1. Good money
from bad debt
urope is awash with bad debt. European banks, companies, and
public institutions are owed some $900 billion of nonperforming
credits,1
and as the economy of the region slows, its credit troubles are
growing. All lenders try to recover as much of their nonperforming credits
as they can, but some do a better job than others. Among small Italian banks,
for example, the best at managing bad debt recover 20 percent more than the
average, largely because they tailor their recovery processes to the particular
types of bad debt they manage and work very closely with debtors.
A handful of large banks have discerned the seeds of a new business in these
facts: they are developing specialist businesses to manage their own and other
companies’ nonperforming credits on an industrial scale, using recovery pro-
cesses tailored to each type of credit, and charging fees of 10 to 15 percent of
the amount recovered. Despite the fees, the debt-recovery expertise of these
banks means that their clients should be better off for using their services.
3
Michele Cermele, Maurizio Donato, and Andrea Mignanelli
Nonperforming credits are draining the profits of Europe’s banks
and industrial companies. Specialized management could not only
staunch those losses but also generate attractive profits.
E
1
Credit that the lender doubts will be paid back according to the terms agreed with the borrower.
Roughly equivalent to Spain’s gross domestic product, the $900 billion includes $280 billion in
Germany, $150 billion in both France and Italy, $100 billion in the United Kingdom, and $30 billion
in Spain.
2. The potential clients of such banks include other banks, which on average
hold 45 to 50 percent of a country’s nonperforming credits; industrial com-
panies, which hold 40 percent; government institutions, which hold the rest;
and securitization houses that buy nonperforming credits from these lenders.
Europe has a galaxy of tiny firms that offer debt-recovery services, and banks
and industrial companies occasionally use them to chase individual debtors.
But for banks and industrial companies to outsource their whole bad-debt
portfolio to outsiders with national or international coverage would be some-
thing new.
Not a business for just banks
Given the size, scope, and geographical spread of the nonperforming-credit
portfolios of large banks, they have an advantage in building industrial-scale
debt-recovery units covering all the varieties of credit, from large corporate
loans to consumer finance. Improving the recovery rate on a bank’s in-house
nonperforming-credit portfolio is a worthwhile business; if, for example, a
bank with a $2 billion portfolio improved its recovery performance by 10 per-
cent, it could save $35 million to $50 million a year before serving a single
external client. If the bank then opened its doors to clients and won, say, a
10 percent share of the national pool of nonperforming credits, the profits
could be substantial: as much as $100 million—roughly 5 percent of the net
income of the leading local banks—in countries such as France and Italy.
Big banks aren’t likely to hand their bad-debt portfolios to direct competi-
tors, but a competitor’s debt-recovery unit will have plenty of noncompeting
lenders to approach. UniCredito Italiano, one of the largest Italian banks,
is targeting its new debt-recovery unit’s services at small to midsize banks,
industrial companies, securitization houses, and utilities.
This business is not only financially promising but also countercyclical—a
particular boon to banks in the current downturn. Banks, though, are not
the only players tempted by these buoyant prospects: some of Europe’s little
debt collectors are keen to scale up, possibly in partnership with one another.
But these firms generally cover only a small geographical area, and some are
barely professional. More powerful contenders are likely to come from the
ranks of nonbank firms that specialize in particular types of credit, such as
consumer credit companies and mortgage lenders, which may leverage their
scale and knowledge of borrowing behavior in their niche to build national
or international credit-recovery units. Some US nonbank credit specialists that
have formed such organizations are poised to enter the European market; for
example, Ocwen Financial, a Florida-based mortgage servicer with a special-
ist mortgage-recovery unit, has already set up shop in Italy (see sidebar,
“Recovering debt in the United States”).
4 THE McKINSEY QUARTERLY 2002 NUMBER 1
3. However, most of these niche lenders specialize in personal loans rather than
manage nonperforming corporate credits—which constitute the most attrac-
tive credit segment given their volume, their average size, and their potential
for credit recovery. It takes a highly professional, “high-touch” approach to
recover corporate credits successfully, and existing credit specialists would
have to develop such an approach if they wished to grow beyond their niche
and to equal the ability of the large banks to offer clients the full range of
credit-recovery expertise.
