## _cr13373

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### Executive Summary — asset quality and impaired loan composition
- Impaired loans represented 8.8 percent of the total loan portfolio as of December 31, 2012 (compared to approximately 4.4 percent prior to the 2008 crisis).
- Distribution of impaired loans (as of end-2012):
  - Consumer: 30 percent of total impaired loan portfolio.
  - SMEs: 30 percent.
  - Housing: 15 percent.
  - Large enterprises: 15 percent.
  - Other household: slightly above 10 percent.
- Impaired loan ratios by sector (as of end-2012):
  - Consumer: 17.2 percent.
  - SMEs: 13.1 percent.
  - Other household: 10.5 percent.
  - Large enterprises: 9.8 percent.
  - Housing (zloty): 4.0 percent.
  - Housing (FX): 1.8 percent.
- A significant portion of the impaired loan portfolio (45 percent) is over 180 days past due.

### Recent dynamics and drivers of deterioration
- Rapid deterioration between 2008 and 2009 driven mainly by lenient underwriting practices before 2008.
- Corporate impaired loan ratio doubled between end-2008 and end-2010 owing to the 2008-09 financial crisis and the 2009 economic slowdown.
- Overall impaired loan ratio stabilized above 8 percent after 2010 due to tightening underwriting standards, credit expansion, and sales of impaired consumer loans.
- Growth in impaired loans 2009–2012:
  - Consumer nonperforming ratio increased by 4 percentage points since December 2009.
  - Housing nonperforming ratio increased by 1.25 percentage points since December 2009.
  - SME impaired loan portfolio decreased slightly from 13.3 percent in 2009 to 13.1 percent in 2012.
  - Large corporate lending decreased by 3.0 percent since 2009.
- In 2012, impaired loans increased by 35 percent in the corporate asset class, reflecting financial difficulties in a few large construction companies.

### Mortgage and FX mortgage specifics; FX exposure
- FX mortgages comprise about 22 percent of the total loan portfolio and more than half of the mortgage asset class.
- Impaired FX mortgages represent 1.8 percent of FX mortgages and 4 percent of the overall impaired loan portfolio as of year-end 2012.
- Portfolio vulnerabilities: adjustable-rate mortgages (ARM), extremely high loan-to-values (LTVs), long tenors, subsidized mortgages, low PLN portfolio seasoning, consumer indebtedness; sensitivity to FX volatility, falling asset prices, and economic slowdown.
- LTV ratios:
  - One third of the housing portfolio has high LTVs.
  - 25 percent of the FX housing portfolio has LTVs over 130 percent.
  - Average LTV for newly originated loans is about 70 percent; some banks reported they are continuing to lend at 100 percent LTV.
- Reserve coverage for impaired housing loans (IFRS, incurred loss model) is 48 percent.
- On-balance sheet open foreign currency position is about 5 percent of total commercial bank assets and 45 percent of total bank equity.
- Hedging and maturity notes:
  - Balance sheet currency mismatches require hedging through FX swaps and cross-currency interest rate swaps.
  - Short-term hedges are cheap; gradual shift towards longer-term contracts despite higher costs.
  - Hedging needs tend to increase as zloty depreciates, likely causing liquidity strains.
  - Stock of FX mortgages has been decreasing since March 2012; majority of mortgage portfolio is young with maturity of 10 years or more.
  - Hedging needs are declining as FX mortgage stock falls, but remaining FX exposure and long maturities leave outstanding stock vulnerable to exchange rate volatility.

### Provisioning, coverage, accounting practice notes, and tax treatment
- Overall reserve coverage for impaired loans is 54 percent; coverage ranges between 36 percent and 77 percent as of December 31, 2012.
  - SME sector reserve coverage is 36 percent.
  - Housing sector reserve coverage is 48 percent.
- Most banks implement IFRS incurred loss models; non-IFRS banks follow PAS with supervisory prescriptive Ordinance.
- PAS provisioning and tax-deductibility summary:
  - Normal: Provisioning under PAS 0-1.5% (retail provision 1.5%); Tax deductibility 0%.
  - Special Mention: Provisioning under PAS 1.5%; Tax deductibility 0%.
  - Substandard: Provisioning under PAS 20%; Tax deductibility 0%.
  - Doubtful: Provisioning under PAS 50%; Tax deductibility 25% one year over due or become doubtful (50% for restructured corporate).
  - Loss: Provisioning under PAS 100%; Tax deductibility 100% after legal documents proving recoverability is probable.
- Concerns:
  - Model flexibility in IFRS (discount rates, PDs, LGDs, cure rates, recovery rates) allows room for aggressive accounting and misstated provisions.
  - Backward-looking IFRS incurred loss models may yield reserve levels that are low given lengthy recovery and falling residential real estate prices.
  - Practice of continuing to accrue interest on impaired loans should be reviewed; statutory limitation interest rate in 2012 is 13 percent but banks impose higher rates on past due loans in practice.
- Tax rules on deductibility:
  - Provisions for doubtful loans are tax deductible up to 25 percent (50 percent for legally restructured corporate loans).
  - Provisions up to 100 percent of the loan value can be recognized for uncollectible loans only if loss is legally confirmed by court or proven probable under tax law (death, legal insolvency, liquidation, or restructuring).
  - Many provisions cannot be immediately claimed as tax deductions, leading to recognition of Deferred Tax Assets (DTA).
  - Under Basel III, DTAs that rely on future profitability are deducted from Common Equity Tier 1.

