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

Abstract

In this paper, we study the impact of mandatory write-off rules on a bank's reservation price
of a non-performing loan (NPL). We develop a model of information asymmetry in NPL markets
where agents are using risk neutral pricing. In contrast to existing literature, we assume
that agents agree on the expected recovery rate of an NPL. We show that differences in the
estimation accuracy of the drift of the underlying recovery rate process lead to valuation
differences. In the model, the differences in the precision when estimating the drift of the
underlying lead to differences in the aggregated variance of the payoff distribution. Since an
NPL's payoff function is nonlinear this results in different NPL valuations depending on this
precision parameter. This, in combination with capital adequacy requirements banks need
to maintain and funding costs they face leads to the result that a bank's reservation price of
an NPL might be below its own valuation.

Keywords: non performing loan, mandatory write-off rules

JEL Classification: G13, G21, G28, D82