiA.S.(TRY256.9mcreditcards) GirişimVarlıkYönetimA.S.(FIBAGroup) (TRY170.9mretailandSMEloans)

Nov 10 Alternatifbank TRY59.6m Not disclosed TRY11.5m GirişimVarlıkYönetimA.S.(FIBAGroup)

Oct 10 Turkland Bank TRY17.8m Not disclosed GirişimVarlıkYönetimA.S.(FIBAGroup)

Sep 10 Denizbank TRY81.6m Credit cards and retail loans TRY7.4m LBTVarlikYönetimiA.S.(TRY49.4mcreditcards) StandardVarlıkYönetimA.S.(TRY32.2mretailloans)

Sep 10 Eurobank Tekfen TRY46m Corporate loans Not disclosed LBTVarlikYönetimiA.S.

May 10 YapıveKrediBankası TRY298.7m Corporate and commercial loans TRY7.5m LBTVarlikYönetimiA.S.

May 10 Fortis Bank TRY54.5m Corporate and commercial loans TRY2.6m LBTVarlikYönetimiA.S.

May 10 Citibank TRY89.2m Credit cards and retail loans GirişimVarlıkYönetimA.S.(FIBAGroup)

Mar 10 YapıveKrediBankası TRY381.9m Credit cards TRY32.4m GirişimVarlıkYönetimA.S.(FIBAGroup)

Mar 10 Fortis Bank TRY30.4m SME loans TRY1.7m GirişimVarlıkYönetimA.S.(FIBAGroup)

Mar 10 YapıveKrediBankası TRY224.4m SME loans TRY31.2m LBTVarlikYönetimiA.S.

Mar 10 YapıveKrediBankası TRY74.6m Retail loans TRY6.5m StandardVarlıkYönetimA.S.

Feb 10 Denizbank TRY50.2m Credit cards and retail loans TRY4.9m StandardVarlıkYönetimA.S.

Jan 10 Akbank TRY326m Not disclosed TRY38.5m GirişimVarlıkYönetimA.S.(FIBAGroup)

Nov 09 Fortis Bank TRY115.9m Retail loans TRY6.5m LBTVarlikYönetimiA.S.

Nov 09 Isbank TRY186.1m Corporate loans TRY8.5m cash and 40% ofthecollection(gross)

StandardVarlıkYönetimA.S.

Nov 09 Isbank TRY37.8m Not disclosed TRY9.5m LBTVarlikYönetimiA.S.

Apr 09 YapıveKrediBankası TRY393.9m Consumer loans and credit cards TRY26.5m GirişimVarlıkYönetimA.S.(FIBAGroup)

Turkey

During the last two years, we have witnessed that almost all foreign investors engaged globally in NPL business have shown interest to the Turkish market. These include Bank of America Merrill Lynch, Deutsche Bank, LBT (former Lehman Brothers) and Standard Bank. Additionally, the local asset management company Girişim Varlık is active in the sector.

In 2010, a total of 19 NPL transactions were disclosed in the market. The NPL portfolio amount subject to sale in these transactions was ca. TRY2.6b (€1.2b). Details of main NPL transactions are shown below:


NPL investors are not required to establish an asset management company (AMC) to invest in an NPL portfolio. However, AMCs enjoy certain tax benefits compared with ordinary companies, therefore, the NPL market is dominated by AMCs. LBT Varlık Yönetim A.Ş., incorporated by Lehman Brothers and acquired by Vector Holdings S.A.R.L. after the collapse of Lehman Brothers Holding in the USA; FinansVarlik, established by FIBA Holding and named as Girisim Varlik; Standard Varlık Yönetim A.Ş., established by Standard Bank Plc., are the most active AMCs in the market and expected to be the potential buyers in future transactions. The number of AMCs increased from four in 2005 to eight as of 2011. Yapi Kredi Bank, İsbank and Fortis, that have realized more than half of the NPL portfolio sales in the market during the last two years, are expected to be the potential sellers, together with other major players and small-scale banks who were not active in the sector in the historical period. Since 2008, €2.2b of NPL portfolios were sold to AMCs in Turkey, and in the coming years, we expect that the market activity will continue. In the long run, considering new regulations regarding capital adequacy requirements and upcoming Basel III requirements, the NPL market in Turkey is expected to grow significantly.

Outlook


Greece

Following a period of high GDP growth, cheap credit and low unemployment, Greece entered into a severe recession in 2009, driven by the global credit crunch and the structural inefficiencies embedded in the local economy that led to a fiscal as well as a sovereign debt crisis.

Greece’s general government deficit is among the highest in the Eurozone, after peaking at 15.4% of GDP in 2009, reducing to 10.5% of GDP in 2010. Given the large size of the fiscal deficit, fiscal policy is expected to remain tight in 2011, which is expected to lead to new contractions in total consumption and investment. Accordingly, GDP is expected to further contract by 3.5% in 2011 and 0% in 2012, following a contraction of 4.4% in 2010. Fiscal policy aimed to reduce fiscal deficit further to 7.5% of GDP in 2011. However, in September the budget plan was revised to 8.5% after Greece announced it would miss the 7.6% target.

Greek public debt is also at unprecedented levels and stood at 142.8% of GDP in 2010, increasing from 127.1% in 2009. The debt position looks especially challenging for Greece that, on the basis of IMF projections, is expected to see its national debt rise to 170% of GDP by 2013. The debt ratio is then projected to edge down slowly, but this is based on relatively optimistic assumptions of Greece fully implementing a fiscal adjustment of over 11% of GDP (on a cyclically adjusted basis) from 2010 to 2015, returning to growth, and regaining access to market financing at reasonable rates.

In 2010, the Eurozone countries and the IMF approved a €110b financial package to support the Hellenic Government over a period of three years with a commitment to implement structural reforms to reduce its deficit.

The Hellenic Government has been progressing slowly in the implementation of structural reforms and required further financial support within only one year.



250

200

150

100

50

0

−2%

−6%

−5%

−4%

−3%

−1%

0%

1%

3%

6%

5%

4%

2%

2004 20152014201320122011201020092008200720062005

300US$ billion


4.4%

2.3%

5.2%4.3%

1.0%

−2.3%

−4.4% −3.5%

0.0%0.7%

1.6%

3.3%

236.

6

242.

0

254.

5

265.

4

268.

2

241.

7

241.

8

243.

4

247.

3

255.

6

261.

9

250.

5


In July 2011, the Eurozone countries agreed on a second bailout program with a €109b loan from the EFSF and IMF. This program also includes a substantial voluntary participation of the private sector, aimed to reach an additional support of €37b until 2014. Banks and insurance companies have four different options to exchange existing bonds for new bonds with different maturities and coupons, together implying a 21% loss in NPV terms for the bond holders. An additional debt buy-back program of around €13b will bring the total support package to €50b. In the medium term, the total contribution of the private sector participation is estimated at around €106b until 2019.

As part of the financial stability packages, the Government has committed to execute an ambitious privatization program that is expected to generate from €30b to €50b between 2011 and 2015.

The Greek banking sector comprises around 60 credit institutions and total banking assets were at €502b in July 2011. Thirty-four of the credit institutions are incorporated in Greece, of which 18 are commercial banks and 16 are cooperative banks.

The banking sector is dominated by six major banks, with the top four Greek banks representing two-thirds of the market in both lending and deposits.

According to ECB statistics, loans to households make up for about a quarter of total banking assets and ca. 40% of total lending.


Total lending 2010

■ NBG

■ EFG Eurobank

■ Emporiki

■ Alpha Bank

■ ATE Bank

■ Bank of Piraeus

■ Others

■ TT Hellenic Postbank

23.7%

15.9%

15.4%11.8%

6.7%

6.1%

17.9%2.6%

Figure 40 | Source: Bank of Greece; Ernst & Young research

While consumer spending had been a key driver for growth and had fueled consumer lending prior to the financial crisis, the deterioration of Greece’s economy and the successive credit rating downgrades of the Greek Government as well as domestic banks have resulted in a sharp decline in credit to households. Significant systemic risks remain in the financial system, with annualized growth in housing loans having decreased significantly from a peak at 33.5% in December 2005 to negative levels in 2010 and 2011.

Greece


229.

1

26.3%

246.

0

27.3%

286.

0

33.6%32

1.4

25.9%

391.

5

21.5%

464.

8

11.2%

492.

6

3.7%

−0.3%

515.

3

−1.4%

498.

6

The total credit growth remained positive in 2010, largely driven by credit growth in the public sector, while credit in the private sector had been contracting for much of 2010 as well. Within private sector credit, corporate credit growth has been contracting since the beginning of 2010 while the credit growth in the household sector started to contract in the third quarter of 2010. The lending growth in the economy remains weak, driven by a secular contraction across sectors in the Greek economy.

