## Debt-Equity Conversions and NPL Securitization in China—Some Initial Considerations

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### Executive summary and key judgments
- Government focus on excessive corporate debt and corresponding burden on banks of impaired assets is welcome.
- Converting NPLs into equity or securitizing them are techniques that can play a role and have been used successfully in other countries.
- These techniques are not comprehensive solutions and could worsen problems by allowing zombie firms to continue operating.
- Design is critical:
  - Debt-equity conversions: convert debt only of viable firms in the context of operational restructuring (which may include changing management), at fair value, and with banks holding the equity for a limited period only.
  - NPL securitization: securitize a diversified pool of NPLs, require banks to keep some residual financial interest (“skin in the game”), and create the legal and operational framework to force operational restructuring of firms and obtain best value.
- Techniques must be nested within a comprehensive, system-wide plan that includes:
  - Assessing viability of distressed firms and restructuring the viable and liquidating the nonviable;
  - Requiring banks to proactively recognize and workout NPLs;
  - Burden sharing among banks, corporates, institutional investors, and the government;
  - Enhancing the framework for corporate restructuring, including the Enterprise Insolvency Law;
  - Developing distressed debt markets.

### I. Chinese context — scale and emerging policy moves
- Corporate debt and asset quality:
  - Corporate debt is some 160 percent of GDP and continuing to rise quickly.
  - GFSR estimate: corporate loans potentially at risk (i.e., owed by firms with an interest coverage ratio less than one) amount to 15.5 percent of total commercial banks’ loans to corporates, or $1.3 trillion (12 percent of GDP).
  - Bank capital and reserves: $1.7 trillion in bank Tier 1 capital (11.3 percent of risk-weighted assets), and $356 billion in reserves.
  - Reported problem bank loans, including “special mention loans,” amount to 5.5 percent of bank corporate and household loans ($641 billion, or 6 percent of GDP), up from 4.4 percent at the end of 2014.
- Emerging tactics under consideration:
  - Two main approaches under consideration: (1) converting NPLs into equity and (2) securitizing NPLs and selling them.
  - Securitization program reported to be piloted by a handful of large banks; instruments can only be sold to institutional investors; program reportedly capped at RMB 50bn.

### II. Considerations — Debt-equity conversions
- Potential roles and benefits:
  - Reduce NPLs and corporate debt overhang.
  - Provide a means to restructure/resolve indebted firms by changing ownership and incentives.
  - Historical precedents include Sweden and the United States.
- Risks and ways conversions could backfire:
  - May allow weak/nonviable firms to continue operating by reducing debt and borrowing costs.
  - Banks may lack incentives to proactively restructure, especially if minority shareholders and if banks and firms are state owned.
  - Banks generally lack expertise to run or restructure businesses and may need competent interim management.
  - Conversion creates moral hazard and conflicts of interest—banks may keep lending to related parties, causing renewed indebtedness and hampering disposal of equity; state ownership of corporates may increase.
  - Conversions may require changes in law that restrict banks from owning private equity investments in companies.
- Key conditions for success:
  - Strict solvency and viability eligibility criteria:
    - Convert senior claims into the most junior security only where upside for the bank is clearly large and equity stake has high probability to be sold in the near future.
    - Require ex-ante assessment of business solvency (true economic value of assets vs liabilities) and viability (ability to generate an economic surplus).
    - Example eligibility: a firm solvent and viable but with excessive leverage would be eligible.
    - An independent viability/solvency assessment process ahead of launch could reduce abuse.
  - Sound corporate governance:
    - Businesses should be well managed; banks as new equity holders should have the ability to replace management.
    - Contractual clauses may be required to give banks sufficient weight to change management even as minority shareholders.
    - Management should be accountable to banks and other shareholders with a plan to attract fresh investors, given equity stakes are expected to be sold.
  - Limitation of bank ownership of equity in scope and time:
    - Banks are ill-placed to exercise prolonged controlling influence over non-banking entities.
    - Banks’ holding of equity should be time-limited; different time frames may be applied by industry and recovery capacity.
    - If not limited, banks need teams or subsidiaries to conduct active asset management of equity holdings.
  - Conversion at fair value and recognition of losses:
    - Avoid temptation to convert at unrealistically high valuations to avoid realizing losses.
    - Higher equity holdings may increase risk weights and require additional capital under strict prudential standards.
  - Robust regulatory treatment of equity holdings:
    - Use a combination of concentration limits and punitive risk weights to discourage equity holdings in non-financial entities.
    - Some jurisdictions (including China) restrict banks from taking an equity stake greater than, for example, 10 percent of any commercial entity.
    - Basel regulatory capital treatment for investments in commercial entities:
      - Significant investments that exceed materiality levels (i.e., 15 percent of the bank’s capital for individual investments and 60 percent of the bank’s capital for the aggregate of such investments) receive a 1,250 percent risk weight (analogous to full deduction from capital); the excess amount above the materiality levels attracts the risk weighting.
      - Investments below these materiality levels should have a risk weight no lower than 100 percent.
    - Large exposure limits/concentration risk:
      - Basel standard confirms that the maximum value of an exposure be limited to 25 percent of a bank’s capital. The exposure can be to a single counterparty or a group of connected counterparties.
      - The Basel large exposure standard will come into force in January 2019.