### Supervisory framework, Recommendations S/T/R, and supervisory risks
- KNF requirements: Recommendation R, Resolution 258/2011, and Ordinance of the Minister of Finance 2008.
  - Recommendation R: principles for identification of impaired exposures and valuation allowances (mainly for IFRS banks).
  - Ordinance: prescriptive provisioning guidelines for non-IFRS banks.
  - Resolution 258/2011: requires identification of impaired exposures, loan classification system, and adequate provisions.
- KNF issues nonlegally binding "Recommendations" and “Letters” that are enforced through supervisory process.
- Recommendation T (2010) tightened retail underwriting: restricted DTI to 50 percent to 65 percent; required income certificates; supervisory expectations.
  - Authorities revised Recommendation T recently: some requirements tightened, others made more flexible (e.g., regulatory thresholds for DTIs lifted; income verification tied to loan size and customer relationship duration).
- Draft Recommendation S (contemplated changes) will:
  - introduce explicit LTV limits for all mortgages;
  - require matching currency of borrower’s income with currency of the mortgage.
  - Draft S would tighten LTV and income requirements for FX mortgages but may loosen DTI requirements in other areas and would benefit from fine tuning related to DTIs and credit risk insurance.
- Supervisory shift from compliance to risk management as fixed DTI limits are lifted; increased need for oversight of boards and credit risk management.

### Empirical findings on loan growth (bank-level regression results)
- Analysis using bank-level quarterly data for 2002Q1–2012Q3 covering 13 banks (assets ~60 percent of system-wide assets) finds key coefficients (across specifications):
  - Nominal GDP growth (yoy, 1st lag): 1.957***, 2.516***, 2.516***, 2.210***, 2.155***, 2.368***, 2.847***.
  - Exchange rate change (+ appreciation): -0.650***, -0.667***, -0.667***, -0.645***, -0.676***, -0.689***, -0.743***.
  - Non-performing loan ratio (%, 1st lag): -3.242***, -3.112***, -3.112***, -3.574***, -2.877***, -3.086***, -2.736***.
- Other findings:
  - Larger banks expand less than smaller banks.
  - Banks with stronger capital positions expand less.
  - Higher income-generating banks expand more.
  - Banks with loan-to-deposit ratio above one expand less.
  - Banks with higher NPL ratios expand more slowly.
- Policy implication: proactive measures to deal with problem assets to reduce NPL ratios can relieve space for lending.

### Restructuring, write-offs, and debt collection practices
- Restructuring approaches:
  - Retail and small SME modifications: longer maturity, balloon payments, lower installments for a period, or reduced interest on principal.
  - Corporate restructuring: voluntary out-of-court restructurings; corporate restructuring teams are limited relative to retail collection departments.
- Tax disincentives:
  - Loss from out-of-court restructuring is not tax deductible for the creditor; legal collection needed for tax deduction.
  - Forgiveness of debt treated as income for the debtor, creating disincentives for debtor participation.
  - Recommendation: allow creditor to treat forgiveness as tax deductible cost; exempt debt relief from personal income tax with anti-evasion safeguards.
- Writing off bad debts constraints:
  - Legal/tax conditions restrict full tax deduction for written-off debts unless legal conditions are met (decision of noncollectability by enforcement body; bankruptcy request dismissed for insufficient assets; taxpayer statement that enforcement costs exceed claim).
  - Electronic courts improved efficiency but data errors in borrowers’ debt information remain prevalent.
  - Over 40 percent of banks’ nonfinancial loans past due over one year are consumer cash loans with no prospect of recovery.
  - Some loans overdue 60 months or more remain on balance sheets; one public bank reported 25 percent of its impaired loans are at least five years past due.
  - Recommendation: tax law and other laws should be made more flexible so banks are encouraged to write off loans timely; allow full tax deduction without court documents where appropriate.
- Interest accrual practices:
  - Major banks following IFRS continue to accrue income on the net present value of loans; IFRS has no nonaccrual concept.
  - Polish law permits accrual of a statutory limitation interest amount for three years, providing disincentives to timely write-offs; statutory limitation interest rate in 2012 is 13 percent (banks impose higher rates in practice).
  - Recommendation: consider guidance requiring cessation of interest accrual if collection of substantially all outstanding principal or interest is not probable.
- Debt collection timelines and impediments:
  - Typical durations: cash loans ~one year; mortgage loans ~2 to 2.5 years; SME loans with collateral: several years.
  - Impediments: bailiff selection tied to collateral location; evictions forbidden between November 1 and March 31 unless alternative premises available; second-auction price reduction limit (housing prices cannot be reduced by more than one third during second auction) reduces recovery rates amid falling prices.
  - Electronic court launch helps but needs better cross-checks to reduce debtor information errors.