5G O O D M O N E Y F R OM B A D D E BT
As yet, no US banks have entered the business
of third-party debt management on an industrial
scale—at least not recently. A few banks devel-
oped specialized nonperforming-credit-recovery
businesses as a result of the collapse of the US
savings and loan industry a decade ago. The
government shouldered the burden of the indus-
try’s bad debts through the Resolution Trust Cor-
poration and quickly privatized them in packages
of related debt. Some of the banks that bought
these packages began not only to specialize in
improving debt recovery but also to manage debt
outsourced by other companies. This new busi-
ness later atrophied, however, because the econ-
omy was so buoyant; there just wasn’t enough
demand.
An improvement in the economy isn’t likely to
have the same effect on third-party bad-debt
management in Europe. Over the course of an
entire business cycle, nonperforming loans rep-
resent a much lower proportion of total credit in
the United States than in Europe, mainly because
bad debts are processed faster through the US
legal system. The stock of nonperforming loans
in the United States is thus highly sensitive to
the business cycle and can grow and shrink at a
dramatic rate in response to changes in overall
economic activity. In Europe, sluggish recovery
processes mean that, even during a boom, a
sizable stock of bad debt to recover will be left
over from the previous downturn. In Italy, for
example, nonperforming loans represented no
less than 4 percent of total credit in 1999 and
2000, compared with just 0.9 percent in the
United States during the very same “end-of-
boom” period.
Recently, “vulture” capitalist companies and
bank departments have appeared—at Citigroup,
for example—in response to the US economic
downturn and the corresponding rise in business
failures. These funds assume the debt of bank-
rupt companies with a view either to altering
the terms of the bankruptcy settlement in the
debtors’ favor or to converting the debt into
equity as a way of taking over a debt-free com-
pany. But they treat each company as a project,
and none of them has so far developed an indus-
trial process for managing bad debts for third
parties.
The United States does, however, have several
nationwide companies specializing in particular
credit segments. Those with expertise in recover-
ing nonperforming credits in specific niches
would be likely contenders to undertake debt
recovery in the same niches in Europe.
Recovering debt in the United States
4. Nonetheless, the field for recovering nonperforming credits in Europe remains
wide open. Given the market’s character, we think any player that gets its
organization and techniques right could build a business earning profits of
$150 million or more within three to four years.
Why now?
Bad debts are enormously costly. Lost repayments constitute about 85 per-
cent of the total, but lenders also bear the operating expenses of their recov-
ery processes—legal and staff costs, for example—and the opportunity cost
of the capital idling in the loan (four years, in the average nonperforming
credit). In 2000, the cost of the bad debts of European banks equaled roughly
half of their total profits (Exhibit 1). Calculated over the previous five years,
the cost reached a staggering 98 percent of total profits.
Europe’s lenders are no strangers to the cost of bad debt. When the Spanish
royal court defaulted on its loans in the 17th century, for example, several
leading finance houses were crippled. If there is still so much bad debt that
costs its owners so much, why is a market for large-scale specialist debt
management only now emerging in Europe? The answer: because, for the
first time, European banks are willing to surrender the management of these
critical assets to outsiders.
Banks are the key to the growth of this business because they not only hold
the largest chunk of nonperforming credits but are also, by definition, credit
experts. If banks begin outsourcing the management of their nonperforming
6 THE McKINSEY QUARTERLY 2002 NUMBER 1
E X H I B I T 1
The high cost of bad debt
1
Such as legal and staff costs.
Italian market example, 2000,
$ billion
Germany 58
Cost of bad debt as share of total
bank profits, 2000, percent
Spain
United Kingdom
France
23
18
34
Italy 65
Weighted
average = 48%
0–1
Credit
loss
Opportunity
cost of
capital
New non-
performing
loans
8–9 1–2
9–12
15
Operating
costs1
Total cost of
nonperforming
loans
5. credits, they will therefore give industrial and institutional lenders the
courage to follow suit. European banks are looking more kindly on the
prospect of outsourcing the management of their bad debt for three main
reasons.
