Europe 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 processes 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.

The potential clients of such banks include other banks, which on average hold 45 to 50 percent of a country's nonperforming credits; industrial companies, 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 something 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 percent, 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 competitors, 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 specialist mortgage-recovery unit, has already set up shop in Italy (see sidebar, "Recovering debt in the United States").

However, most of these niche lenders specialize in personal loans rather than manage nonperforming corporate credits—which constitute the most attractive 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.

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 percent of the total, but lenders also bear the operating expenses of their recovery 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 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 outsourcing 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 specialists, 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 securitization 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 leading issuer recently bought a network of small though reputable specialists in the recovery of debt. But as the securitization market grows in Europe, demand for external specialists to improve the performance of the issuing banks' nonperforming 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 portfolio by its dominant characteristics and develop recovery processes accordingly (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 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 maximizes 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 customers solvent?

Unlike most lenders, when the cash outlook is poor, specialists in corporate debt recovery keep a constant eye on collateral values

If the cash outlook is poor, corporate debt-recovery specialists, unlike most lenders, keep a constant eye on collateral 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 independently 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 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 information, such as local property values and the time needed for proceedings in each relevant court. Recovery specialists can use the system's case information to analyze the effects of the process and to fine-tune it as needed.

Some packaged information systems can be customized to support the management of nonperforming credits. The most advanced, Internet-based systems 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, companies that recover debt well create a separate, dedicated business unit, with efficient management systems. Such a company treats its recovery agents like a sales force—measuring their performance by how much money they recover and how quickly—and rewards them accordingly. Talented staffers are attracted by performance-based incentives that can equal more than 40 percent of their base salaries.

Within the unit, tailored processes work best in a structure establishing separate divisions, each specializing in a credit segment. The key skills required across the unit are credit rating (to price services), finance (to evaluate recovery alternatives), negotiations, and law. But the mix and level of skills will be different for each division, as will its critical scale, which depends on the volume and characteristics of the credits in its portfolio.

A centralized team of professionals can manage a geographically dispersed portfolio of high-value corporate credits worth more than $300,000 each. Midsize credits (such as mortgages and smaller corporate debts) are better managed by the employees of local units or by self-employed agents paid through commissions on what they recover. To achieve critical scale, the local unit must have at least four people, each managing 250 loans that have an average value of $25,000 and that are distributed within a radius of 100 kilometers—an area small enough for agents to travel and talk to people without being on the road all the time. Agents in such an operation can develop the detailed local economic knowledge needed to decide when to renegotiate bad debts and when to realize the value of the underlying assets immediately. By contrast, small unsecured retail credits, thanks to their high volume and similarity, can be managed remotely, at least in the first phases of the debt-recovery process, using mail and call centers.

Europe's nonperforming credits drain the profits of its banks and industrial companies. Specialized management of bad credit could staunch those losses and generate attractive profits for companies that approached the problem with the right processes and organization. At the current stage of the business cycle, competition to launch such a countercyclical undertaking is likely to be fierce. Although large banks have many advantages in this field, it also remains open to nonbank niche contenders.