### Restructured loans, reporting, and supervisory data needs
- KNF reports less than two percent of total loans have been restructured; over 70 percent of restructured loans are impaired.
- Reserve coverage for restructured loans is 55 percent.
- Banks use different definitions of "restructured" and IFRS lacks sufficient guidance on restructured loan classification.
- Recommendations:
  - Tighten definition of restructured loan in line with BCBS guidance.
  - Collect granular data on restructured loans (number of times restructured, losses, performance, re-aging, amount modified year to date, charge offs, recoveries).
  - Conduct on-site inspections focused on restructured loans.
  - Enhance Pillar III disclosures to require banks to disclose restructuring practices and provisioning practices.

### Market for impaired loans and securitization funds
- Secondary market for impaired consumer loans began in 2004 and has grown strongly since 2011.
- Debt collection business expanding rapidly from a low base; net internal rates of return about 20 percent to 30 percent.
- Debt collection agencies funding channels: parent funding, money market, equity market, bond markets.
- Securitization funds:
  - Easy and attractive to set up (200,000 to 300,000 zloty equity).
  - Some funds established in offshore centers such as Luxemburg.
  - Fund exempt from corporate income tax on income from debt collection services.
  - If fund proves other business than debt collection, some VAT exemption allowed.
  - Profit payments to investors exempt from withholding tax.
- Market for mortgage impaired loans remains incipient; bank enforcement titles are nontransferrable, reducing attractiveness for buyers; legal and tax impediments affect development of secondary mortgage market.

### Insolvency framework, creditor voice, and court receivers
- Courts appoint court receivers with full discretion; creditors lack effective venue to voice concerns about quality of court receivers.
- Rights of creditors’ council are limited: courts decide which creditors are allowed to sit, and proposed council members may not be chosen.
- Lack of supervisory mechanism and absence of an insolvency regulator; judge-commissioner appointed from same court leading to insufficient checks and balances.
- Summary reform emphasis:
  - Improve insolvency framework with more emphasis on restructuring, increasing creditor voice, and improving supervision mechanisms to increase value and reduce cost of collectable loans.
- Polish bankruptcy law (Bankruptcy and Recovery Law of 2003) features:
  - Two types of bankruptcy and one form of reorganization/recovery proceeding.
  - Proceedings are primarily business-oriented and creditor-protective; consumers eligible to file only since 2009 with significant restrictions.
  - Practices outside emerging norms: single creditor can commence case with small claim; requirement to file within two weeks of insolvency impractical; restriction on consumer filing vague and limiting; lack of prepackaged plans, priority financing, and effective rehabilitation provisions; unduly fast time limits (e.g., recovery proceedings dismissed if creditors do not approve a composition within four months).

### Key recommended actions (summary)
- Strengthen accounting practices for impaired loans:
  - Revise Recommendation R or introduce separate guidance to standardize risk inputs for loss provisioning models and implement nonaccrual of interest income on impaired loans.
- Intensify credit risk management:
  - Ensure underwriting standards do not revert to pre-2008 practices.
  - Define DTI more precisely and establish a standard calculation for banks and supervisors.
  - Tighten definition of restructured loan and collect granular monthly restructuring data.
  - Consider conducting thematic reviews of restructured loans.
- Increase transparency:
  - Require disclosure of restructuring activities and provisioning practices in Basel II Pillar III reports.
- Remove tax and legal obstacles:
  - Consider enhancing tax deductibility of loan loss provisions.
  - Ease insolvency procedures and develop a secondary market for impaired mortgage loans.
  - Enhance creditor protection rights by adopting an out-of-court code of conduct.
- Promote timely recognition of losses:
  - KNF and the Polish Banking Association should consult tax authorities and push for changes to promote timely recognition of losses.
- Supervisory actions:
  - KNF intends thematic reviews of impaired loan portfolios for 13 banks in 2013; findings should guide modifications to Recommendation R or additional guidance (including an interest nonaccrual principle and standardization of risk inputs).
  - Tighten oversight of credit risk management during on-site visits and through surveys.
  - Promote reporting by nonbank financial institutions to the credit bureau to assist underwriting decisions.

*Source: Excerpt and summaries from IMF document _cr13373.*

### Executive Summary ......................................................................................................

### Executive Summary

### Asset quality and impaired loan portfolio: overview and composition
- As of December 31, 2012, impaired loans represented 8.8 percent of the total loan portfolio compared to approximately 4.4 percent prior to the 2008 crisis.
- Distribution of impaired loans (as of end-2012):
  - Consumer: 30 percent of total impaired loan portfolio.
  - SMEs: 30 percent.
  - Housing: 15 percent.
  - Large enterprises: 15 percent.
  - Other household: slightly above 10 percent.
- Impaired loan ratios by sector (as of end-2012):
  - Consumer: 17.2 percent (impaired loan ratio by sector figure).
  - SMEs: 13.1 percent.
  - Other household: 10.5 percent.
  - Large enterprises: 9.8 percent.
  - Housing (zloty): 4.0 percent.
  - Housing (FX): 1.8 percent.
- A significant portion of the impaired loan portfolio (45 percent) is over 180 days past due.