### II. Considerations — Securitization of NPLs
- How securitization differs from debt-equity conversion:
  - Securitization moves the NPL to another entity; debt-equity conversions transform the NPL into a different asset that remains with the bank.
  - Securitization does not directly change the debtor firm’s ownership.
- Main advantages of securitization:
  - Gets asset off bank balance sheets quickly.
  - Allows banks to receive cash that could be used for lending.
  - Transfers debt to privately managed specialist vehicles with clearer mandates and expertise to engage in corporate restructuring; only this third aspect has potential to drive faster restructuring of the debtor company.
- Main disadvantages:
  - May make debts harder to restructure (debts not converted into equity, need to deal with many creditors, unclear insolvency framework, possible political “capture” of new creditors).
  - Lack of depth in domestic institutional investor base (though existing and newly-created provincial AMCs may play a role).
  - Difficult to create a viable securitization market (requires supporting legislation and aligned market incentives).
  - May transfer risk outside regulated financial sector to entities less able to absorb losses.
- Key preconditions for success:
  - Diversified pool of NPLs:
    - Ideal portfolio: large number of debtors, low loan concentration ratios, similar loan terms.
    - Challenge in China: NPLs from SOEs account for about 60 percent of the total stock and are concentrated in a few distressed industries, making debtor and sectoral diversification difficult.
    - Loan agreement terms may vary widely based on borrower condition.
  - Credit enhancements and “skin in the game”:
    - Banks should maintain some exposure to attract other investors.
    - Banks likely to retain relatively large tranches of the most junior exposures; a large part of the credit risk will continue to be retained by banks, increasing attractiveness of senior tranches but costly in regulatory capital.
    - Additional credit enhancements, e.g., state guarantees, could help attract investors and provide liquidity relief (example cited: Italy).
    - Consideration: explicit state guarantees could trigger uncertainty regarding implicit state guarantees on other products.
  - Strong legal and operational capacity to manage distressed assets:
    - Impediments include complicated local and legal regulatory environments, opaque judicial processes, and lack of debt restructuring and resolution skills in law firms and servicers.
    - Without sufficient capacity to extract value and service securities, securitization will fail or require substantial liquidity enhancements from banks.
  - Strong consumer protection and distribution safeguards:
    - Securitized assets should be sold to qualified investors only (institutional investors, high net worth individuals, sophisticated investors).
    - Impose strict disclosure requirements and high penalties for non-compliance on further distribution.
    - To avoid regulatory arbitrage and understatement of credit risks, banks’ purchases of these assets should occur only under strict regulatory treatment.
    - Regulatory agencies (CBRC, CSRC, and CIRC) have important roles.
  - Robust regulatory treatment aligned with Basel:
    - Basel standards on securitization call for operational and due diligence requirements increasing further from 2018.
    - Basel requires significant loss/credit risk transfer to third-party investors in SPVs; failure to meet requirements means the bank must maintain capital against securitized exposures.
    - Amount of credit enhancement provided by the bank is taken into account when assessing risk transfer.
    - A bank purchasing a securitized asset must conduct due diligence; absent due diligence, a 1,250 percent risk weight would apply to the securitized holding (analogous to a full deduction from capital).

