Non-Performing Loan (NPL)
Are bank loans that are subject to delayed repayment or unlikely to be repaid by the debtor.
It refers to the satisfaction obtained from available goods and services in a country. A further definition would include the less quantified aspects of life like happiness, life expectancy, and living environment. Having a high standard of living is one of the macroeconomic goals of a country.
Alternatively, it means a loan several months late or in arrears. It is more than just an indicator of the debtor's inability to meet the debt/loan requirement. The latter is a burden for both the lender and the borrower.
From a debtor's perspective, it can trap valuable collateral, and the unresolved debt makes it harder to obtain new funding in the future. It can also result in bonds issued in the end receiving lower ratings and higher funding costs, thereby affecting equity valuations.
The lender's profitability affects its profitability, as they tend to contract credit supply and distort credit allocation.
An increase in the number of NPLs affects a bank in the following ways:
- Fall in net interest income
- Increase in impairment costs
- Lower risk appetite for future lending
Additional management time and servicing costs to resolve the problem
Essential information about the United States Non-Performing Loans Ratio
- These stood at 1.2% in Mar 2022, compared with a ratio of 1.3% in the previous quarter
- The above ratio reached its all-time peak at 7.5% in March 2010 and a record low of 1.2% in March 2022
When debtors fall behind on their loan payments, the bank must devise a new payment method or foreclose on the collateral the borrower has pledged. Either option tends to cost money, meaning lenders must try to avoid NPLs whenever possible.
1. Sudden Market Changes
Fluctuations in market conditions directly impact the loan market by affecting people's ability to make loan payments. For example, an economic downturn resulting in job losses will imply that borrowers have less money at their disposal to pay off their loans.
The above situation will hence increase the frequency of such loans.
2. Bank Performance
Bank performance is also a key determinant of such loans. Therefore, a well-run and efficient bank should be able to calibrate its loan rates and terms against the current market to lower the chance of non-performing loans.
If a bank fails to meet the above requirements, there are bound to be NPLs.
3. Credit Culture
Borrower decisions cause a high number of such loans. There are situations whereby borrowers decide to apply for loans without considering future implications.
When this occurs, a credit culture becomes prominent as borrowers take out large loans not because it's financially wise but because they see others doing it.
A lack of strength, weakness, opportunity, and threat analysis on behalf of the lending institution is another reason for increased NPLs. When providing unsecured advances, the banks tend to rely on the borrower's honesty, integrity, financial soundness, and creditworthiness.
Instead, the banks should seek to collect credit information of the borrowers by performing diligent research on their credit history, income source, spending patterns, and job. In addition, credit analysts should also perform a thorough examination of the borrower's balance sheet (in the case of a business).
Finally, when giving a loan, banks must examine the borrower's intention when taking the loan and grant the loan for productive purposes only. They must also examine the long-term viability and profitability of the project while financing.
5. Willful Defaults
Sometimes, borrowers can repay their loans but don't or intentionally withdraw them. It is unethical; in this case, the bank should take adequate legal measures to get back the money loaned.
Practical Ways to reduce:
Ways to reduce are:
1. Financial statement analysis of the borrower: This practice attempts to evaluate, from a financial perspective, the company's (borrower's) performance.
The viability of a borrower's core business is generally determined by the demand for the company's goods/services and its ability to generate sales over their break-even, generate positive cash flow, and cut costs.
2. Data analytics: Banking institutions can use big data to identify customers who may default on their loans, helping them better prepare for anticipated losses.
Lenders should also review their recovery and collection policies and prepare for increased activity in this area.
3. Redesigning the operational model: Banks (lenders) can work on adjusting their operating model for corporate loans and develop a workflow management tool to streamline collaboration between credit and commercial units. It can result in a 50% increase in the repayment rate, hence lowering NPLs.
5. Establishing an AMC: Establishing an Asset Management Company (AMC), specially tasked with purchasing, managing, and ultimately disposing of the NPLs of banks, can be an effective reduction strategy for an economy.
Ultimately, banks faced with such loans can sell them to a national AMC established by their government.
6. Implementation of a credit appraisal system: This is a process in which the bank appraises the technical aspects, economic viability, and bankability, including the creditworthiness of the prospective borrower.
This practice will require the bank to set its criteria that must be satisfied by a business to qualify as a certified borrower of money/assets.
The NPL Ratio
It is the ratio of non-performing loans in a bank's portfolio to the total amount of outstanding loans the bank holds. The ratio measures the bank's effectiveness at receiving loan repayments.
The calculation for the ratio is simple: Divide the total value of NPLs by the total amount of outstanding loans in the bank's portfolio. For example, imagine Deutsche Bank's total loan portfolio of $300 million with $10 million in non-performing loans. In this case, Deutsche bank's NPL ratio would be ($10 million/ $300 million)= 0.033= 3.33%.
Financial analysts widely use the ratio to compare the quality of loan portfolios between banks. From their perspective, lenders with high NPL ratios are likely to engage in higher-risk lending, resulting in bank failures.
Economists also value the NPL ratio as they can use it to predict potential financial market instability. Investors can also use the above ratio when deciding where to invest their money; they will favor a bank with a low ratio as it signals lower risk investment than those with a higher ratio.
The relationship between Non-Performing Loans, the Performance of Banking Institutions, Inflation, and Economic Development are:
These can be used as a metric to assess the performance of banks. For example, a high ratio of NPLs to total loans indicates that the bank is highly exposed to a loss if it fails to recover the loaned amount owed by borrowers.
They represent a significant challenge for the banking sector, as they reduce banks' profitability and often reduce banking institutions' ability to lend more to businesses and clients. In addition, it reduces spending and production in an economy, thereby reducing economic growth.
Growth in unpaid loans can indicate an impending banking crisis since it negatively affects a nation's economic strength by limiting credit growth.
To be more specific, the non-performing loans cancel out interest revenues, slow down investment opportunities, and can create a liquidity crisis in a financial system.
They present a burden for the lender and borrower since they reduce credit supply, distort credit allocation, reduce market confidence, and dampen economic growth.
- Standard Assets - These are NPAs with an average risk level past due for anywhere from 90 days to 12 months.
- Sub-Standard Assets - These are NPAs past due for more than 12 months.
- Doubtful Debts - These have been past their repayment date for at least 18 months. In this situation, the bank has low expectations that the borrower will repay their loan.
- Loss Assets - Here, banks have the confirmation that the loan will forever be lost and must hence record it as a loss.
Banks sell these to other investors to eliminate risky assets and clear off their balance sheets. Selling the loans at a discount can be more profitable than collecting money from an untrustworthy borrower.
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Researched and authored by Alvin Dookhony | LinkedIn
Reviewed and edited by James Fazeli-Sinaki | LinkedIn
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