### Recent dynamics and drivers of deterioration
- Asset quality deteriorated rapidly between 2008 and 2009, driven mainly by lenient underwriting practices observed before 2008.
- The corporate impaired loan ratio doubled between end-2008 and end-2010 due to the 2008-09 financial crisis and the 2009 economic slowdown.
- The overall impaired loan ratio stabilized at above 8 percent after 2010 due to tightening of underwriting standards, credit expansion, and sales of impaired consumer loans.
- Growth in impaired loans between 2009 and 2012:
  - Consumer and housing portfolios: nonperforming ratio increased by 4 percentage points and 1.25 percentage points, respectively, since December 2009.
  - SME impaired loan portfolio decreased slightly from 13.3 percent in 2009 to 13.1 percent in 2012.
  - Large corporate lending decreased by 3.0 percent since 2009.
- In 2012, impaired loans increased by 35 percent in the corporate asset class, the highest increase across asset classes, reflecting financial difficulties in a few large construction companies.

### Mortgage and FX mortgage specifics
- FX mortgages comprise about 22 percent of the total loan portfolio and more than half of the mortgage asset class.
- Impaired FX mortgages represent 1.8 percent of FX mortgages and 4 percent of the overall impaired loan portfolio as of year-end 2012.
- Portfolio characteristics and vulnerabilities: adjustable-rate mortgages (ARM), extremely high loan-to-values (LTVs), long tenors, subsidized mortgages, low PLN portfolio seasoning, and consumer indebtedness; sensitivity to FX volatility, falling asset prices, and economic slowdown.
- LTV ratios:
  - One third of the housing portfolio has high LTVs.
  - 25 percent of the FX housing portfolio has LTVs over 130 percent.
  - Average LTV for newly originated loans is about 70 percent; some banks reported they are continuing to lend at 100 percent LTV.
- Reserve coverage for impaired housing loans (IFRS, incurred loss model) is 48 percent.

### Provisioning, coverage, and accounting practice notes
- Overall reserve coverage for impaired loans is 54 percent; coverage ranges between 36 and 77 percent, reflecting lower coverage for certain sectors such as the SME sector.
- Most banks’ models for calculating incurred losses follow international accounting standards, but model flexibility (discount rates, PDs, LGDs, cure rates, recovery rates) allows room for aggressive accounting treatment and risk of misestimated provisions.
- The practice of continuing to accrue income on impaired loans should be reviewed; banks are legally allowed to accrue high rates of interest on impaired loans for three years after which the debtor stops repaying. The statutory limitation interest rate in 2012 is 13 percent; in practice banks impose higher interest rates on past due loans.
- Tax rules on deductibility of provisions:
  - Provisions for doubtful loans are tax deductible up to the amount of 25 percent (50 percent in case of legally restructured corporate loans).
  - Provisions up to 100 percent of the loan value can be recognized for uncollectible loans, but only if the loss is legally confirmed by the court or proven probable according to tax law (e.g., by death, legal insolvency, liquidation, or restructuring of the debtor).
- The backward-looking nature of IFRS incurred loss models may lead to reserve levels that are low considering lengthy recovery processes and falling residential real estate prices.

### Structural and market impediments to balance sheet cleanup
- Disincentives and obstacles:
  - Tax disincentives that restrict deductibility of provisions.
  - Interest income accrual practices that may discourage speedy resolution.
  - Underdeveloped securitization markets and a nonfunctional covered bonds system.
  - Impediments in out-of-court restructurings and limited creditor protection rights.
  - Mortgage foreclosures and evictions carry social costs and legal challenges.
- Funding and market structure constraints:
  - Lenders fund mortgages with short-term domestic deposits creating significant maturity gaps.
  - Market for long-term bonds constrained by absence of a deep domestic investor base and restrictive regulations governing pension funds’ investment decisions.
  - Legal, tax, and accounting obstacles impede securitization and wider use of covered bonds.
- The market for distressed debt is growing; the market for impaired mortgage loans remains incipient.

### Supervisory and policy risks from recent regulatory changes
- Recent loosening of underwriting standards for retail loans (amendments to Recommendation T) and proposed changes to Recommendation S (lifting fixed DTI norms) may carry risks by removing maximum DTI limits.
- Proposed changes to Recommendation S would, however, tighten LTV and income requirements for FX mortgages.
- Supervisory responsibility shifts from a compliance focus to a risk management focus as fixed DTI limits are lifted; this increases the need for stronger oversight of banks’ Boards and credit risk management.

### Key recommended actions (summary)
- Strengthen accounting practices for impaired loans:
  - Revise Recommendation R or introduce separate guidance to standardize risk inputs for loss provisioning models and to implement nonaccrual of interest income on impaired loans.
- Intensify credit risk management practices:
  - Ensure credit underwriting standards do not reflect pre-2008 practices.
  - Define DTI more precisely for a standard calculation to be followed by banks and supervisors.
  - Tighten the definition of restructured loan and collect more granular monthly data on restructuring activities (performance, re-aging, amount modified year to date, accruals and cash revenues).
  - Consider conducting thematic reviews of restructured loans.
- Increase transparency:
  - Require banks to disclose restructuring activities and provisioning practices in Basel II Pillar III reports.
- Remove tax and legal obstacles:
  - Consider enhancing tax deductibility of loan loss provisions.
  - Ease insolvency procedures and develop a secondary market for selling impaired mortgage loans.
  - Enhance creditor protection rights by adopting an out-of-court code of conduct.
- Promote timely recognition of losses:
  - KNF and the Polish Banking Association should more actively consult tax authorities and push for changes in the law to promote timely recognition of losses on banks’ balance sheets.
- Supervisory actions and reviews:
  - KNF intends to conduct thematic reviews of impaired loan portfolios for 13 banks in 2013; conclusions should guide modifications to Recommendation R or additional guidance, including an interest nonaccrual principle and standardization of risk inputs.
- Additional supervisory measures:
  - Tighten oversight over credit risk management practices during on-site visits and through surveys.
  - Promote reporting by nonbank financial institutions to the credit bureau to assist banks in underwriting decisions.