Asset quality continues to deteriorate, with the NPL ratio having increased from 10.4% in December 2010 to 11.5% in March 2011. Provisioning for bad loans increased 18% during Q1 2011 and the stock of


Figure 41 | Source: Bank of Greece

600 35%

50030%

400

25%

300

20%

1000%

−5%

200

15%

5%

10%

0 −10%2003 2004 2005 2006 2007 2008 2009 2010 2011

■ Total banking assets ▬ Housing loans

€ billion

11.6

26.0

5.5

13.2

3.9

9.3

2.7

9.2

3.3

9.2

3.6

8.6

0.9

1.6

NPLs

Figure 42 | Source: Bank of Greece; Ernst & Young research

30%

25%

20%

10%

15%

5%

0%

Emporiki ATE Bank Alpha Bank EFG Eurobank NBGBank of Piraeus

TT Hellenic Postbank

■ 2008 ■ 1Q2011

restructured loans also increased significantly to 3.7% of total loans.

The domestic deposit base of the Greek banks has been contracting since March 2010. Given the weak economic environment and the lack of confidence in the domestic banking sector, Greek banks are facing large-scale drawdown on their deposit base. This continued outflow of funds is adding to the

funding pressure the banks have been facing given the near closure of the wholesale markets for the banks.

Profitability in the Greek banking sector is under strong pressure. Revenues have declined 6% between 2008 and 2010 and the three largest Greek banks reported sharply lower net income for 2010. At the same time, loan loss provisions have increased 95% between 2008 and 2010 while credit costs are up 116 basis points in the period, causing the profitability of the sector to drop sharply.

% of total loans


In 2008, the Greek state approved a €28b government liquidity package to stabilize the banking sector and to enhance liquidity of the Greek economy. The package comprised three pillars: €15b of state guarantees for new medium- to long-term bank loans issued until the end of 2009; €5b for capital injections through the purchase of preferred shares by the Government, and €8b for the issuance of special bonds by the state to be able to inject liquidity into banks. The three pillars were made available in two installments of €11b in 2009 and €17b in 2010. In June 2010, this liquidity package was further extended through additional guarantees of €15b, which can be pledged to ECB for provision of liquidity, with the top four Greek banks receiving the largest support distributions.

In conjunction with the €110b emergency loan package by the Eurozone countries and IMF, in June 2010 the ECB approved the establishment of a €10b Hellenic Financial Stability Fund (HFSF) to stabilize the Greek banking system by strengthening the capital adequacy of credit institutions when capital is not available through normal, generally private, options. It provides equity capital to credit institutions by acquiring preference shares and, under certain conditions, common shares in respective banks.

As part of a wider banking consolidation initiative that is encouraged by the Greek Government, a number of proposals have been put on the table. In early 2011, NBG approached Alpha Bank in order to proceed with a merger, which was rejected by the management of Alpha Bank. Later in 2011, state-owned Hellenic Postbank absorbed T-Bank. However, as part of the Greek privatization program, it is expected that the Greek Government will sell its stakes in both Hellenic Postbank and ATE Bank in the short term. In August 2011, Alpha Bank and Eurobank, the second and the third largest lenders, announced their intention to merge. The merger is still pending approvals and is expected to be completed by end of 2011. The new group will be among the top 25 largest Eurozone banking groups with pro forma total assets of €146b. As part of the transaction, the new group will proceed immediately with the implementation of a comprehensive €4b capital strengthening plan to improve the Core Tier 1 ratio of the combined entity.

Greece

4.2

3.8

2.2

2.2

2.6

Split of the received support


3.0

2.5

2.0

1.5

1.0

0.5

0

OthersBank of PiraeusAlpha BankEFG EurobankNBG

3.5

4.0

4.5

€ billion



5.0

6.8

7.7

9.0

11.5

10.4

Greece

The deterioration of the financial situation of both consumers and corporate due to the overall economic crisis in Greece has led to a steep increase in NPLs on banks’ balance sheets.

The NPL ratio has surged to above 10%, with that for consumer loans being significantly higher at around 17%, compared with around 9% for mortgage loans and around 7.5% for corporate loans. Translated into euros, the total NPL volume in Greece has risen to approximately €22b, of which around €6b relates to mortgage loans.

The macroeconomic environment negatively affected the financial condition of households and businesses, making it increasingly difficult for them to service their debt. This adverse trend is expected to continue in the near future as a result of the continuous austerity measures imposed by the Greek Government. At the same time, demand for new loans declined and banks have been reluctant to extend new credit.

We expect the level of NPLs to continue to increase in 2011 and stabilize during 2012. The Greek Government has introduced certain temporary measures to regulate the collection of NPLs in Greece creating uncertainties around the recovery and hence the pricing of NPL portfolios. Such measures include extensive documentation obligations, a strict time frame at which debt collectors can contact the delinquent borrower, allowing a one-month break between contacts, and a list of “dishonest practices,” such as contacting employers or relatives, with fines of up to €500,000 if debt collectors or banks are in breach of the law.

No activity has been observed in the Greek market regarding the sale of NPL portfolios of the Greek banks over the last two years and it remains to be seen if the sale of NPL portfolios to international investors will be a way for Greek banks to tackle their NPL problem.

Loan market

NPL ratio

Figure 44 | Source: Bank of Greece; IMF

12%

10%

8%

6%

4%

2%

0%Dec 10 Mar 11Jun 10Dec 09Jun 09Dec 08

14%

% of total loans


Outlook

Asset quality deterioration to continue. Driven by the weak economic environment in Greece, NPL formation is expected to remain at levels similar to 2010 at least in 2011.

Profitability to remain under pressure. As a result of deteriorating asset quality, loan loss provisions are expected to show only a modest decline in 2011. On the other hand, revenue growth will continue to remain under pressure driven by a weak economy, a shrinking loan book and negative liability spreads. Thus, Greek banks are expected to have a low return on equity in 2011 and 2012.

Reduction of ECB reliance is difficult. Reducing reliance on ECB would be difficult for Greek banks. These banks funded 22% of their total assets through the ECB as of 1Q 2011, which was the highest in Europe. Though these banks are making efforts in this direction by undertaking measures such as deleveraging and asset disposals, the deposit reductions that have been overtaking loan run-offs and are expected to continue to do so in the near future, are likely to make the process difficult.

Liquidity position expected to remain weak. With no catalyst in sight for liquidity improvement, Greek banks are expected to face a strained liquidity position in the near future. Besides, the cost of funding for these banks may increase due to continued sovereign debt risks. Although the Greek Government has been able to secure a bailout, the market does not seem to be totally unconvinced that European sovereign debt problems are solved.

Sector consolidation expected. Given the lack of drivers to improve profitability, the banks in the sector may look at consolidation as a possible source of growth. Consolidation will also be attractive for increasing scale, and improving efficiency, while the regulators may also push weaker players, from a capital perspective, to find a possible suitor. The Greek Government is also looking to sell its stake in ATE Bank and TT Hellenic Postbank to reduce its own debt burden.


Portugal

The Portuguese economy experienced a significant boost when joining the European Union in 1986 and the EMU in 1999. However, in recent years, it has suffered from sluggish and negative growth and uncompetitive industries. The country is now facing one of the worst economic crises in its 868-year-old history.

Due to poor economic growth, the Portuguese economy has consistently under performed its respective EU members. However, in 2007, the Portuguese economy grew by 2.4% due to a wider EU recovery but suffered contractions of 0% and 2.5% in 2008 and 2009, respectively.

The onset of the Eurozone debt crisis has led to government debt exceeding 90% of GDP, record-high spreads on sovereign debt and downgrades in credit ratings. In April 2011, the acting prime minister was forced to seek assistance from the European Union and IMF, and agreed a financial bailout package of approximately €78b. The strict conditions stipulated in the bailout package and associated austerity measures present a real possibility that Portugal may slide further into recession in the short term. To this extent, real GDP is expected to decline by 1.8% in 2011 and 1.5% in 2012.



250

200

150

100

50

0

−2%

−3%

−1%

0%

1%

2%

3%

2004 20152014201320122011201020092008200720062005

300

US$ billion


1.6%

0.8%

1.4%

2.4%

0.0%

−2.5%

1.3%

−1.8% −1.5%

0.9%

1.7%

2.6%

189.

6

191.

0

193.

8

198.

4

198.

4

196.

0

192.

4

189.

5

191.

3

194.

5

199.

6

193.

4


The Portuguese banking industry did not suffer significantly as a direct result of the global financial crisis due to low exposure to Lehman Brothers and US subprime products. However, as the crisis unwound, the banking industry began increasingly to suffer from the wider global economic downturn, facing significant funding issues. This led to the nationalization of two Portuguese banks. To maintain confidence in the sector, the Government was forced to nationalize Banco Português de Negócios in November 2008 and Banco Privado Português, a small financial institution that provided private banking, which became insolvent in 2010.

More recently, despite the Portuguese Government implementing heavy austerity measures, relentless pressure from global markets has resulted in a downgrade of Portuguese debt to junk status and prompted Portugal’s banks to threaten to cease buying government debt. This in turn led to Portugal seeking a €78b bailout package from the ECB and IMF to increase liquidity and ease capital outflows in the banking sector. As a condition of the bailout, Portugal will be expected to implement further austerity measures and conduct an ambitious privatization program. Further reforms to the tax system, labor market laws and protected sectors of the economy are also expected.

