Refinancing banks : Expect unexpected losses, an analytical approach
D'Artagnan Corporate Finance
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This articles cover the following
Increasing share of non-performing loans ("NPL") should trigger:
Current macroeconomic conditions should lead to
A growing market
In recent years, the Norwegian refinancing market has experienced strong growth attracting new players and intensifying competition, resulting in heightened product awareness. We observe that mortgage loans to customers grew by ~14% over the past year among niche lenders (MyBank ASA, Bank2 ASA, Kraft Bank ASA, Bluestep Bank AS - Norwegian branch and Instabank, data for Nordax was not available). This article delves into two key aspects: expected credit losses (provisioning level) within these banks, as well as concerns about potential future losses. These concerns arise because of the current macroeconomic climate characterized by high inflation and considerable uncertainty regarding the development of housing prices. Despite some relief from salary increases in mitigating inflation's impact, they prove insufficient to fully offset the rapid rise in interest rates on mortgage loans, often reaching four to five times a household's annual income.
In absolute figures, mortgage loans provided by refinancing banks have increased by NOK 2.4 billion in the past year. However, during the same period, there has only been an increase of ~NOK 0.4 billion in “healthy loans” (stage 1 loans under IFRS 9 rules) where customers consistently make on-time payments.
This should raise questions about the credit quality of the loan portfolios, especially considering the increasing uncertainties surrounding the broader economy.
Non-performing loans are on the rise too...
The share of non-performing loans (Stage 3) has almost doubled over the period despite the overall growth in the market. Further, the Norwegian central bank has continued to raise the policy rate, which has increased by 1.0% since the beginning of May 2023.
Consequently, we expect to see a further increase in NPL share for the refinancing banks in the coming quarters as the full effect of the rate hikes is reflected in lending rates to customers.
Borrowers, facing more expensive borrowing costs, could find it increasingly challenging to meet their debt obligations, further testing the adequacy of the loan loss provisions.
Implementing an NPL strategy should be on the CFO's agenda
Banks with NPLs comprising more than 5% of their loan portfolio are required to establish a strategy for reducing their exposure to these loans. You can find detailed guidance on this requirement in the European Banking Authority's (EBA) guidelines provided in the link below.(https://www.finanstilsynet.no/regelverk/eba-retningslinjer/eba-retningslinjer/eba-guidelines-on-management-of-non-performing-and-forborne-exposures/).
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At DCF, we firmly believe that banks should place a significant emphasis on refining their strategies for managing non-performing loans (NPLs). This should be done while also taking into careful consideration the potential impact of back-stop rules on their capital adequacy. Additionally, we are of the opinion that debt purchasers should explore the possibility of acquiring secured NPL portfolios, similar to practices observed in other countries.
Provisioning levels for Stage 3 loans
When assessing stage 3 provisions, the significance of the Probability of Default (PD) parameter diminishes, as loans in this stage are already in default (PD = 100%). Therefore, the primary judgment factor becomes the expected value of the collateral.
We observe a non-negligible decrease in provisioning levels over the period despite a worsening economic outlook driven by i) higher inflation reducing overall collection potential and ii) rising interest rates, which have introduced uncertainty regarding the trajectory of the Norwegian housing market.
We are raising concerns about whether banks have exercised adequate conservatism in their cash-flow analysis and whether they have applied a sufficient illiquidity discount when valuing collateral (residential properties).
An overview of the banks' respective provisioning levels is provided at the end of this article.
The provisioning level for performing loans is not impacted
When it comes to stage 1 loans, we have noticed that loan loss provision levels have remained consistent over the past year, despite a significant rise in default rates. In such cases, we would expect banks to account for this by incorporating a higher underlying probability of default rates into their models. The same principle applies to stage 2 provisions for loans showing substantial signs of credit deterioration.
In light of the recent rise in non-performing loans (NPLs, which serve as an indicator of the probability of default), it would be reasonable to anticipate an adjustment in the experience factor related to the probability of default in the expected credit loss (ECL) calculations.
Comparison of the banks in the panel
The following information is provided to assist the reader in evaluating the provisioning levels of different banks. It's important to consider that variations among banks can be attributed to various factors such as their risk profiles, types of collateral, and geographic concentration. A meaningful comparison between banks necessitates a more comprehensive understanding of their underlying portfolios and methodologies.
Stage 1 provisions
Stage 2 provisions
Stage 3 provisions