*Source: Executive Summary, Technical Note prepared by Nancy Rawlings (MCM) and Yinqiu Lu (EUR).*

### 5.      The outstanding stock of FX loans remains vulnerable to exchange rate volatility

### 5.      The outstanding stock of FX loans remains vulnerable to exchange rate volatility

### FX exposure and hedging
- On-balance sheet open foreign currency position is about 5 percent of total commercial bank assets and 45 percent of total bank equity.
- Balance sheet currency mismatches require banks to hedge FX risk through FX swaps and cross-currency interest rate swaps.
- Faced with reduced foreign currency funding from parent banks, a number of foreign subsidiaries are hedging through FX derivatives.
- Short-term contracts are cheap for hedging but there is a gradual shift towards using longer-term contracts despite their higher costs; however, the hedging needs tend to increase as zloty depreciates, likely causing liquidity strains.
- Increased holdings of zloty assets by foreign investors—who tend to hedge the zloty risk—support supply of hedging instruments.

### FX mortgages and maturity structure
- The stock of FX mortgages has been decreasing since March 2012, assisted by principal being repaid faster owing to the low level of Swiss franc interest rates and new issuance being close to zero.
- The majority of the total mortgage portfolio is young with a maturity of 10 years or more.
- Hedging needs are declining as the FX mortgage stock falls, but remaining FX exposure and long maturities leave the outstanding stock vulnerable to exchange rate volatility.

### Supervisory and regulatory framework (KNF)
- KNF’s requirements for addressing impaired loans are set forth in several documents including Recommendation R, Resolution 258/2011, and the Ordinance of the Minister of Finance 2008.
- Recommendation R sets forth principles of good practice in the identification of credit exposures that have become impaired and determination of the valuation allowances; it mainly applies to banks following IFRS.
- Non-IFRS banks follow the prescriptive Ordinance of the Minister of Finance of December 2008 which sets forth provisioning guidelines.
- All banks must adhere to Resolution 258/2011 which requires banks to:
  - identify impaired credit exposures;
  - establish a system for classifying loans based on risk categories and a system of write-offs; and
  - establish adequate provisions.
- KNF has limited legal powers that have led them to issue nonlegally binding "Recommendations" and “Letters” which are de facto but not de jure regulations and enforced during the supervisory process.

### Underwriting standards, Recommendations S and T
- Prior to 2008 underwriting standards were quite flexible; many banks’ retail consumer lending policies were practically nonexistent and borrowers’ income was not always verified.
- KNF tightened standards after 2008; Recommendation T (2010) aimed to improve assessment of retail clients and restricted DTI levels to 50 percent to 65 percent; required potential borrowers to produce income certificates and detailed specific supervisory expectations.
- To address FX mortgage lending risk, KNF measures from 2006 onward included stress tests assuming 30 percent zloty depreciation and stronger creditworthiness requirements for FX mortgage applicants. April 2009 and the second half of 2011 measures included:
  - restricting LTV ratios to 80 percent to 90 percent; and
  - establishing DTIs thresholds for FX mortgage borrowers at 42 percent.
- Recommendation T tightened standards and helped improve asset quality, but induced regulatory arbitrage with increased nonbank consumer lending (authorities estimated consumer lending comprised about 0.5 percent of GDP).
- Authorities recently revised Recommendation T: some requirements tighten, others are made more flexible (e.g., regulatory thresholds for DTIs lifted; income verification tied to loan size and duration of customer relationship) to discourage customers migrating to foreign nonbank finance companies.
- Authorities are contemplating changes in Recommendation S to strengthen the mortgage sector. The draft Recommendation S will:
  - introduce explicit LTV limits for all mortgages; and
  - require matching the currency of the borrower’s income with the currency of the mortgage.
- Draft Recommendation S would benefit from fine tuning related to DTIs and use of credit risk insurance as the current proposal could loosen DTI requirements in other areas.
- Supervisory actions recommended:
  - supervisors will need to intensely supervise banks’ credit risk management practices to prevent drift toward pre-2008 practices;
  - banks should establish their own DTI thresholds for retail loans, and the establishment of a standard methodology for calculating DTI would be useful to avoid manipulation and allow consistent supervisory evaluation.