### III. Need for a comprehensive corporate restructuring strategy
- Core objectives:
  - Improve performance of viable companies and ensure exit of nonviable companies.
  - Viability test for debtor firms: viable firms restructured; non-viable resolved.
  - Existing management must have capacity and incentives to deliver restructuring; replace management if necessary.
  - Specialist private firms are well equipped to undertake and coordinate firm-level restructuring work.
- Regulatory and supervisory requirements:
  - Require banks to recognize and workout NPLs.
  - Critical supervisory/policy areas: loan classification and provisioning; bank capital; write-off of uncollectible loans; collateral valuation; prudential reporting; and a supervisory review approach fostering active NPL resolution (restructuring, write off, or sale).
- Burden sharing:
  - Recognizing the full extent of impaired loans will likely result in significant losses; a plan to allocate these losses and, if necessary, backstop them with government funds will be critical.
  - Creditors may act strategically to minimize individual loss at the expense of overall losses; state may need an active role (example: Korea).
- Enhancing legal and institutional frameworks, including Enterprise Insolvency Law:
  - Debt/equity conversions require specialized analysis of financial situation and business prospects to determine viability, typically conducted by an insolvency professional in reorganization.
  - Recommended reforms:
    - Reinforce position of insolvency administrators, strengthen disclosure requirements, and regulate contents of viability reports and reorganization plans.
    - Clarify position and role of shareholders in reorganization to prevent blocking tactics and interference in debt/equity conversions via voting or pre-emption rights; allow for “cramdown” of shareholders in approval of reorganization plans (may require changes to corporate and securities law).
    - Provide a clear insolvency framework to support informal or hybrid solutions, such as pre-packaged reorganization plans; in China, explore solutions without full court involvement.
- Improve the market for distressed debt:
  - Developing a deeper distressed debt market, specialized servicers, and enhanced legal/operational capacity will support both debt-equity conversions and securitization as tools for resolving corporate distress.

### Findings on market development for distressed assets
- Access to timely financial information on distressed borrowers, collateral valuations and recent NPL sales are critical for the development of an active market for NPL restructuring.
- Well functioning collateral auctions (i.e. widely advertised to attract a sufficient number of bidders, providing transparently detailed information about the auctioned collateral, etc.) would help raise recovery values.
- The role of the existing AMCs, provided they have the right incentives and independence from state interventions, in helping jump-start a market for distressed assets should be further explored.

### Policy recommendations to deepen NPL restructuring markets
- Facilitate the licensing of nonbanks for restructuring to lower the cost of entry into this market and allow for greater specialization.
- Promote use of specialist NPL servicing and legal workout agencies to improve recoveries and workout outcomes.
- Improve transparency and reach of collateral auctions by ensuring auctions are widely advertised and provide detailed, transparent information about auctioned collateral.

*Source: TNM/16/05 — Section 1*

### Section 1

### Debt-Equity Conversions and NPL Securitization in China—Some Initial Considerations

### Executive summary and key judgments
- It is welcome that the government is focusing on the problems of excessive corporate debt and the corresponding burden on banks of impaired assets.
- Converting NPLs into equity or securitizing them are techniques that can play a role in addressing these problems and have been used successfully by some other countries.
- They are not comprehensive solutions by themselves and could worsen the problem, for example, by allowing zombie firms (non-viable firms that are still operating) to keep going.
- Getting the design right is critical:
  - For debt-equity conversions: convert debt only of viable firms in the context of operational restructuring (which may include changing management), at fair value, and with banks holding the equity for a limited period only.
  - For NPL securitization: securitize a diversified pool of NPLs, require banks to keep some residual financial interest (“skin in the game”), and create the legal and operational framework that will allow owners of distressed assets to force operational restructuring of firms and obtain best value from those assets.
- Techniques need to be nested within a comprehensive, system-wide plan that includes:
  - Assessing viability of distressed firms and restructuring the viable and liquidating the nonviable;
  - Requiring banks to proactively recognize and workout NPLs;
  - Burden sharing among banks, corporates, institutional investors, and the government;
  - Enhancing the framework for corporate restructuring, including the Enterprise Insolvency Law;
  - Developing distressed debt markets.

### I. Chinese context — scale and emerging policy moves
- Corporate debt and asset quality:
  - Corporate debt is some 160 percent of GDP and continuing to rise quickly.
  - Global Financial Stability Report (GFSR) estimate: corporate loans potentially at risk (i.e., owed by firms with an interest coverage ratio less than one) amount to 15.5 percent of total commercial banks’ loans to corporates, or $1.3 trillion (12 percent of GDP).
  - Bank capital and reserves: $1.7 trillion in bank Tier 1 capital (11.3 percent of risk-weighted assets), and $356 billion in reserves.
  - Reported problem bank loans, including “special mention loans,” amount to 5.5 percent of bank corporate and household loans ($641 billion, or 6 percent of GDP), up from 4.4 percent at the end of 2014.
- Emerging tactics under consideration:
  - Two main approaches: (1) converting NPLs into equity and (2) securitizing NPLs and selling them.
  - Securitization program reported to be piloted by a handful of large banks; instruments can only be sold to institutional investors; program reportedly capped at RMB 50bn.