The banking industry of Portugal is supervised by three supervisory authorities and complies with the Basel Core Principles for Effective Banking Supervision and with the International Organization of Securities Commission’s (IOSCO) Objectives and Principles of Securities Regulation.

In the context of the Portuguese financial assistance program negotiated with the European Commission, the ECB and the IMF, it was established that the solvency levels of the national banking system should be strengthened. As such, Banco de Portugal has approved a new regulation, requiring all banking groups to meet a minimum Core Tier 1 ratio of 9% in 2011 and 10% from the end of 2012 onward.

Based on the specific risk profile of each banking group and taking into consideration the results of the solvency and deleveraging assessment framework, conducted under the program, the regulation also envisages the possibility of Banco de Portugal being more demanding on a case-by-case basis regarding the minimum Core Tier 1 requirement for some banks. Moreover, the Portuguese banks must reduce the transformation ratio (ratio of medium- and long-term loans to time deposits) to 120% until the end of 2014.

In the wake of the financial crisis, Banco de Portugal increased its supervision activity in the banking system, keeping supervisory teams permanently in banks. According to the financial assistance program, Banco de Portugal will boost its supervisory activities by increasing resources for the recruitment of specialist banking supervisors and intensifying on-site inspections and data accuracy verification. Systemically important institutions will be required to prepare contingency resolution plans reviewed on a regular basis.


Portugal

Regulatory aspects

Total loans by customer type as of December 2010

Figure 46 | Source: Banco de Portugal

■ €141.3b Private individuals■ €138.5b Real estate workout■ €47.2b Other financial intermediates■ €2.9b Insurance corporations and pension funds

43%

42%

14%

1%


5.0

1.7%

7.1

2.2%

10.9

3.3%

13.5

4.1%

The Portuguese banking system experienced a large increase in loan originations until 2008. Since then, total credit granted has remained stable at around €330b, as banks started to encounter difficulties in securing funding, and consequently lending criteria were tightened. Meanwhile, default rates started to increase significantly since 2007, due to increases in the unemployment rate, inflation, taxes and, more recently, interest rates.

The level of NPLs as a percentage of total loans in the Portuguese banking sector has seen a steep increase during the global financial crisis. The ratio surged from 1.7% in 2007 to 4.1% in 2010. With additional austerity measures due to come into effect as a condition of the bailout, Portugal’s current recession and trend of increasing NPL levels looks set to continue over the short to medium term.

Loan market

2007

In 2010, the total loans and advances to customers of selected banks amounted to €284b, of which more than €7.5b were NPLs. The NPL ratio for these institutions increased from 2.3% in 2009 to 2.7% in 2010.

NPL dynamics


10

8

6

4

2

0

0.5%

1.0%

0.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

2008 2009 2010

12

14

16

€ billion

■ NPLs ▬ Gross NPLs/total loans


2.5

1.8

1.1

2.9

3.3

1.6

5.3

5.5

3.1

5.0

7.0

3.0

5.5

8.1

3.4

Portugal

During 2006 and 2007, NPL transactions occurred with some regularity, attracting the attention of international investors. NPL transactions were expected to continue over the following years. However, following Lehman Brothers’ bankruptcy, Portuguese banks stopped selling their NPLs as prices dropped to uneconomic levels. Consequently, the Portuguese NPL market dried up.

However, banks started outsourcing NPLs management, giving rise to a new opportunity for servicing providers. While there are servicing providers that only manage external NPL portfolios (Intrum Justitia is probably the most active player in this segment and recovered NPLs of €600m in 2010), there are others that manage external assets, as well as investing (Whitestar and Servdebt are the major servicing providers here as they are managing a portfolio of more than €1b each). According to APERC (the Portuguese servicing companies association) there are now about 50–60 companies in this business. Based on the latest data from APERC, the association has 27 affiliates which, during 2010, recovered €539m, while managing a portfolio of almost €3b and employing almost 1,500 employees.

During 2010, the NPL market started to show signs of life, mainly in response to the new regulatory framework that forces banks to sell NPLs to reach the capital requirements. Moreover, the prices have been increasing, particularly in the case of unsecured portfolios, although they are still behind those offered in 2005 and 2006.

The most active buyers in Portugal are foreign investors, such as private equity firms and hedge funds, for example, Bank of America, Citibank, Credit Suisse, UBS and Apollo.

Estimate of NPLs in selected banks

Figure 48 | Source: Banks‘ annual reports; Ernst & Young research

2

1.5

1

0.5

0Caixa Geral de

DepósitosBES Millenium bcp BPI Santander Totta Banif

2.5

3

■ 2009 ■ 2010

2.3

2.5

0.9

1.1

2.0

2.5

0.6

0.6

0.4

0.5

0.2

0.4

NPL ratios in selected industries


6%

4%

5%

3%

2%

1%

0%2007 2008 2009 2010 2011

7%

8%

■ Transforming industries ■ Construction ■ Other corporate services

€ billion

% of total loans

Outlook

In the short run, NPL transactions are expected to increase in terms of number and volume, according to NPL market players. Even though the Portuguese economy is not expected to grow in the next two years; the increase of unemployment, interest rates and a tightened regulatory framework will force banks to sell NPLs, even at discount.

According to some key players, there are high hopes for the Portuguese NPL market. These expectations are specifically based on international investors that have achieved higher returns than expected on previous investments in Portuguese assets.

Historically, servicing companies have been working mainly with banks. However, there are new market opportunities in other businesses, such as utilities and telecommunications that are interesting for servicing providers, as well as governmental NPLs. This could be an interesting option, not only for servicing companies that would increase their portfolio, but also in helping the Portuguese Government recover some of its NPLs, which in turn would help to achieve its deficit targets.


Poland

Poland is the only country in the European Union to have recorded positive GDP growth during the global financial crisis, with 1.6% in 2009, which was then followed by a further increase of 3.8% in 2010.

The strong GDP growth of the past three years was mostly driven by consumption and positive trade balances. On accession to the EU, Poland recorded a strong improvement in the labor market but, more recently, unemployment rates have increased, peaking in double-digit levels in 2009 as a result of the global financial crisis. The Polish economy is also beginning to experience inflationary pressure with the CPI inflation rate reaching 4.5% in April 2011, resulting in the National Bank of Poland increasing interest rates to 4.5% in June 2011.

According to, World Bank, in 2011, Poland’s GDP per capita is projected to reach around 56% of the EU-15 level of income, increasing from only 33% in 1991. However, concerns still remain on sovereign debt. Although the key ratio is still below the safety threshold of 55% of GDP, the Polish Government has implemented a number of measures (including changing the pension funds regulatory with respect to the mandatory premium transfers) to keep the fiscal deficit under control. Prospects for the Polish economy are improving and economic growth is expected to accelerate from 3.8% in 2010 to above 4% in 2011. However, some doubt remains as to whether Poland will be able to return to the higher growth rates of above 5% recorded prior to the global financial crisis.



500

400

300

200

100

0

−10%

−15%

−5%

0%

5%

10%

15%

2004 20152014201320122011201020092008200720062005

600


293.

3

303.

9

322.

9

344.

9

362.

5

368.

4

382.

4

397.

7

413.

0

430.

3

449.

5

468.

9

5.3%3.6%

6.3% 6.8%5.1%

3.8% 4.0% 3.8% 4.2% 4.5% 4.3%

1.6%

US$ billion


538.

5

586.

4

681.

1

801.

7

1,03

5.4

1,15

8.0

The Polish banking sector, despite strong connections to the more established European banking markets, was one of the most resilient models in the wake of the global financial crisis. The Polish Government was not forced to support the banking market in respect of capital injections or similar liquidity measures, in part due to a low level of exposure of Polish banks to US subprime instruments. In general, Polish banks are well capitalized with an average capital adequacy ratio of 13.8% as at 31 December 2010, well above that recorded by other more established European banking markets.

The majority of banks remained fairly profitable throughout the crisis, with the Polish banking sector recording an average 41% increase in net profit to PLN11.7b (€2.9b) in 2010. Based on a survey made by the Polish Financial Supervision Authority (KNF), the Polish banking sector is expected to grow further by 25.6% in 2011.

As at December 2010, there were 646 banks in the Polish financial system, and total banking sector assets of PLN1,159b (€290b) accounted for 70% of total financial institution assets (excluding the National Bank of Poland). Commercial banks (49) accounted for 89.2% of total banking assets, while cooperative banks, which are very dispersed due to historical reasons, accounted for the remainder of banking assets. International shareholders controlled 66.2% of banking assets as at December 2010, while the rest were owned by local investors.


The concentration of the top five banks, as at December 2010, was almost 43.9% and was very close to the EU average (44.3%). PKO BP (State Treasury) and PEKAO (UniCredit) are the most dominant banks on the market in terms of assets and profits. Over 25% of total assets and 45% of the Polish banking sector‘s profit is attributable to these two players.

