Since the 2008 global financial crisis and the ensuing economic challenges that rippled through Europe, the pool of non-performing loans and non-core assets across the continent grew exponentially to record levels, fuelling a distressed credit market that now totals more than €2 trillion.
With their capital positions exposed and under increasing pressure from regulators, banking institutions across the continent have spent recent years attempting to free up their balance sheets while maintaining healthy capital buffers.
Despite their best efforts, however, the sector still found itself with more than €640 billion of NPL stock even before covid-19 took hold. The pandemic and the economic fallout are likely to further add to vulnerabilities, at a time when banks had not even finished resolving the issues they set out to deal with following the last significant financial crisis.
Pandemic could cause NPL ratios in Europe to double
While it is too early to accurately forecast the extent of its impact on global debt levels, it is widely predicted that covid-19 will lead to a sharp increase in loan default rates and NPL stocks across Europe, significantly reversing the many efforts made over recent years. The pandemic continues to reshape our economies during the most acute dislocation event in modern history and will grow and extenuate existing regulatory and balance sheet stress-points within the banking sector.
According to forecasting by consultancy Oliver Wyman, in a scenario with a slow economic recovery where most countries avoid a second lockdown, it estimates bad debts would surge to €400 billion, about 2.5 times the level in the prior three years. In a worst-case scenario where a severe second wave of the virus is experienced, that figure doubles and banks’ NPL ratios rise to 10 percent of their total lending. Given the recent resurgences of the virus in Asia, and now in certain regions of Europe, it is looking increasingly likely that the best-case scenario may be redundant.
European banks are already seen to be significantly lagging behind their US counterparts in terms of building up coverage ratios for impending NPL exposures. When you set this consideration against an existing backdrop of low gross savings rates, inflated debt to GDP ratios across Europe and tighter profit margins, bank and non-bank lenders will find themselves under immense pressure to learn from 2008 and alleviate this significant and growing NPL burden. Indeed, it will be necessary for them once again to reduce their NPL burden to navigate successfully through the uncertainty ahead.
Private capital provides solution for banks under stress
To date, part of the solution to this ongoing issue has been the involvement of institutional, private capital in the sector. More than €960 billion of portfolios has been acquired by global debt firms in the primary market over the past eight years, placing private capital at the centre of the recovery effort for the worst hit European economies, particularly in the south of Europe.
Perhaps one of the lesser known alternative investment strategies in the asset management community, NPLs and non-core bank books as an asset class has generated strong alpha for investors over the past decade. Having invested in the sector every year since the GFC, Arrow has achieved 18 percent gross internal rate of return – a clear indication of superior returns versus better known, mainstream strategies. Furthermore, when looking at the three years to 2012, this figure sat at 27 percent, reflecting the sheer opportunity open to private capital in the immediate aftermath of a significant dislocation.
Yield hungry investors turn to NPLs
We find ourselves in an environment of ongoing record-low interest rates that show no signs of shifting higher while central banks look to safeguard public finances. Against this backdrop, NPL exposure provides an attractive proposition to yield-hungry investors struggling to generate alpha in public bond markets, and who are sceptical about valuations across public equities that will not move in contrary directions to the real economy.
Providing such exposure, AGG Capital Management, an independent manager with access to Arrow Global’s servicing, pricing, sourcing and successful ‘Local Operator Investor’ track record, announced the second close of its inaugural fund, Arrow Credit Opportunities, at €1.2 billion earlier this year.
The amount we raised, combined with the positive response we received first-hand from investors, is a demonstration of the recognition of the attractiveness of this asset class even before the current crisis became apparent. Now, when set against the newly evolving post-covid backdrop, the value of such a proposition has become even clearer.
There is a real opportunity for institutional investors to tap into a market made up of a fast-growing pool of investible assets while alleviating the pressures on the financial system.
Zach Lewy is founder and chief investment officer at Arrow Global Group, the Manchester, UK-based investment manager