### II. Considerations — Debt-equity conversions
- Potential roles and benefits:
  - Reduce NPLs and corporate debt overhang.
  - Provide a means to restructure/resolve indebted firms by changing ownership and incentives.
  - Historical precedents include Sweden and the United States.
- Risks and ways conversions could backfire:
  - May allow weak/nonviable firms to continue operating by reducing debt and borrowing costs.
  - Banks may lack incentives to proactively restructure, especially if minority shareholders and if banks and firms are state owned.
  - Banks generally lack expertise to run or restructure businesses and may need competent interim management.
  - Conversion creates moral hazard and conflicts of interest—banks may keep lending to related parties, causing renewed indebtedness and hampering disposal of equity; state ownership of corporates may increase.
  - Conversions may require changes in law that restrict banks from owning private equity investments in companies.
- Key conditions for success:
  - Strict solvency and viability eligibility criteria:
    - Convert senior claims into the most junior security only where upside for the bank is clearly large and equity stake has high probability to be sold in the near future.
    - Require ex-ante assessment of business solvency (true economic value of assets vs liabilities) and viability (ability to generate an economic surplus).
    - Example eligibility: a firm solvent and viable but with excessive leverage would be eligible.
    - An independent viability/solvency assessment process ahead of launch could reduce abuse.
  - Sound corporate governance:
    - Businesses should be well managed; banks as new equity holders should have the ability to replace management.
    - Contractual clauses may be required to give banks sufficient weight to change management even as minority shareholders.
    - Management should be accountable to banks and other shareholders with a plan to attract fresh investors, given equity stakes are expected to be sold.
  - Limitation of bank ownership of equity in scope and time:
    - Banks are ill-placed to exercise prolonged controlling influence over non-banking entities.
    - Banks’ holding of equity should be time-limited; different time frames may be applied by industry and recovery capacity.
    - If not limited, banks need teams or subsidiaries to conduct active asset management of equity holdings.
  - Conversion at fair value and recognition of losses:
    - Avoid temptation to convert at unrealistically high valuations to avoid realizing losses.
    - Higher equity holdings may increase risk weights and require additional capital under strict prudential standards.
  - Robust regulatory treatment of equity holdings:
    - Use a combination of concentration limits and punitive risk weights to discourage equity holdings in non-financial entities.
    - Some jurisdictions (including China) restrict banks from taking an equity stake greater than, for example, 10 percent of any commercial entity.
    - Basel regulatory capital treatment for investments in commercial entities:
      - Significant investments that exceed materiality levels (i.e., 15 percent of the bank’s capital for individual investments and 60 percent of the bank’s capital for the aggregate of such investments) receive a 1,250 percent risk weight (analogous to full deduction from capital); the excess amount above the materiality levels attracts the risk weighting.
      - Investments below these materiality levels should have a risk weight no lower than 100 percent.
    - Large exposure limits/concentration risk:
      - Basel standard confirms that the maximum value of an exposure be limited to 25 percent of a bank’s capital. The exposure can be to a single counterparty or a group of connected counterparties.
      - The Basel large exposure standard will come into force in January 2019.

### II. Considerations — Securitization of NPLs
- How securitization differs from debt-equity conversion:
  - Securitization moves the NPL to another entity; debt-equity conversions transform the NPL into a different asset that remains with the bank.
  - Securitization does not directly change the debtor firm’s ownership.
- Main advantages of securitization:
  - Gets asset off bank balance sheets quickly.
  - Allows banks to receive cash that could be used for lending.
  - Transfers debt to privately managed specialist vehicles with clearer mandates and expertise to engage in corporate restructuring; only this third aspect has potential to drive faster restructuring of the debtor company.
- Main disadvantages:
  - May make debts harder to restructure (debts not converted into equity, need to deal with many creditors, unclear insolvency framework, possible political “capture” of new creditors).
  - Lack of depth in domestic institutional investor base (though existing and newly-created provincial AMCs may play a role).
  - Difficult to create a viable securitization market (requires supporting legislation and aligned market incentives).
  - May transfer risk outside regulated financial sector to entities less able to absorb losses.
- Key preconditions for success:
  - Diversified pool of NPLs:
    - Ideal portfolio: large number of debtors, low loan concentration ratios, similar loan terms.
    - Challenge in China: NPLs from SOEs account for about 60 percent of the total stock and are concentrated in a few distressed industries, making debtor and sectoral diversification difficult.
    - Loan agreement terms may vary widely based on borrower condition.
  - Credit enhancements and “skin in the game”:
    - Banks should maintain some exposure to attract other investors.
    - Banks likely to retain relatively large tranches of the most junior exposures; a large part of the credit risk will continue to be retained by banks, increasing attractiveness of senior tranches but costly in regulatory capital.
    - Additional credit enhancements, e.g., state guarantees, could help attract investors and provide liquidity relief (example cited: Italy).
    - Consideration: explicit state guarantees could trigger uncertainty regarding implicit state guarantees on other products.
  - Strong legal and operational capacity to manage distressed assets:
    - Impediments include complicated local and legal regulatory environments, opaque judicial processes, and lack of debt restructuring and resolution skills in law firms and servicers.
    - Without sufficient capacity to extract value and service securities, securitization will fail or require substantial liquidity enhancements from banks.
  - Strong consumer protection and distribution safeguards:
    - Securitized assets should be sold to qualified investors only (institutional investors, high net worth individuals, sophisticated investors).
    - Impose strict disclosure requirements and high penalties for non-compliance on further distribution.
    - To avoid regulatory arbitrage and understatement of credit risks, banks’ purchases of these assets should occur only under strict regulatory treatment.
    - Regulatory agencies (CBRC, CSRC, and CIRC) have important roles.
  - Robust regulatory treatment aligned with Basel:
    - Basel standards on securitization call for operational and due diligence requirements increasing further from 2018.
    - Basel requires significant loss/credit risk transfer to third-party investors in SPVs; failure to meet requirements means the bank must maintain capital against securitized exposures.
    - Amount of credit enhancement provided by the bank is taken into account when assessing risk transfer.
    - A bank purchasing a securitized asset must conduct due diligence; absent due diligence, a 1,250 percent risk weight would apply to the securitized holding (analogous to a full deduction from capital).