Over the past two years, the Polish M&A market has been principally shaped by a slowdown in activity or the withdrawal of foreign investors, as they seek to respond to adverse market conditions in their home or other overseas territories, coupled with increased consolidation in the local market. The most prominent transaction was the acquisition of Bank Zachodni WBK, Poland’s fifth largest universal bank, by Spain’s Banco Santander for around €4.1b. Other recent transactions include the €490m purchase of Polbank (a Polish branch of Greek EFG) by Austria’s Raiffeisen, and Getin Holding‘s €35m acquisition of Allianz Bank Polska.

Poland

Total banking assets NPL dynamics

Figure 51 | Source: Polish Financial Supervision Authority Figure 52 | Source: Polish Financial Supervision Authority

10080

8060

60

4040

2020

0 02004 200420102009 2009 20102008 20082007 20072006 20062005 2005

120 100

■ Total banking assets (PLNb) ▬ Growth rate ■ NPL volume ▬ NPL as % of portfolio for non-financial institutions

34.8

29.0

24.2

22.7

29.8

50.7

61.4

0%

5%

10%

15%

20%30%

25%

20%

15%

10%

5%

0%

15.6%

16.1%17.7%

29.2%

9.5%

11.0%

7.4%

5.2% 4.9%

7.9%8.8%

PLN billion PLN billion

1,05

7.4

8.9%

2.1%


The fast growth of mortgages, consumer loans and foreign-currency risks-taking by Polish households triggered the Polish Financial Supervision Authority to tighten regulations. At the end of April 2011, Swiss-franc-denominated mortgage loans amounted to 53% of the total mortgages, down from 61% at December 2009. The stricter criteria applied to foreign-currency loans are producing results.

Liquidity. Based on the last Financial Stability Report, published in July 2011 by the National Bank of Poland, the funding position of Polish banks remained stable. Their funding structure, including the share of foreign funding, did not change significantly. The short-term liquidity position of the banking sector has improved; however, it remains considerably diversified among individual banks. In the longer term, the situation of banks will be influenced by new European liquidity risk regulations. In line with the decision of the Basel Committee, observation periods for the Liquidity Coverage Requirement (LCR) and for the Net Stable Funding Ratio (NSFR) were to begin in 2011 and 2012, respectively.

Capital. According to the National Bank of Poland, the regulatory capital of the domestic banking sector has increased slightly over the last few years. Based on the last available data (April 2011), the structure of regulatory capital was favorable in terms of the capacity to absorb potential losses, as it was largely composed of core capital.

Operating regulations. The growth of regulatory capital in 2010 was due to the issue of new shares by five commercial banks and retention of 2010 profits. The analysis of the dividend pay-out plans in banks provides reasons to expect a further growth in regulation of capital in the Polish banking sector.

Firstly, in 2010, KNF issued new rules, the “T-recommendation,” which could limit the access of lower-income households to credit. Under the new regulations, it will be obligatory for foreign currency borrowing that the loan-to-value (LTV) ratio does not exceed 90% for five-year loans and 80% for longer tenor loans. Moreover, banks will have to ensure a segregation of duties for loan sales and underwriting. Banks should also consider internal and external sources of information while assessing credit capacity. At the same time, information given to the clients should be comprehensive and unambiguous. Finally, banks must allow clients to take and pay credits off directly in a given currency. According to KNF, the introduction of T-recommendation will improve the quality of credit risk management for banks in Poland.

Regulatory aspects

Secondly, in accordance with the newly issued KNF S-recommendation, from 2012, loan repayment instalments will be restricted to less than 42% of the borrower’s monthly income. Currently, the limit applicable for clients with a monthly income less or equal to the national average salary is 50% of their monthly income. For clients earning above the average income, the proportion may amount to not more than 65%. The new regulations are also likely to reduce the credit capacity of clients willing to draw loans in foreign currencies, as the maximum crediting period to be assumed for the purpose of calculation of repayment instalments will be 25 years. Currently, the credit ability of clients contracting foreign currency loans is 20% lower than in the case of loans denominated in Polish zloty. The implementation of the new regulations will also oblige banks to take into account the possibility of income decreases among clients who may retire during the loan repayment period.

Provisioning. In 2010, there was a significant increase in the profits of the banking sector; however, banks’ results still came under pressure from write-offs as credit risks materialized. Provisions and write-offs were on a similar level in 2009 and 2010 (PLN11.7b (€2.9b) and PLN11.3b (€2.8b), respectively) and much higher than in 2008 (PLN4.1b (€1.0b)).

The negative balance of write-offs is primarily a consequence of the materialization of risks associated with the retail segment, which accounted for 80% of total write-offs made by banks in 2010 (75% in 2009). The total scale of write-offs made in 2010 and resulting from the impairment of financial assets related to households amounted to PLN9b (€2.2b) and was 2.3% higher than in 2009. The negative balance of write-offs and provisions related to consumer loans amounted to PLN7b (€1.7b), a decrease from the previous year of 1.0%, with write-offs made in the second half of last year significantly lower than in the first half. According to the Polish Financial Supervision Authority, the gradual decline in the level of write-offs (especially in the fourth quarter of 2010) may be a signal that the second half of 2010 saw a break in the growth of adverse trends and a gradual abating of negative pressure.


While annual growth rates in some segments of the credit market exceeded 50% during 2004 to 2008, the rate of expansion subsequently slowed considerably to moderate, single-digit levels, with domestic bank borrowings reaching almost PLN700b (€176b) at the end of 2010. The rapid growth in loan portfolios was mainly driven by: (i) increased private consumption, particularly in 2009; (ii) further demand for real estate; and (iii) heightened competition between banks.

However, increasing funding costs, PLNcurrency fluctuations and macroeconomic uncertainty have resulted in deleveraging among corporate borrowers and stagnation in the SME sector. At the start of 2011, there were early signs of recovery in demand for investment loans and in banks’ willingness to lend. The loans- to-deposits ratios of the banking sector in general, is around 120%. This is a factor to consider when projecting further loans’ growth.

The NPL portfolio of Polish banks amounted to PLN61.4b (€15.4b) in April 2011. Of this, retail NPLs amounted to PLN34.9b (€8.8b), mainly consisting of consumer loans, (66% of the portfolio) while the corporate loans balance amounted to PLN26.4b (€6.6b) and mainly relates to SME loans (69%). The volume of loans originated by the top five banks represents 50% of the total of bank loans in Poland.

The NPL ratio of the banks in Poland increased to 8.8% as of December 2010, compared with 4.9% in December 2008. This growing trend was mainly caused by rising indebtedness among consumers (a significant share is attributed to consumer finance banks that accepted higher-risk clients during the credit boom)

Loan market

Top five banks: total loans and NPL ratio (as of Q1 2011)


120

100

80

60

40

20

0BZ WBKINGBREPEKAOPKO BP

140

160

PLN billion

■ Total loans ▬ NPL ratio

134.

0

88.3

61.9

33.7

34.5

0%

2%

1%

3%

4%

5%

6%

7%

8%

7.0% 7.0% 7.0%7.1%

4.8%

NPL ratio in retail and coporate banking

Figure 53 | Source: Polish Financial Supervision Authority

20%

15%

10%

5%

0%2008 1Q 2010 3Q 20102009 2Q 2010 4Q 2010

▬ Customer loans ▬ SME ▬ Large corporates▬ PLNmortages ▬ FX mortages

Poland

and SME clients who were affected by the financial unrest. It should be noted that, despite the currency fluctuations, foreign currency-denominated mortgages have demonstrated a better payments history than PLNdenominated loans.

The fundamental change to the first wave of NPL transaction in Poland (2005–2008) is the stronger position of local purchasers. Companies such as Kruk SA (the current market leader), EGB and BEST are present in the recent transactions both as a servicer and an investor. The possibility of issuing bonds or raising capital on the stock exchange allowed those entities to become active players in all phases of NPL transactions.


Outlook

In both 2009 and 2010, banks in Poland recorded provisions exceeding PLN11b (€2.7b). Recent development indicates that NPL sales activity seems to be picking up again since 2010. According to the debt collection companies, the total market value of Polish outstanding debt is estimated to as much as PLN180–280b (€45–70b) and 25% of this amount is linked to the banking system. The NPL market in Poland continues to develop with several collection companies growing in size and being able to attract capital. This creates additional demand for NPL portfolios. The tendency toward higher sale prices from 2010 is evident and continues throughout 2011.

Prospects for the NPL market are very promising. Forecasts based on independent scientific research, the National Bank of Poland and major NPL market players in Poland confirm expectations of a 2011–2012 peak in NPL transactions. Moreover, certain forecasts for 2011 expect annual growth of two digits for both retail and corporate NPL transactions in terms of their face value. Nevertheless uncertainty at international financial markets may cause significant slowdown in the transaction activities.


Russia

Russia is the largest country in the world by territory and still is the world’s largest exporter of natural gas, the second-largest exporter of oil and the third-largest exporter of steel and primary aluminium. Mindful of this over-reliance on commodity exports, over the last several years, the Russian Government embarked on a program to decrease dependency on exports and develop high technology sectors. Despite the oil price drop, Russia, like other emerging markets hit hard by the crisis, was fast to recover and come back from the dip phase to normal development.