### Empirical findings on loan growth (box summary)
- Analysis using bank-level quarterly data for 2002Q1–2012Q3 covering 13 banks (assets ~60 percent of system-wide assets) finds:
  - Nominal GDP growth (yoy, 1st lag) coefficients: 1.957***, 2.516***, 2.516***, 2.210***, 2.155***, 2.368***, 2.847*** across specifications.
  - Exchange rate change (+ appreciation) coefficient: -0.650***, -0.667***, -0.667***, -0.645***, -0.676***, -0.689***, -0.743***.
  - Non-performing loan ratio (%, 1st lag) coefficient: -3.242***, -3.112***, -3.112***, -3.574***, -2.877***, -3.086***, -2.736***.
  - Other findings: larger banks expand less than smaller banks; banks with stronger capital positions expand less; higher income-generating banks expand more; banks with loan-to-deposit ratio above one expand less; banks with higher NPL ratios expand more slowly.
- Policy implication: proactive measures to deal with problem assets to reduce NPL ratios can relieve space for lending.

### Provisioning for impaired loans
- Most banks have implemented IFRS and apply an incurred loss approach for provisions; non-IFRS banks follow PAS with an asset classification system (satisfactory, special mention, substandard, doubtful, loss).
- Supervisory requirements for IFRS banks: Recommendation R; for PAS banks: Ordinance of the Minister of Finance.
- Table summary (provisioning and tax treatment as described):
  - Normal: Provisioning under PAS 0-1.5% (retail provision 1.5%); Tax deductibility 0%.
  - Special Mention: Provisioning under PAS 1.5%; Tax deductibility 0%.
  - Substandard: Provisioning under PAS 20%; Tax deductibility 0%.
  - Doubtful: Provisioning under PAS 50%; Tax deductibility 25% one year over due or become doubtful (50% for restructured corporate).
  - Loss: Provisioning under PAS 100%; Tax deductibility 100% after legal documents proving recoverability is probable.
- Reserve coverage and sector variation:
  - Overall reserve coverage is 54 percent.
  - Reserve coverage ranges between 36 percent and 77 percent as of December 31, 2012.
  - SME sector reserve coverage is 36 percent.
  - Housing sector reserve coverage is 48 percent.
  - The coverage appears low for the SME sector (36 percent) and housing sector (48 percent), especially given long recovery processes and falling asset prices, raising potential Loss Given Default.
- Supervisory actions and reviews:
  - Supervisors intend to conduct a thematic review in 2013 of impaired loans focusing on the incurred loss model prescribed by IFRS; the scope includes the 13 largest banks.
  - The review responds to concerns that flexibility in IFRS assumptions yields inconsistent provisioning across banks; supervisors need to promote strong provisioning practices and standardize accounting practices.
  - Authorities should use thematic review findings to modify Recommendation R or develop new guidance.
- Tax incentives and prudential treatment:
  - For tax purposes, provisions for doubtful debts are generally deductible up to 25 percent of the debt (50 percent for restructured corporate loans); remaining losses are deductible when legally confirmed or proven probable under tax law.
  - Banks are unable to immediately claim many provisions as tax deductions, leading to recognition of Deferred Tax Assets (DTA) on financial statements.
  - Under Basel III, DTAs that rely on future profitability of the bank are deducted from Common Equity Tier 1.

*Source: IMF staff summary of section 5 from the provided PDF chapter.*

### 18.      The increased tax deductibility of loan losses would provide a strong incentive to

### 18.      The increased tax deductibility of loan losses would provide a strong incentive to

### Tax deductibility and provisioning incentives
- Increased tax deductibility of loan losses would provide a strong incentive to set aside adequate loan loss provisions.
- Current observation: "it appears that the major banks provisioning practices are not significantly affected by the tax law in Poland" but "a friendlier tax law would certainly provide more incentives."
- Supervisory alternative: require impaired loans to be provisioned for 100 percent after a certain period (example given: "100 percent provisioning is required after 2 years for unsecured loans or 3 years for secured loans").29
- Example reporting: one bank reported tax deferred assets attributable to loan loss provisions is "less than one percent of the total assets." About "four percent" of its provisioning expenses were tax deferred.27,28

### Writing off bad debts — findings and disincentives
- Legal and tax conditions restrict full tax deduction for written-off debts unless certain legal conditions are met; these include:
  - Decision of noncollectability issued by the authorized enforcement body;
  - Bankruptcy request dismissed by the courts because assets are not sufficient to cover costs of the proceedings;
  - The taxpayer files a statement that the expected costs of enforcement proceedings would exceed the amount of the claim.
- Electronic courts have improved efficiency in obtaining enforcement (one required proof of noncollectability), but issues remain such as "high frequency of data errors related to borrowers’ debt information."
- Recommendation: "The tax law and other laws should be made more flexible so that banks are encouraged to write off their loans in a timely manner."
- Supervisory and international guidance cited:
  - Writing off noncollectible loans in a timely manner is endorsed by supervisors worldwide and expected under the Basel Core Principles.
  - The “Vienna Initiative” Working Group on NPLs issued a report in 2012 supporting supervisors encouraging write-offs.
- Poland-specific findings:
  - "Over 40 percent of the banks’ nonfinancial loans past due over one year are consumer cash loans so there is no prospect of recovery (Figure 2)."
  - Some banks report loans "overdue 60 months or more" sitting on balance sheets.31
  - In one public bank Annual Report, "25 percent of its impaired loans are at least five years past due."30
- Policy recommendation: tax law should allow banks to "fully deduct from taxable income their nonrecoverable assets without having to obtain court documents."
- Suggestion for authorities: "The KNF and the Poland Banking Association should be more aggressive and consult the tax authorities and push for changes in the law."