### III. Need for a comprehensive corporate restructuring strategy
- Core objectives:
  - Improve performance of viable companies and ensure exit of nonviable companies.
  - Viability test for debtor firms: viable firms restructured; non-viable resolved.
  - Existing management must have capacity and incentives to deliver restructuring; replace management if necessary.
  - Specialist private firms are well equipped to undertake and coordinate firm-level restructuring work.
- Regulatory and supervisory requirements:
  - Require banks to recognize and workout NPLs.
  - Critical supervisory/policy areas: loan classification and provisioning; bank capital; write-off of uncollectible loans; collateral valuation; prudential reporting; and a supervisory review approach fostering active NPL resolution (restructuring, write off, or sale).
- Burden sharing:
  - Recognizing the full extent of impaired loans will likely result in significant losses; a plan to allocate these losses and, if necessary, backstop them with government funds will be critical.
  - Creditors may act strategically to minimize individual loss at the expense of overall losses; state may need an active role (example: Korea).
- Enhancing legal and institutional frameworks, including Enterprise Insolvency Law:
  - Debt/equity conversions require specialized analysis of financial situation and business prospects to determine viability, typically conducted by an insolvency professional in reorganization.
  - Recommended reforms:
    - Reinforce position of insolvency administrators, strengthen disclosure requirements, and regulate contents of viability reports and reorganization plans.
    - Clarify position and role of shareholders in reorganization to prevent blocking tactics and interference in debt/equity conversions via voting or pre-emption rights; allow for “cramdown” of shareholders in approval of reorganization plans (may require changes to corporate and securities law).
    - Provide a clear insolvency framework to support informal or hybrid solutions, such as pre-packaged reorganization plans; in China, explore solutions without full court involvement.
- Improve the market for distressed debt:
  - Developing a deeper distressed debt market, specialized servicers, and enhanced legal/operational capacity will support both debt-equity conversions and securitization as tools for resolving corporate distress.

*Source: TNM/16/05 — Section 1*

### Section 2

### Section 2

### Findings on market development for distressed assets
- Access to timely financial information on distressed borrowers, collateral valuations and recent NPL sales are critical for the development of an active market for NPL restructuring.
- Well functioning collateral auctions (i.e. widely advertised to attract a sufficient number of bidders, providing transparently detailed information about the auctioned collateral, etc.) would help raise recovery values.
- The role of the existing AMCs, provided they have the right incentives and independence from state interventions, in helping jump-start a market for distressed assets should be further explored.

### Policy recommendations to deepen NPL restructuring markets
- Facilitate the licensing of nonbanks for restructuring to lower the cost of entry into this market and allow for greater specialization.
- Promote use of specialist NPL servicing and legal workout agencies to improve recoveries and workout outcomes.
- Improve transparency and reach of collateral auctions by ensuring auctions are widely advertised and provide detailed, transparent information about auctioned collateral.

*TNM/16/05 International Monetary Fund Asia and Pacific Department, Legal Department, and Monetary and Capital Markets Department*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/tnm/2016/_tnm1605.pdf_