The Russian economy achieved high rates between 2000 and 2008 but experienced a severe recession in 2009 when real GDP decreased by 7.8%. In response to the crisis, the Central Bank of Russia spent one-third of its US$600b international reserves to slow the devaluation of the rouble, and injected a further US$200b into the financial system to increase liquidity and aid Russian firms with large foreign debts. In 2010, the economy began to recover and GDP grew by 4%, driven largely by investment demand, stock building and private consumption.

However, more recently, the economy has struggled due to reduced growth in energy output, a weak banking sector (relatively to developed economies) and high dependence on natural resources. Despite these concerns, the economy is expected to grow by 4.3% on average between 2011 and 2015, increasingly driven by domestic demand, rising oil prices and acceleration of global economic growth. Annual average inflation is forecast to rise to around 9% in 2011 as a consequence of rising food prices and risks underpinned by high oil prices.

718.

2



1,000

500

0

−10%

−15%

−5%

0%

5%

10%

15%

20%

2004 20152014201320122011201020092008200720062005

1,500

2,000


764.

0

826.

3

896.

8

943.

9

870.

1

905.

2

943.

5

982.

4

1,02

2.0

1,06

2.3

1,10

5.0

7.2% 6.4%8.2% 8.5%

5.2%4.0% 4.2% 4.1% 4.0% 3.9%

5.2%

−7.8%

US$ billion


Due to the massive liquidity support by the Government, Russian banks have emerged fairly unscathed from the recent global financial crisis and have actively competed for good quality corporate and retail loans despite the downturn in economic growth over the last several years.

At the beginning of the crisis, in order to sustain liquidity in the banking system, the Russian Central Bank introduced direct lending to pre-qualified banks (those having international or national credit ratings). The auctions have been organized between those banks for unsecured loans. At the end of 2010, the bulk of such loans have been repaid.

However, while the interest rate has fallen from 13% to 8% during the last few years, a lack of liquidity and the absence of long-term funding still remains and represents an issue for the economy. Further, lending policies have become more conservative over the recent past, resulting in reduced profitability and growth in the banking sector.

Since the crisis in 2008, the Russian Government and regulators have exerted growing influence over the banking sector. In return for government support for state-owned banks during the financial crisis, more conservative capital requirements and reporting procedures have been introduced.


Russia

Jan 04 Jan 06 Jan 08 Jan 10Jan 05 Jan 07 Jan 09 Jan 11 Mar 11

2,30

0

3,18

9

4,18

8

5,80

3

8,73

1

12,8

44

12,8

79

14,5

30

14,6

72

300

619

1,17

9

2,06

5

3,24

2

4,01

7

3,57

4

4,08

5

4,10

3

8,000

10,000

12,000

14,000

16,000

6,000

4,000

2,000

0

5%

10%

0%

15%

30%

20%

35%

25%

40%

■ Banking sector assets ■ Top five largest banks’ assets ▬ Ratio of corporate to retail loans

Corporate and retail loans

Figure 56 | Source: Russian Central Bank

RUB billion

Between 2007 and 2010, the total number of banks and other credit organizations decreased from 1,135 to 1,012. The role of the liquidator of insolvent banks is played by the State Deposit Insurance Agency. The largest five banks by assets are almost fully directly or indirectly state owned and account for approximately 48% of total banking assets.

2008

20,2

41

28,0

22

33,8

05

8,56

0

12,9

41

16,1

39



40,000

30,000

20,000

10,000

0

10%

20%

0%

30%

40%

50%

2009 2010 2011

■ Banking sector assets ■ Top five largest banks’ assets▬ Banking assets‘ annual growth rate

29,4

30

14,0

93

RUB billion

44%

15%

5%

38%

13%

19%

28%

36% 37%

31%

28% 28% 28%


Since 2007, the Russian Government and regulators have exerted significant influence on the banking sector. The Government offered support to state-owned banks during the financial crisis, leading to their strengthened position in the market. The Central Bank has also introduced more conservative capital requirements, required more stringent reporting procedures and generally increased monitoring of all players.

On 28 February 2009, amendments were made to Russian Federal Law No 395–1 (1990) “On Banks and Banking Activity” (the Banking Act). These set minimum charter capital levels at RUB180m (€4.3m) for newly registered banks, RUB90m (€2.2m) for newly registered non-banking credit institutions applying for a license to make settlements between legal entities and RUB18m (€0.4m) for all other recently established non-banking credit institutions.

The amendments also lay down stricter requirements for credit institutions applying for a general banking license (one that entitles credit institutions to enter into transactions in roubles and foreign currency and to take roubles and foreign currency deposits from legal entities and individuals). Such a license may only be issued to institutions with capital of at least RUB900m (€21.6m).

Subject to certain other conditions set out in the Banking Act, a bank may only take deposits from individuals if its own funds (capital) or charter capital is at least RUB3.6m (€0.1m).

The Central Bank of Russia also has increased the extent of disclosure requirements, especially for non-performing debt and non-core assets (e.g., real estate assets held on the balance of the banks).

Regulatory aspects

There are only 2 foreign banks among the largest 10 banks in Russia by assets, namely, UniCredit and Raiffeisen. International banks, including HSBC, BNP Paribas, Barclays, Santander, Rabobank, Swedbank AB and KBC Group N.V., are either exiting the market or partly ceasing operations (mostly in the retail sector) due to low profitability and an inability to compete with state-owned banks.

The Government has various plans to develop the banking sector including development of the Moscow financial center and a national payment system. There are also plans to develop the retail network of the largest banks on the basis of the Russian Post and there is further discussions that the control of state-owned banks should be reduced to less than 50% by 2015.


A number of factors point to a future upsurge in the level of activity in the NPL market, with high volumes of NPLs among banks’ assets (estimates vary from 10% to 30%) and the foreseeable reclassification of restructured debt as NPLs (estimates vary between 30% to 70% of restructured debt becoming non-performing in the near future). Banks are reluctant to continue to increase bad debt reserves and sacrifice capital for that purpose in order to maintain profitability levels.

Corporate bad loans have been estimated at 80% of total NPLs at the end of 2010. The rest is attributable to retail loans. However, as noted above, the market for corporate debt currently remains stymied by the gap between buyer and seller estimations on NPL valuation, due to the lack of a widely accepted methodology to value these portfolios.

At present, the potential NPL market is dominated by sellers unwilling to dispose of their bad debt at currently proposed prices; however, a number of banks are currently developing specialized departments or creating vehicles for management of their non-performing and non-core assets. These include Sberbank-Capital, VTB Debt Center and Alfabank’s “A2.”

Recent NPL sales from banks under rehabilitation procedures

Figure 59 | Source: Russian Central Bank; Ernst & Young research

Seller Volume(RUBbillion) Acquirer

Svyaz-Bank 80.0 VEB

Petrovskiy Bank 56.0 DIA

KIT Finance 50.3 DIA

Soyuz Bank 30.9 DIA

Otkritie Bank 9.0 DIA

NPSB 4.5 DIA

Recent NPL transactions

Figure 60 | Source: Russian Central Bank; Ernst & Young research

Seller Volume(RUBbillion) Acquirer

GE Money Bank 9.0 Collector agencies

MDM Bank 8.0 EOS Group

Alfa-Bank 1.1 Collector agencies

VTB 24 6.7 Rusdolg

Tinkoff Credit Systems 0.76 Collector agencies

OTP Bank 5.4 Morgan & Stout

Russia

Total NPLs in the Russian banking system are estimated at RUB1,815b (€43.7b) face value, accounting for 8.2% of loans granted as at 1 January 2011. As a consequence of the crisis, the level NPL ratio sharply increased from 2.5% in 2008 to 3.8% and 9.5% in 2009 and 2010, respectively. The value of bad debt reserves also significantly increased.

Historically, in Russia, NPLs correlate with net job numbers. Net job numbers have stabilized, indicating underlying overdue payments are also stabilizing at levels similar to last year (in absolute terms). In 2010, total lending increased by 15%, which contributed to a fall of the percentage of NPLs at the beginning of 2011.

The market for trading NPLs in Russia is similar to the market in other European countries, with most trades being for retail portfolios. There is very little trade in corporate NPL portfolios, mainly due to a wide gap between buyers and sellers over price and the unwillingness of many banks to make public the poor quality of their portfolios. There are transactions when banks sell (transfer) NPLs to their related parties in order to remove them from their balance sheets and to deal with collaterals (specifically real estate) in a tax-efficient way.

Trading in corporate NPL portfolios is very likely to increase in Russia if liquidity dries up because NPL volumes are high, legal obstacles appear manageable and the market is developing.

Loan market

2008

13,4

17

19,8

85

19,8

47

22,1

40

335

756

1,88

5

1,81

5

NPL dynamics


25,000

20,000

15,000

10,000

5,000

0

2%

4%

0%

6%

8%

10%

2009 2010 2011

■ Total lending ■ NPLs ▬ NPL ratio

US$ billion

3%

4%

10%

8%


Outlook

Despite the before-mentioned factors, overall activity in the NPL market is rising (for instance, IFC launched a €450m fund for bad debt buyouts). Significant portfolios have passed through specialized state agencies, such as Deposit Insurance Agency (DIA) and VEB. The most significant NPL purchases were made by the state agencies from sanitized banks that entered the insolvency process. We expect the market activity to increase significantly in the coming years.