First, financial markets are subjecting banks to unprecedented pressure to
improve their profitability. In response, many are scrutinizing the activities
in their value chains, identifying the most profitable, and outsourcing the
rest. Reviewing the value chain has revealed the true cost of nonperforming
credits to some banks for the first time—traditionally, European banks have
measured the expense solely in terms of credit losses. The management of
nonperforming-credit portfolios could be the next process in line for out-
sourcing in many small and regional banks because of the potential for
improving returns. If a specialist agency can consistently recover debts as
successfully as the best Italian banks do now, companies using it may reduce
their cost of credit by more than 10 percent (Exhibit 2).
Second, having successfully outsourced other processes, banks now find the
risks of outsourcing debt management less daunting. Better information-
management systems leave less room for incorrect valuations of debts handed
over to specialist agencies to manage—besides fraud, the most important
operational risk in the process. The new debt-management agencies have
shown themselves willing, in their outsourcing agreements, to protect credit
owners from the risk of such mistakes.
Third, just as banks are seriously thinking about using debt-recovery special-
ists, a new type of potential client has appeared in Europe: securitization
houses. During 2000, some $84 billion in debt-backed securities was issued
in Europe. From 1999 to 2001, the total volume of securitization in Italy
came to $40 billion, half of it related to nonperforming credits. A securitiza-
tion house that could recover a greater part of the underlying nonperforming
credit could improve
the rating (and thus
the profitability) of
a securities issue.
A few issuing banks are
bringing debt-recovery
skills in-house; in Italy,
for example, one lead-
ing issuer recently
bought a network
of small though repu-
table specialists in the
7G O O D M O N E Y F R OM B A D D E BT
E X H I B I T 2
Bad debt made better
Italian market example, 2000; index: total amount of nonperforming loans = 100
1
Such as legal and staff costs.
Outsourcing
Opportunity
cost of
capital
Total cost of
nonperforming
loans
Credit
loss
Operating
costs1
72
50 N/A 659
Outsourcing
costs
6
Traditional
process
55 512 N/A
6. recovery of debt. But as the securitization market grows in Europe, demand
for external specialists to improve the performance of the issuing banks’ non-
performing credits is likely to grow, too.
Industrial debt recovery
How can bad debts be made to perform better? Most lending organizations,
relying on the legal process in 70 percent of all cases, now take a “one-size-
fits-all” approach to recovery. But the companies that succeed best at the job
set up separate, specialized business units.
Tailored processes
These units use processes—supported by advanced information systems—
that are tailored to each type of nonperforming credit. Such credits have a
number of characteristics: for example, their duration, their size, the type of
borrower, and the collateral. A debt-recovery specialist will arrange a port-
folio by its dominant characteristics and develop recovery processes accord-
ingly (Exhibit 3). Each process relies upon a mixture of data-gathering tools,
contact techniques, and transaction tactics, whose common feature is that
the law is used only as a last resort. To see how tailoring works in practice,
consider the difference between general and specialist processes in three
sample segments.
Corporate secured loans. Before making a loan, corporate lenders require
evidence of a borrower’s ability to repay—a business plan, at least. But when
8 THE McKINSEY QUARTERLY 2002 NUMBER 1
E X H I B I T 3
Know your nonperformers
Percent
of credits
Percent
of value
42
51
Percent
of credits
Percent
of value
13 13
Percent
of credits
Percent
of value
27
4
• Amount
• Duration
• Secured or unsecured
Segmentation criteria
Portfolio segmentation for typical European retail bank
Character-
istics of Segmenting by
Unsecured
Secured
(mortgage)
Corporate Retail
Credit
• Location
• Corporate or retail
• Sector
• Volume
Debtor
Credit
Debtor
Percent
of credits
Percent
of value
9
41
7. a debtor defaults, few corporate lenders check to see whether its future cash
flows can ever meet their requirements. The specialist, by contrast, assesses
how much the defaulting debtor will be able to pay back and then maxi-
mizes the client lender’s share of the available cash. To make the assessment,
specialist agents must understand the situation of the borrower, find reliable
information sources at the right level in its management structure, and test
its cash-flow claims against reality by asking specific questions. Does the
borrower have enough orders? Is
its stock ready to ship? Are its cus-
tomers solvent?
