Non-Performing Loan (NPL)
Are bank loans that are subject to delayed repayment or unlikely to be repaid by the debtor
What is a Non-Performing Loan (NPL)?
A Non-Performing Loan (NPL) is a loan in default because the borrower has failed to make scheduled payments for a specific period. The monthly scheduled payments include the interest payment and the principal amount.
The borrower either makes a late payment or is unlikely to pay the amount due. The borrower is not able to pay the due amount because of a lack of cash. He might also be in a situation that makes it difficult to continue with the repayment schedule.
Non-performing loans create a serious problem for the banking industry. Banks classify a loan as NPL when the principal and interest payment is due for more than 90 days or as defined in the loan agreements.
NPLs are referred to as bad debts when there is very minimal or zero chance of receiving the payment. The borrower tends to default on payment. However, if a borrower starts to repay the loan amount after the default, then the NPL will be converted to a Re-Performing loan.
NPL prevents economic growth as banks cannot conduct their essential lending and borrowing functions. The global financial crisis of 2008 also depicts the European Commission’s management of NPL.
Key Takeaways
- NPL is a loan that is not repaid by the borrower as per the agreements of the loan contract within a specific time period, often around 90 days.
- NPLs are known as bad debts because there are near zero chances of recovery of the loan amount.
- NPL can be caused when the borrower cannot repay because of some unforeseen circumstances or when the lender incorrectly assesses the borrower's profile.
- Banks' profitability takes a major hit due to an increase in NPL. The banks are unable to perform their basic function of lending and borrowing.
Criteria for Non-Performing Loans
Banks would declare a loan as a Non-Performing loan in the following ways:
- When the scheduled interest and principal amount are due for at least 90 days, and the lender no longer believes in receiving the payment. Thus, the loan is written off as bad debt in the lender's books of account.
- When there are changes in loan agreements, 90 days' worth of interest payments may be delayed, capitalized, or refinanced.
- When interest and principal amounts are due for less than 90 days, lenders have reasons to doubt that the borrower might default on the repayment.
Causes of NPL
Non-performing loans can be caused by both the borrower and the lender. Both these types are explained below in detail.
Borrower-induced Causes
A borrower is someone who borrows money or takes a loan. A borrower is obliged to pay the interest and principal amount. However, he may be unable to repay the loan amount due to the following reasons.
1. Unexpected events
Even after having a favorable risk profile, a borrower may encounter any uncertain event that might lead him to default on his loan repayment. E.g., losing a job, a severe illness requiring costly treatment, any natural calamity, etc.
2. Mismanagement of finances
The borrower is earning well and has a decent livelihood but still is unable to manage his finances properly. This may be due to his lure to have a lavish lifestyle and enjoy benefits he cannot afford. As a result, the borrower always finds himself trapped and becomes spendthrift.
3. Lending fraud
Borrowers deceitfully borrow money from the banks by providing false information or identity theft by some other party to take a loan from the bank.
Lender-induced Causes
A lender is a person who lends or provides money as a loan. He is entitled to receive the interest and principal amount. However, at times, the lender may cause a rise in NPL due to the following reasons:
1. Incorrect risk-profile assessment
The lender or the bank does not pay heed to the borrower's profile. They don't do a proper background check, risk assessment, family and income check.
The borrower may also paint a rosy picture of their financial well-being, misleading the lender and, as a result, not checking the borrower's profile.
2. Lack of understanding of borrowers’ real finances
Sometimes, when the lender cannot understand the borrower's financial position, it may lead to default on repayment of loans.
For instance, a borrower’s majority income comes from investment in the share market, and the loan is approved.
If the stock market crashes, the borrower cannot pay the loan as his fixed income is really low. Hence, the bank overlooked the finances of the borrower, leading to default in repayment of loans.
Impact of NPLs on banks
When a lender classifies a big chunk of its outstanding loans as NPL, it hurts its financial performance. The profitability of the banks is affected. They are not able to earn enough interest income and have high expenses, leading to very little or no profits.
Banks main source of income is from the interest they charge on the loans.
However, when banks cannot collect the owed interest payments from NPL, they have less cash inflow for their daily operations and cannot create new loans for other borrowers.
The interest and principal amount is an income that is lost, and it affects the profitability of the lender or the bank. It further disrupts the lending and borrowing cycle of the bank, as banks would not be able to generate new loans due to insufficient cash, and borrowers would also be left with only a few options to borrow.
Potential investors are interested in investing in companies with profitability and healthy books of accounts. The increase in NPLs makes investment less attractive for investors as profits and earnings would decrease in the future.
Apart from this, the lender also has to set aside a portion of its profit as provisions for bad debts to write off bad debts. If NPLs keep increasing, the company has to maintain higher provisions for bad debts and write them off.
As a result, banks suffer due to an increase in NPLs; their credit business is affected, leading to less profitability in the future and making it unattractive for potential investors to invest.
How do Banks Handle Non-Performing Loans?
NPL poses a serious challenge to the banking industry. Below are some ways banks can handle NPL and recover their amount:
- Maintaining an account of provision for bad debts. The amount is written off from this account when the borrower defaults on loan repayment.
- The bank can also renegotiate the terms of the loan. The bank, for example, can adjust the time period and extend the time limit for repaying the loan amount.
- If the borrower is deemed insolvent, then he will only return the loan amount to the extent that his assets allow.
- Banks can also sell the NPL to an investor at a low value. It may lead to losses but not as much in the case that a borrower is declared insolvent or writes off the amount from provision for bad debts.
- Banks also shift their NPLs to bad banks. These asset management companies help banks sell off their NPLs to investors and regain their financial position.
- Banks should also have a proper background check of the borrower and should have stringent rules and policies for lending and defaulting.
Non-Performing Loans to Total Loans Ratio
The NPL ratio is computed by dividing the bank's NPL by its total loan. It evaluates the credit risk and quality of loans.
NPL Ratio = Total Outstanding Loan / NPL
A high NPL ratio indicates poor financial performance for the bank. It is highly vulnerable if the borrower fails to repay the amount owed. A low NPL ratio implies that the bank is doing well and that the outstanding loans provide low risk.
For example, suppose Oriental Bank has $ 10 million in non-performing loans out of a total loan portfolio of $ 200 million. Oriental Bank's NPL ratio would be:
10 million/200 million = 0.05 = 5%
As per the ratio, NPL accounts for 5% of the total outstanding loans.
Non-Performing Loan FAQs
Some of the factors behind NPLs are Low GDP, Inflation, and unemployment.
NPLs present a burden for both the lender and borrower since they reduce credit supply, decrease the lending and borrowing capacity, reduce market confidence, and dampen economic growth.
Banks sell NPLs to other investors to eliminate risky assets and clear off their balance sheets. This improves the financial health of the company. Selling the loans at a discount can be more profitable than collecting money from an untrustworthy borrower.
Researched and Authored by Chhavi Gupta | LinkedIn
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