Ukraine

Ukraine is the second-largest country in Europe after Russia by territory and is seen as a key element in economic and political stability in the region. Prior to the global financial crisis, Ukraine had one of the highest global GDP growth rates, foreign direct investment (FDI) and consumer spending levels. However, it has been one of the worst-affected economies by the global financial crisis, recording a 15.1% contraction in GDP to US$114b over 2008 to 2009.

Prior to the global financial crisis, GDP growth was driven by commodity exports, such as steel and external financing. However, with the onset of the crisis, export volumes declined significantly owing to a decrease in real wages, rising unemployment and reduced credit availability. Ukraine has one of the lowest average incomes in the Central and Eastern Europe (CEE) region, US$225 per month, and is experiencing significant inflation, which is expected to reach 10.5% in 2011. Since the global financial crisis, the Ukrainian Hryvnia has depreciated against the US dollar by over 70%, leading to significant increase in debt servicing costs of Ukrainian companies on foreign currency loans. Regular interventions by the National Bank of Ukraine to stabilize the Hryvnia have resulted in Ukraine becoming the second largest IMF borrower with a current IMF debt of more than US$14b. This has led to national debt reaching US$56.4b as of 31 March 2011.

In 2010, the economy began recovering from recession and recorded a real GDP growth rate of 4.2%. Growth rates are forecast to increase over the next few years, driven primarily by a competitive depreciation of the Hryvnia and anticipated export growth resulting from the recent award of WTO membership. Furthermore, a Free Trade Agreement is under negotiation with the EU that would further encourage exports and FDI. With world demand for steel (a key Ukrainian export) recovering, steel prices rising and an inexpensive, abundant and educated labor force, the prospects for Ukraine over the next several years appear encouraging.

83,6



100

80

60

40

20

0

−15%

−20%

−10%

−5%

5%

0%

10%

15%

2004 20152014201320122011201020092008200720062005

120


86,1

92,6

99,6

101,

9

86,8

90,5

94,9

100,

0

105,

7

111,

4

116,

7

12,1%

3,0%

7,4% 7,6%

2,3%

−14,8%

4,2% 4,8% 5,4% 5,7% 5,4% 4,7%

US$ billion


42,3

5267.2%

67,3

62

59.1%

118,

692

76.2%

120,

271

1.3%

110,

244

−8.3%

118,

327

7.3%

The Ukrainian banking sector was among the hardest hit in the entire CEE region in 2008 and 2009 due to the global financial crisis. According to the results of the second stress test communicated by the National Bank of Ukraine (NBU), the capital shortfall in the banking sector was estimated at US$5b, of which US$1.9b related to ailing banks Nadra and Rodovid.

The financial crisis has adversely impacted the profitability ratios of Ukrainian banks. In 2009 and 2010, the banks recorded negative returns on both assets and equity. Despite this, the banking sector was able to maintain a net interest margin of over 5%. In response to the IMF granting a US$14.9b loan to the Ukraine in July 2010, Standard & Poor’s improved the long-term debt credit rating of Ukraine in foreign currency from CCC+ to B+ along with upgrading the credit rating of obligations in its national currency from B− to BB−.

As at 1 January 2011, 194 banks in the Ukrainian financial system, including 55 banks with foreign equity, has been recorded. Of these 176 banks have an NBU license for banking activity with the remaining 18 banks currently in the process of liquidation. The share of foreign capital within the total registered authorized capital of banks in Ukraine amounted to 40.6%. These banks benefited from foreign ownership during the financial crisis and are regarded as an attractive home for domestic deposits due to a perceived lower risk, enhanced stability and increased transparency.


Ukraine

21,5

88

6,56

6

33,2

00

15,3

97

54,6

90

30,4

22

61,3

75

34,9

16

59,4

85

27,8

70

63,8

42

23,4

30

Corporate and retail loans

Figure 62 | Source: National Bank of Ukraine

70

60

50

40

20

30

10

02005 2006 2007 2008 2009 2010

■ Corporate loans ■ Retail loans

US$ million



140

120

100

80

40

60

20

0

40%

20%

60%

80%

0%

−40%

−20%

2005 2006 2007 2008 2009 2010


US$ million

In 2010 the total assets of the Ukrainian banking system (before deduction of provisions on active operations) increased by US$8b and keep growing in 2011. The adequacy of regulatory capital for the whole banking system remains high (20.8%, according to the NBU estimates as of 1 January 2011). However, certain banking institutions have issues with equity levels due to significant losses attributable to additional provisions booked on loan portfolios.

As at 1 January 2011, the top 10 banks accounted for 54% of total banking assets, with Privatbank being the largest. Nadra, the ninth largest bank in terms of assets, is currently in financial difficulties, having received an emergency US$1b restructuring loan and it is estimated that an additional capital of US$1b may be required.

Corporate lending exceeds retail lending by more than 100% and both sectors experienced strong growth prior to the financial crisis. After the onset of the financial crisis, lending effectively froze until the end of 2009. In 2010, corporate loans increased by 7% while retail loans continued to decrease by a further 16% during the same period.


The National Bank of Ukraine is the country’s central bank; a specific central body of the state administration that acts as its currency issuer and that pursues common state policy in money circulation, credit and supporting the value of the monetary unit. It oversees the functioning of the banking system in general and also determines the exchange rate of the monetary unit against foreign currencies.

The NBU is responsible for determining and enacting revisions to the discount rate and other interest rates. It grants permission for commercial banks’ registration and licenses banking business, as well as determining the obligatory reserve fund for commercial banks and other financial and credit institutions.

According to the constitution of Ukraine, the main function of the NBU is to ensure the stability of the national monetary unit — the Hryvnia (UAH). To carry out its main function, the NBU fosters the stability of the banking system and, to the best of its ability, seeks to ensure price stability.

Between 2008 and 2010, the NBU adopted a number of regulations to stabilize the activity of the banking system.

Liquidity. The NBU continues to support banking sector liquidity through refinancing loans. During Q4 2008, when Ukraine faced a liquidity crisis, it provided UAH105.4b (€9.6b) of refinancing loans to support a number of banks. The loans were mainly issued with 12-month maturities but the term of those issued for distressed banks were subsequently extended for several years.

Capital. The minimum level of bank’s regulatory capital has increased to UAH120b (€11.0b). At the same time, the level of regulatory capital should not be less than share capital. According to Associations of Ukrainian Banks data, at 1 January 2011, 34 banks or 19% of all banks operating in Ukraine had equity of less than UAH120m (including subordinated debt and excluding unformed provision). According to resolutions of the NBU from November 2010, banks are no longer permitted to take subordinated debt into account when calculating regulatory assets.

Operating activity. Financial institutions are prohibited from unilaterally increasing interest rates or other costs under facility agreements or changing the debt repayment schedules. Financial institutions are also prohibited from requiring early repayment of outstanding debt and from unilaterally terminating the facility if the borrower does not agree to the increased interest rates or other costs.

Provisioning. Resolutions of the NBU from November 2010 superseded a number of anti-recessionary decrees. According to the new resolutions, when calculating provisions for their statutory books, banks can take into account additional collateral for loans to producers, real estate firms and agricultural producers. Such provisions should stimulate lending to key industries and facilitate debt restructuring.

The legislative changes that allow the banks to sell NPL to venture funds for investment certificates, and not to create 100% provision against the certificates, have now been discussed by the Government and the NBU. This would speed up the transactions and stimulate the banks to get rid of their bad debts.

Regulatory aspects


Ukraine

Although, in general, the financial sector conditions are slowly improving, banks remain under stress. High NPL levels represent a major challenge to banks’ balance sheets and the resumption of lending, with weaknesses in the legal, tax and judicial systems preventing more aggressive resolutions of bad loans. As a result, and notwithstanding that the banking system as a whole is highly liquid, anaemic credit growth conditions have continued in 2011. Lending to households remains stalled due to perceived high credit risks, though credit to enterprises has shown some signs of revival recently.

With the start of the financial crisis, the level of NPLs has increased dramatically. In 2009, loan loss provisions increased by 152% compared with 2008, while gross loans fell by 2% year on year. In 2010, loan loss provisions continued to increase as Ukrainian banks recognized further loan impairment. Among the top 20 Ukrainian banks, Rodovidbank, Swedbank and Ukrgasbank were most hit by NPLs.

Standard & Poor’s experts attributed Ukraine’s banking system to a group of the weakest because of the high level of country risk. The share of problem loans (including restructured loans) stands at almost 50% in 2010. Fitch and Moody’s credit agencies assessed the proportion of NPLs at the level of 56.5% and 40% respectively.

During 2009 and 2010, Ukrainian banks were looking for ways to manage their NPL portfolios. Different options were considered, ranging from establishing their own collection units to outsourcing and disposal of NPLs. Many of the NPL portfolio transactions that took place in 2009–2010 were between related parties or SPVs created by the banks to clean up their balance sheets.