If the cash outlook is poor, corporate
debt-recovery specialists, unlike most
lenders, keep a constant eye on col-
lateral values. If a loan is secured by
an industrial building, is it correctly valued? Is there a potential buyer for the
space? Has the buyer been approached? Bank lenders tend to act indepen-
dently of suppliers, but debt-recovery specialists will get in touch with all
other major creditors to see if any are being repaid. The specialist agent will
then have the facts required to negotiate a new deal with the borrower or to
threaten bankruptcy proceedings.
The largest loans fall in this segment, so just a small improvement in the
debt-recovery rate would have a big impact on a lender’s bottom line. Large
business-to-business lenders would make a promising target market. In Italy,
for instance, the top 250 B2B companies—particularly those in real estate,
heavy manufacturing, and chemicals—have nonperforming credits of more
than $10 billion. However, to make the judgments that improve corporate
debt-recovery rates it is necessary to have detailed knowledge of not just the
business and industry of the debtor but also its relations with other players
in the industry’s value chain, plus considerable negotiating skill.
Retail mortgages. European mortgage lenders mostly take a passive approach
to default: once a borrower has missed a certain number of payments, the
lender starts the legal procedure to realize the value of the property securing
the loan. Usually this process, which can take three to ten years, ends in an
auction at which the property sells for less than its open-market value.
By contrast, a recovery specialist designs a process to realize the maximum
value from the mortgage instead of waiting for the law to take its course.
First, the specialist’s recovery agents identify troubled mortgages in which
the value of the property to be auctioned is unlikely to cover the amount
of the loan outstanding. In these cases, the agent immediately gets in touch
with the borrower to discover why repayments have stopped. Without going
9G O O D M O N E Y F R OM B A D D E BT
Unlike most lenders, when the
cash outlook is poor, specialists in
corporate debt recovery keep a
constant eye on collateral values
8. through the courts, the agent negotiates a new mortgage or helps the debtor
find a buyer for the real estate—an outcome that benefits both debtor and
lender.2
Unsecured retail loans. Despite the lower average value of unsecured retail
loans, most lenders spend as much time trying to recover them as trying to
recover other forms of nonperforming credit. These lenders frequently start
costly legal proceedings after the first failed contact. But the unsecured retail
segment’s low-value, high-volume nature requires a more cost-conscious
approach. A specialist uses a computer-based process that offers a “ladder”
of debt-recovery actions—from telephone calls to letters to visits—leaving
the courts as a last resort. The process, which automatically presents the
agent with the most cost-effective action and the timing for it, suggests steps
up the ladder only if their expected benefits outweigh their costs.
An information system that works
Each tailored process uses an advanced information system to support the
debt-recovery agents’ decisions. Such systems are based on algorithms that
calculate, for example, the expected recovery value of a particular loan or
the optimal sequence of offers in negotiations. The systems also schedule
the activities of the agents and give them access to useful current informa-
tion, such as local property values and the time needed for proceedings in
each relevant court. Recovery specialists can use the system’s case informa-
tion to analyze the effects of the process and to fine-tune it as needed.
Some packaged information systems can be customized to support the man-
agement of nonperforming credits. The most advanced, Internet-based sys-
tems allow several people at a time to access and use the current information
on each credit, thus cutting the interval between steps in the debt-recovery
process. In the case of a secured mortgage, for example, real-estate agents
can look for acquirers in the market while lawyers simultaneously prepare
for a quick auction if no buyer is found.
A separate organization
The best and brightest are seldom attracted to a career in bad debts; for
instance, the average age of recovery officers in the Italian banks we surveyed
was over 45. Most officers in the survey managed more than 400 loans, and
more than 70 percent worked on debt recovery part-time. As we have seen,
10 THE McKINSEY QUARTERLY 2002 NUMBER 1
2
Say the debtor has an apartment with a market value of $100,000 and a $30,000 debt that cannot be
repaid. The debtor might get $100,000 by selling the apartment, give back $30,000 to the bank, and
buy an apartment with the remaining $70,000. If the debtor goes to auction, the apartment will fetch
less money—perhaps $80,000—and the debtor must still pay $30,000 to the bank, plus $10,000 in
legal costs. Only $40,000 is left for a new home.