### Comparative practices and write-off schedules
- Many countries’ tax laws include specific write-off schedules based on overdue period:
  - Czech Republic: schedules allowing 50 percent deduction at 18 months and 100 percent at 36 months starting January 1, 2015, "without the need to initiate the collection procedure."
  - Portugal: impairment loss tax deduction ranges from "25 percent at 6 months to 100 percent at 24 months."
- Caveat: "the creditor should attempt to collect the claim using all reasonable efforts in all cases."

### Interest accrual practices and implications
- Major banks follow IFRS and "continue to accrue income on the net present value of the loans." There is "no suspension of interest, or nonaccrual, concept in IFRS."
- Supervisors have not provided alternative guidance to require nonaccrual; some countries’ supervisors do require nonaccrual under certain conditions.
- Polish law permits accrual of a statutory limitation interest amount for "three years," providing disincentives to timely write-offs.33
- Observed correlation: strong correlation between accrued interest and nonperforming loans (text chart).
- Under Polish law, a debtor is relieved after "three years of nonpayment" if no successful collection attempt occurred; consumer protection is underdeveloped and many debtors are unaware of the "three year statute of limitations."
- Accounting mechanics under IFRS: banks accrue interest on impaired loans and measure impairment losses by calculating NPV of estimated future cash flows (including estimated future interest income). The difference between current loan balance and discounted cash flows is the provision/impairment charged to income.
- Operational difficulty: "applying the IFRS credit loss impairment principles are significantly more challenging and complex than applying a simple nonaccrual principle" leading to more margin for error.35
- Regulatory recommendation: "the Polish authorities should consider issuing guidance that would require banks to cease accrual of interest if the collection of substantially all of the outstanding principle or interest of a borrower’s debt is not probable." This could be aligned to also be observed for accounting purposes.

### Approaches taken to address bad debts — restructuring (retail and corporate)
- Restructuring is the first step; consumer and small SME modifications include longer maturity, balloon payments, lower installments for a period, or reduced interest on principal. Banks often monitor borrower income and cost of living when negotiating and may waive first-time restructuring fees.
- Banks engage in voluntary out-of-court restructuring with corporate borrowers; decision typically by restructuring experts. Resources and expertise for corporate restructuring remain limited; corporate restructuring teams are still a fraction of retail collection departments.
- Multiple-creditor issues: out-of-court deals can be judged invalid if they cause grievance to other creditors within two years.
- Tax disincentives for out-of-court restructuring:
  - Loss from out-of-court restructuring is not tax deductible for the creditor; a legal collection process is needed to qualify for tax deduction.
  - Forgiveness of debt is treated as income for the debtor, which is a disincentive (particularly for retail borrowers subject to personal income tax).
- Policy options to reduce disincentives:
  - Allow creditor to treat forgiveness as tax deductible costs, especially where receivables were reported as taxable revenue.
  - Exempt debt relief from personal income tax while limiting tax evasion possibilities. Examples cited: Belgium, France, Italy allow out-of-court restructuring with anti-evasion provisions; Italy and Belgium provide tax exemption of debt forgiveness for individuals (nonbusiness) under conditions.
  - Preference for legal provisions over vague general anti-avoidance concepts to reduce uncertainty.
- Summary recommendation: "ensuring adequate creditor protections and eliminating tax disincentive are important as they will provide incentives for out of court restructurings and the authorities are encouraged to move forward in a timely manner."

### Restructured loans — regulatory aspects and data needs
- Reported data: KNF indicates "less than two percent of the total loans have been restructured." Of those restructured, "over 70 percent are impaired." Reserve coverage for restructured loans is "only 55 percent."
- Reporting limitations: banks report total loan balances based on original due date and actual due date and total provision amounts; banks have different definitions of "restructured" and "IFRS does not provide sufficient guidance."36
- Recommendation: tighten the definition of a restructured loan in line with BCBS guidance.37
- Supervisory data collection recommendation: KNF should collect more detailed data on restructured loans, including number of times restructured, losses, performance, re-aging, amount modified year to date, charge offs, and recoveries.
- Prudential measures: additional guidance may be needed to ensure proper prudential treatment; on-site inspections focused on restructured loans recommended.
- Transparency: enhance Pillar III disclosures—banks should disclose restructuring practices under Basel II to facilitate market discipline.

### Debt collection practices — retail and corporate
- Collection approach: banks collect sizable loans in-house; outsource collection for small loans with fee structures based on success rate and loan amount. Outsourcing thresholds vary and portfolios (e.g., cash loans) may be outsourced.
- Retail and small SME collection timeline: typical multi-step process—contract to standard/electronic court, obtain title (after a few months), send to bailiff; for secured loans, title must be sent to local bailiff where collateral is located.
- Typical durations reported:
  - Cash loans: approximately "one year";
  - Mortgage loans: about "2 and 2.5 years";
  - SME loans with collateral: "several years."35
- Impediments in mortgage collection:
  - Bailiff choice restricted by collateral location, potentially creating local monopoly power.
  - Eviction constraints: evictions forbidden between "November 1 and March 31" unless alternative premises are available.
  - Price limitations during second auction reduce success rate, especially amid falling housing prices.38
  - Electronic court launch helps but needs improved cross-checks to reduce debtor information errors.
- Corporate insolvency culture:
  - Poland exhibits a "liquidation culture" where courts tend to favor liquidation over restructuring; one bank reported "more than 70-80 percent of bankruptcies ended up in liquidation, not restructuring."
  - Courts often lack skills/interest in restructuring; financing under restructuring is difficult because Polish law "does not allow for the priority of such financing in the hierarchy of claims" and courts can overrule creditors' agreements.
  - Out-of-court restructuring is viewed by practitioners as more effective than in-court restructuring.