Also, debt collection businesses started to grow and attracted a few foreign investors (Horizon Capital and Abris Fund). Currently, the sector is considered to be very attractive and large investment funds are looking to enter the market through the establishment of a collections business or investment in an existing one. Due to legal obstacles related to registration of collateral and assignment of rights to the loan, the NPLs that were sold in the last two years were mostly Hryvnia-denominated unsecured consumer loans.

Industry experts assess the total NPL market capacity at UAH300b (€27.5b) with almost equal split between corporate and retail loans. More than 80% of NPLs relate to non-performing banking loans. The remaining 20% of NPLs refer to debts to telecommunication companies, insurance companies and companies that provide housing and utility services.

Prices for the NPL purchase of debt vary from 0.1% to 20% of their nominal value. Increased competition among debt collectors has driven an increase in prices.

Loan market

142

8 246

11 430

17 742

42 726

107

751

140

NPL dynamics


700

800

600

500

400

200

300

100

02005 2006 2007 2008 2009 2010

■ Total loans ■ Loan loss provisions ▬ Aggregate loan loss provision rate

UAH billion

20%

15%

10%

0%

5%

5.5%4.7%

4.0%

5.7%

14.8%

18.6%

Two major debt collection schemes include “collect and get commission” and “buy and collect.” Following the resumption of retail lending, it is expected that, in 2011, the volume of the collect and get commission market will increase to around UAH6b (€0.6b), and to around UAH8b (€0.7b) in 2012.

The size of the buy and collect market is forecast to increase in 2011 up to UAH4.0–4.5b (€0.4b) as Ukrainian banks will continue selling loans impaired as a result of the economic downturn in 2008–2009. However, from 2012, the market is expected to shrink to UAH3.0–3.5b (€0.3b) unless a new economic downturn arises.


Outlook

The recent troubles in the global financial markets and a potential onset of a double-dip recession may have a negative impact on the growth of the Ukrainian economy. However, deleveraging of the Ukrainian banking sector from the highs of 2008, as well as consolidation of the government monetary and fiscal policies, make the repeat of the dramatic fall in 2008 (when real GDP slumped almost 15%) unlikely.

Despite positive signs, the recovery of Ukrainian banks is still fragile as they continue to clear their balance sheets of bad debt. In the first half of 2011, Ukrainian banks recorded a collective loss of US$133m — a significant improvement from the first half of 2010, when the losses were US$1b.

Under the pressure from IMF, Ukraine has been implementing structural reforms including a new tax and pension legislation. However, in view of the upcoming parliamentary elections, some of the critical but unpopular measures (such as an increase in gas retail prices) are likely to be delayed until 2012. The majority of experts expect the Ukrainian economy to maintain a positive momentum with real GDP growth rates of around 5% within the next few years.

The overall sentiment among market players is that the market for NPLs will develop over the coming years as Ukrainian banks learn the benefits of outsourced collection as well as continue to clear their books through true sale of NPLs.


Kazakhstan

The Kazakh economy grew significantly between 2003 and 2007, mostly driven by foreign direct investment (FDI) inflows into geological exploration works, crude oil and gas extraction, and rising energy prices. The global financial crisis, as well as a significant decline in commodity prices, had an adverse effect on GDP growth.

Prior to the global financial crisis, the Kazakh economy experienced accelerated growth followed by a gradual economic deceleration in 2008 and 2009. In order to sustain and enhance the economic competitiveness of domestic producers, and to maintain the country’s gold reserves, the local currency experienced a significant devaluation in 2009. The Kazakh economy regained momentum in 2010 due to the influence of liquidity injections (11% of GDP), as part of the implemented economic stabilization measures, and positive market conditions supported by a solid performance in industrial production, oil and gas, mining and agriculture. In 2010, the country’s exports — predominantly mineral resources including hydrocarbons and base metals — grew by 37.1% on the prior year.

Despite the recent positive trends, there still remains uncertainty with respect to medium term prospects for capital markets and commodity prices, upon which the Kazakh economy is so dependent. Furthermore, liquidity restrictions in global capital markets have negatively impacted on Kazakhstan’s sovereign credit rating. Kazakhstan’s GDP is forecast to grow at an average of 5.1% p.a. over 2011 to 2015; however, this forecast is heavily dependent on projected commodity prices.



100

80

60

40

20

0

−10%

−15%

−5%

0%

5%

10%

15%

2004 20152014201320122011201020092008200720062005

120

US$ billion


52.1

57.1

68.9

71.1

71.9

77.0

81.6

85.7

89.4

93.7

98.6

63.2

9.6% 9.7% 10.7%8.9%

3.2%1.2%

7.0%6.0%

5.0% 4.4% 4.8% 5.2%


The Kazakhstan banking sector is headed by the National Bank of Kazakhstan, which is charged with maintaining financial sector stability through primarily developing and implementing monetary policy and exercising exchange rate controls.

The rest of the banking system consists of 39 banks, with the 6 largest banks by assets (Kazkommertsbank JSC, BTA Bank JSC, Halyk Bank JSC, Bank CenterCredit JSC, ATF Bank JSC and Alliance Bank JSC) accounting for almost 76% of total banking assets in the Kazakh banking sector.

The banking sector developed rapidly during the period 2000 to 2007, driven by growing GDP and an influx of foreign financial investments. However, the global financial crisis led to a significant decline of the banking sector, primarily due to the low quality of banking assets and significant levels of external debts held by commercial banks. This in turn led to the default of a number of large financial institutions, leading to a lack of liquidity and sharp rises in interest rates offered to borrowers.

In response, the Kazakh Government founded the Sovereign Wealth Fund Samruk-Kazyna (SWF SK) in order to ensure stability and enhance competitiveness of the Kazakh economy. The stabilization program, put forward by SWK SK during 2009 and 2010, allocated additional funding capital provided by the Kazakh government on the following basis: financial sector stabilization of KZT486b (€2.4b); residential property sector development of KZT360b (€1.7b); small and medium business support of KZT120b (€0.6b); and innovative, industrial and infrastructure projects of KZT120b (€0.6b).


In 2010, total assets of the Kazakh banking system grew by 4% to KZT12.03b (€60m) on the prior year, against a recorded 2.8% decrease in 2009. Loan portfolios have traditionally constituted the largest portion of commercial banking assets, accounting for 75% of total banking assets in 2010. Moderate growth of loan portfolios was recorded in 2009 due to the economic incentives provided by the financial stabilization program conducted by SWF SK. However, the tightening of banking lending criteria led to a subsequent decline in 2010.

Financial indicators of Kazakh second-tier banks in 2010

Figure 67 | Source: AFN; in accordance with KAS

KZT billion Income- earning assets

Loan portfolio

Provisions for loan portfolio

Kazkommertsbank JSC 2,029 2,344 724

Halyk Bank JSC 1,798 1,224 286

BTA Bank JSC 1,500 1,645 922

Bank CenterCredit JSC 1,121 720 110

ATF Bank JSC 927 849 128

Alliance Bank JSC 333 546 319

Other 2,403 1,738 317

Total 10,111 9,066 2,806


Figure 66 | Source: AFN

20

−1.1 −3.20.8 1.0 0.90.6 1.1 1.00.9 1.8 2.2

9.6 9.1

0.30.3 0.41.1

1.7 1.715

10

5

0

−5

4%

3%

2%

1%

0%

5%

−1%

−2%

−3%2008 20102009

−2.6%

2%

4%

KZT trillion

■ Provisions

▬ Total assets growth rate (right scale)

■ Direct investments

■ Cash, affinated precious metals and correspondent accounts

■ Other assets

■ Securities

■ Interbank deposits

■ Loan portfolio

−4.0

9.2

Kazakhstan


In April 2011, the previous regulator — the Agency of Financial Regulation (AFN) — was abolished and regulatory functions covering commercial banks were passed over to the National Bank of Kazakhstan.

Amendments to the regulatory requirement for commercial banks during 2008–2010 included the establishment of business continuity plans to strengthen risk management, lower called-up share capital requirements, lower minimum reserve requirements and revisions to the corporate income tax code with respect to restructuring revenues.

At the end of 2010, the Kazakh Government put forward an initiative to implement an economic program to maintain and further develop the financial sector in the post-crisis environment. The concept includes the utilization of public-private partnership schemes as the main financing mechanism for the economy, regulation of the monitoring system applied to the financial sector, development of a mechanism for early detection and prevention of financial sector imbalances, and the revision of legislation.

In addition, the Government is planning an amendment to the tax system, which would allow banks to effectively write off NPLs on their balance sheets. However, according to Standard & Poor’s, asset quality indicators will not reach the pre-crisis levels in the medium term.

Capital. The financial authorities approved a harmonization policy, effective from 2013, between domestic and international banking capitalization requirements based on the Basel III accord, in order to overcome the shortcomings of the country’s banking activities exposed by the global financial crisis. In line with Basel III guidelines, the harmonization introduces the concept of common equity as paid-up ordinary shares and reserves for bank risk, and it excludes perpetual financial instruments and preferred shares from Tier 1 capital.

