Sell or Hold? On the Value of Non Performing Loans and Mandatory Write-Off Rules

Abstract

This paper investigates the decision rational banks face when considering selling a non performing loan (NPL). We start with developing a risk neutral pricing model for non performing loans and show that even if a bank and a potential buyer agree on the expected recovery value a difference in the precision in the estimation of the drift of the underlying recovery process may greatly influence the decision to sell a NPL. This difference could be due to private information of the bank about the borrower’s loan history or due to a larger sample of similar borrowers where defaults can be observed. Furthermore, the question if it is optimal to hold on to a NPL is also affected by capital requirements and funding costs banks typically face. This question is of particular interest in the light of mandatory write-off policies, which basically force banks to write-off/provision for NPLs after some time has passed. This raises the question whether or not banks are incentivized to sell NPLs at prices that are too low and thus represent a wealth transfer from banks to other capital market participants. Given the results presented here it can be concluded that these rules would indeed lead to the aforementioned transfer and these policies should be refined to incorporate a bank' ability to estimate time-series properties of a NPL's underlying recovery rate process.

Keywords: non performing loan, mandatory write-off rules, provisioning backstop

JEL Classification: G13, G21, G28