*Source: IMF staff assessment as presented in the supplied text.*

### 38.      Creditors lack an effective voice in the insolvency process. Courts appoint court

### _cr13373 - 38.      Creditors lack an effective voice in the insolvency process. Courts appoint court

### Creditor voice and court receivers
- Courts appoint court receivers with full discretion, creating opportunities of favoritism in the appointment process.
- Creditors have no venue to voice their concerns about the quality of court receivers.
- The rights of the creditors’ council, an advisory body which in theory supervises the court supervisor and court receivers, are very limited:
  - The courts decide which creditors are allowed to sit in the council.
  - Those proposed to set up the council may not be chosen.
- During the second auction, housing prices cannot be reduced by more than one third.

### Supervisory mechanisms and institutional gaps
- There is a lack of a sufficient supervisory mechanism.
- There is no insolvency regulator to take responsible for the oversight of insolvency case.
- A judge-commissioner is appointed from the same court, but there are insufficient checks and balances and the courts appointed court supervisor is very likely to be the court receiver.

### Summary findings and reform emphasis
- There is a pressing need to improve the insolvency framework with more emphasis on:
  - restructuring,
  - increasing creditor’s voice,
  - improving supervision mechanism.
- These reforms are crucial in increasing the value and reducing the cost of collectable loans.

### Market for impaired loans
- The market for impaired consumer loans has expanded rapidly:
  - A secondary market for impaired consumer loans started in 2004.
  - Markets have grown strongly since 2011, as banks enhanced efforts to dispose consumer impaired loans.
  - Some banks are able to conduct regular auctions to sell impaired consumer loans.
- Debt collection business is expanding rapidly, but from a low base.
  - The business is profitable with net internal rates of return of about 20 percent to 30 percent.
  - Debt collection agencies have various funding channels—parent funding, money market, equity market, and bond markets.
  - Banks and telephone companies have started to engage in long-term cooperation with debt collection agencies.
  - Collection agencies often set up securitization funds to buy impaired loans.
  - It is easy and attractive to set up a securitization fund (200,000 to 300,000 zloty equity) and some securitization funds are established in offshore centers such as Luxemburg.
  - The fund is exempt from corporate income tax on the income generated from debt collection services.
  - If it can be proved that the fund has other business than debt collection, some exemption from VAT tax is also allowed.
  - In addition, the profit payments to investors are also exempt from withholding tax.
- The market for mortgage loans is incipient, with few transactions:
  - Debt collection agencies expect this business to develop as banks will take more efforts to sell impaired loans given the expected deterioration of mortgage portfolio.
  - The fact that bank enforcement titles are nontransferrable may reduce the attractiveness for the demand for impaired mortgage loans.
  - The same legal and tax impediments to mortgage debt collection are affecting the development of the secondary market.

### Box 2 — Summary of Polish Bankruptcy Law (key points)
- Polish bankruptcy law is codified in the Bankruptcy and Recovery Law of 2003 (in Polish, “Prawo upadlosciowe i naprawcze,” and hereafter “Bankruptcy Law”).
- The law recognizes two types of bankruptcy, and one form of reorganization or recovery proceeding.
- Despite recent efforts to modernize these statutes, these proceedings are primarily business-oriented, and are deeply-rooted in a creditor-protective tradition.
  - Consumers have only been eligible to file since 2009, and there are significant restrictions on their use of the bankruptcy system.
  - The system traditionally has looked to involuntary liquidation and distribution to creditors of assets of defaulting debtors as its goal, and is only very slowly and incrementally moving towards a system that encompasses rescue or rehabilitation.
- Polish practices are generally within international norms, but many aspects are outside of emerging norms:
  - The legitimate commencement of a case by a single creditor, with a small claim, undermines the notion of bankruptcy as a collective and rehabilitative action, and makes the system more of a large debt collection system.
  - The requirement upon the debtor and its management to file within two weeks of insolvency is not practical, especially given the lack of specificity as to the valuation of assets.
  - The restriction on consumer filing to only those cases in which there are “extraordinary circumstances beyond [the consumer’s] control” is both vague and limiting.
  - The lack of special provisions for prepackaged plans, priority financing during the administrative phase, the exclusion of secured creditor in rem claims contributes to a lack of a fully effective rehabilitation scheme.
  - Time limits set forth in the Bankruptcy Law appear to be unduly fast; recovery proceedings, for example, must be dismissed if creditors do not approve a composition within four months, which generally is too short a time to notify all creditors, negotiate a plan, and obtain a favorable vote.

*Source: Excerpt from IMF document _cr13373.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13373.pdf_