Regulatory aspects Loan market

The total banking system’s loan portfolio experienced a decline in quality during the financial crisis. On average, during 2008–2010 69% of total loans were granted to legal entities, 56% of the loan portfolio was denominated in national currency, 82% of the portfolio consisted of long and medium-term loans and half of total loans consisted of NPLs. During the same period, the NPL ratio increased from 4% to 20%.

The measures implemented in 2009 and 2010 to reduce the bad debt of commercial banks’ portfolios had limited success. Banks enthusiasm for writing off bad loans from their balance sheets remained low due to the possible negative consequences from an income tax perspective, due to recovering provisions and a lack of appropriate instruments.

In March 2011, the financial regulatory authority proposed a new conceptual plan to improve the quality of commercial bank’s assets, which includes (i) the establishment of a new distressed assets fund specialized in the acquisition of distressed assets of commercial banks, and (ii) set up or acquisition of asset management companies by the commercial banks with the purpose to acquire and resolve problematic assets of commercial banks.

During 2008–2010 the principal funding channel for Kazakh banks was in the form of deposits. In 2010, deposits from corporate clients were twice as large as those of individuals. Due to the strengthening of the local currency last year, deposits denominated in local currency increased from 58% of total deposits in 2008 to 62% in 2010.

In addition, borrowings from international financial institutions decreased by 21% in 2010 as a by-product of the restructuring process of the commercial banks. As a result of governmental actions to stabilize the country’s financial sector, public sector borrowing increased by 83% over 2008–2010.

25%

43%

20%

31%

4%

54%

44%

53%

26%

Loan portfolio quality

Figure 68 | Source: AFN

2008

20%0% 40% 60% 80% 100%

2010

2009

■ Standard loans ■ Problem loans ■ Bad loans


Kazakhstan

Sale of RBS’ retail loan portfolio to HSBC (2010)In June 2010, HSBC Holdings plc acquired the retail banking assets of RBS Kazakhstan for up to US$52m. Assets subject to the deal included a retail loan portfolio (comprising primarily of personal loans and credit cards), 80 ATMs and 2 support offices. The deal was completed in September 2010.

Acquisition of ProstoCredit by Eurasian Bank (2011)On 21 February 2011, Eurasian Bank, one of the top 10 commercial banks in Kazakhstan, completed the acquisition of ProstoCredit LLP, a non-banking lending institution and former subsidiary of Société Générale in Kazakhstan, for an undisclosed sum. According to the terms of the agreement, the non-defaulted credit portfolio was immediately absorbed into the balance sheet of Eurasian Bank. The full integration of the newly acquired ProstoCredit business into the bank’s structure (including the organizational model, sales system and information platform) will be completed over time. ProstoKredit is currently designated as a retail business of Eurasian Bank and operates as a separate and independent legal entity.

Acquisition of Dana Bank by Punjab National Bank (2010)In March 2010, Punjab National Bank completed the purchase of a 64% stake in Dana Bank, a privately owned small-cap commercial bank in Kazakhstan, for US$23.8m from BATT Corporation. The proceeds from the transaction were to be used to invest in the bank’s equity in order to meet the minimum capital requirements introduced by the Government in 2009.

M&A activity

Acquisition of Metrocombank (2009)Former shareholders of ATF Bank acquired a 100% stake in Metrocombank, a small privately owned commercial bank in Kazakhstan for an undisclosed amount. Again, the proceeds from the transaction were to be used to invest in the bank’s equity in order to satisfy the Government’s new minimum capital requirements.

Sale of Alliance Bank of its retail NPL portfolio (2011)In August 2011, Kazakhstan-based Alliance Bank has found a buyer for its problem retail loans. The deal to sell the non-operating loans is nearing its completion. As a result, the bank will receive KZT14b (€70m) worth of equity capital under IFRS. As reported, in April 2011, the bank announced its intention to get rid of bad retail loans worth KZT182b (€0.9b).

Recent M&A transactions


Target Seller Buyer Deal type Dealvalue,US$million Completion date

ProstoKredit Société Générale Eurasian Bank Corporate Not disclosed Feb 11

DanaBank(64%) BATT Corp PNB Corporate 23.8 Dec 10

Retail business of RBS RBS Kazakhstan HSBC Asset >52 Sep 10

Metrocombank Private investor Private investor Corporate Not disclosed Dec 09

Alliance Bank retail NPL portfolio

Alliance bank Not disclosed Asset Not disclosed n/a


Outlook

According to projections published by the Regional Financial Centre of Almaty, the profitability of Kazakh commercial banks is not expected to increase in the short term due to low interest income growth. The structure of the loan portfolio is projected to respond to the anticipated changes in the overall economy. Specifically, the percentage share of the overall loan portfolio for telecommunications, agriculture, logistics, gas generation or distribution and utility sectors is expected to grow.


Restructuring• Review of the operating model and

loan origination process to identify quality and risk issues and evaluate against leading practice

• Credit risk analysis and its impact on performance indicators

• Support, challenge and advise management during decision-making process

Transactions Advisory Services• M&A lead advisory• Financial due diligence• Portfolio valuation• Transaction database

Real Estate Advisory• Real estate due diligence• Drive-by and desktop valuations• Strategic real estate advisory

Legal, Tax and Accounting• Legal due diligence• Transaction documentation

(NDA, SPA, annexes)• Audit and tax compliance• Regulatory implications

Process management

Real Estate

Advis

ory

Legal, Tax and

Transaction Advisory

Rest

ructuring

Accounting

Ernst & Young’s leading value proposition

Our Strategic Portfolio Solutions team is a multi-disciplinary team of experienced transaction managers and professionals, who closely work together in an integrated approach to increase transaction value for our clients. We are committed to bringing all required knowledge and skills right to your doorstep, advising you on your most complex loan portfolio transactions. This is how Ernst & Young makes a difference.

NPL market offerings to date have concentrated on disposal and very rarely provide a holistic way of looking at the problem from the point of view of maximizing value. Yet, this is the way the shareholders and management of banks perceive the NPL issues.

We believe the time is right for a broader approach driven by value improvement across a range of options — managed to produce higher, faster, lower-risk recoveries.

The Strategic Portfolio Solutions team takes responsibility for all stages of delivery, right through to completion, and provides a dedicated senior delivery leader with highly relevant skills and experience, pooling knowledge from different professional teams within Ernst & Young, such as real estate, advisory and tax.

Serv

ices

111Ernst & Young European Non-Performing Loan Report 2011Ernst & Young European Non-Performing Loan Report 2011 111

Our approach to addressing non-core loan portfolios

We have the capability and resource to support from the early stages of the decision-making process right through to the execution of the chosen strategy.

• The process of taking strategic decisions regarding non-core portfolios requires a robust analysis to be undertaken based on high-quality input data. A significant challenge lies in balancing the need for taking immediate action with the time required to analyze portfolios adequately.

• Portfolio sales can be complex, with buyers typically expecting to obtain significant amounts of detailed portfolio information. Therefore, a thorough preparation and execution phase is required to meet investors’ expectations.

• Structured solutions are only achievable if they are implemented on a bespoke basis, giving consideration to the assets together with the desired accounting, regulatory and tax treatment.

Decision support Execution support

Options analysis

Sale

Structured solution

Hold for futureexit

Hold and restructure

Impairment loss and cash

flow modeling

Data collection andverification

Stratification and performance

analysis

Loanfilereviews

Capital impact analysis

• The decision-making process may conclude that a portfolio is non-core but that it is not possible, or it is not economically favorable, to pursue an exit in the short to medium term. In this case, holding the portfolio while maintaining flexibility to facilitate a future exit, is the most appropriate course of action.

• The decision-making process may show that an immediate exit of the portfolio is not optimal and that it should be worked out with a view to maximizing and/or accelerating individual loan recoveries.

We provide the required services through an integrated, cross-boarder advisory team with one senior delivery leader.

Cont

acts

Europe Thomas GriessPhone +49 6196 996 [email protected]

Nora von ObstfelderPhone +49 6196 996 [email protected]

Germany Ana-Cristina GrohnertPhone +49 40 36132 [email protected]

Daniel MairPhone +49 6196 996 [email protected]

Andreas EwaldPhone +49 40 36132 [email protected]

UK Ian CosgrovePhone +44 20 7951 [email protected]

Fraser GreenshieldsPhone +44 20 7951 7151 [email protected]

Spain Cristina Almeida LunaPhone +34 9 1572 [email protected]

Ireland Marcus PurcellPhone +353 1 221 [email protected]

Italy Mauro IacobucciPhone +39 02722 [email protected]

Portugal Miguel FarinhaPhone +351 217 912 [email protected]

Greece & CEE Eric TourretPhone +30 210 [email protected]

Turkey Muge OnerPhone +90 212 368 [email protected]

Poland Arkadiusz KrasowskiPhone +48 225 577 [email protected]

Russia Alexander YerofeyevPhone +7 495 755 [email protected]

Ukraine Larysa MarchenkoPhone +380 44 499 [email protected]

Kazakhstan Timur PulatovPhone +7 727 259 [email protected]

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