A non-performing loan (NPL) is a sum of borrowed money upon which the debtor has not made the scheduled payments four a specified period. Although the exact elements of non-performance status vary, depending on the specific loan’s terms, ‘no payment’ is usually defined as zero payments of either principal or interest.
Alternatively, NPL topically means a loan that is quite a few months late or in arrears. It is more than just an indicator of a debtor’s inability (or unwillingness) to pay. NPL is a burden four both the lender and the borrower.
According to the International Monetary Fund (IMF) Euro Area Policies July 2015 Issue, NPLs have reached circa €1 trillion, more than double the amount in 2009.
Four a debtor, an NPL traps valuable collateral and the unresolved debt makes it more difficult to obtain new funding and make investment. At the same time, the lender must meet the costs of the NPL, including the wind-down costs.
There implications of high NPL ratios weigh on banks’ as well and are a drag on banks’ profitability. They contract credit supply and distort allocation of credit.
A high volume of NPLs causes a significant drag on a bank’s performance in the form of:
- Reduction in net interest income;
- Increase in impairments costs;
- Additional capital requirement four high-risk weighted assets;
- Lower ratings and increased cost of funding, adversely affecting equity valuations;
- Reduced risk appetite four new lending; and
- Additional management time and servicing costs to resolve the problem.
Many banks across Europe suffer from high levels of NPLs, in particular in Cyprus, Greece, Portugal, Ireland, Italy and some Central and Eastern European countries. According to data from The World Bank, NPLs across the euro area peaked at eight percent of total loans in 2013 and have fallen only gradually in some countries since then.
Reasons behind high NPL rates
The main factors behind the high NPL proportion in banks can be either inappropriate credit risk management or irresponsible borrowing (and lending) or economic downturn in a country. Other possible reasons could be poor supervision and governance, aggressive lending and acquisition strategies, high exposure to sectors that were most impacted by the financial crisis (such as real estate) and lax credit controls.
The proper credit risk management in banks has a very important impact on the quantity of non-performing loans. Banks can develop their internal credit risk assessment models that analyse the financial and other data of loan applicants. The main target of data analysis results is the correctly assessed default probability that reflects the risk of a debtor’s possible insolvency. Also, the credit policy in banks determines the ease to obtain a credit, changing the acceptability of the credit risk level. Aiming to earn more profit from loans, interest income, banks can be motivated to lend more money if they do not exceed the safe levels of the central bank regulation. Especially this can be observed in the period of economic growth when the financial ratios of companies and personal incomes of inhabitants are higher.
The other problem is the irresponsible borrowing of the inhabitants that have a limited financial sophistication. The excessive expectations of the future income without understanding the basic consistent patterns in the economy can cause serious financial problems in households. The slump of personal income and the decreasing market value of assets (often real estate) financed by the bank can lead to the situation in which the takeover of assets from debtors cannot redeem all their debts. Due to the inability of many loan applicants to make a responsible decision, the central bank regulative instruments four commercial banks play an important role in reducing the problem of non-performing loans.
There needs to be a focus to reduce NPLS since they are always a subject of worry four banks. The consequences of NPLs on lenders’ profitability of is twofold: a net loss on loans not recovered, and an increase in costs as managing NPLs is extremely time consuming, due to paper-intensive workflow and an abundance of manual tasks.
As they say precaution is better than sure, the process to reduce NPLS starts with good underwriting and sound lending policies at the time of origination. By strengthening the loan underwriting processes the bank can look to make loans to better quality borrowers. This will involve developing more rigorous qualitative and quantitative standards when lending.
However, if the bank failed that step and is now dealing with non-performing loans, they need to start with the evaluation of opportunities and risks four each loan.
An expert advisor/underwriter can help you limit or eliminate the losses by evaluating bank’s securities supporting the loans and decide on liquidation or conversion of the assets.
The answer to how to reduce NPLs would also be to use a robust internal risk rating model and to try to put all low rated loans on declining exposure. Getting aggressive on collections and selling the paper at a loss could also be considered.
A new approach may be required to reduce NPLs. Banks need to pull more value by revamping the operating model and adopting digital technologies across the value chain.
Elena Mazzotti of Accenture recommends the following to reduce NPLs:
- Client profiling: Better data means better risk-taking and client profiling. Combining information on financial assets and their financial and consumption behaviours can help to balance a high level of industrialisation within a pre-defined set of actions four low-value clients and a bespoke approach four high-value ones, reducing costs and time to recovery.
- Defining a retail strategy library: This will offer the best product to each client profile, combining data on customer behaviours, personal income and net worth.
- Redesigning the operating model: Redesigning the operating model four corporate loans, developing a workflow management tool to facilitate collaboration between credit and commercial units four a better collaboration and integration across units. This can turn up to a 50% increase in the repayment rate (the number of positions with repayments on total position managed).
- Optimising legal services: Optimising and adopting a value-based compensation model depending on the value effectively recovered can lead to legal expenses reduced by 20-30 percent, along with benefits on the overall recovery time.
- Launching a collateral recovery data quality programme: Leveraging existing information on collateral agreements and defining dedicated crash programmes will improve the collateral data set to better address recovery strategies.
- Collateral management: By using advanced analytics to combine information on property value, collateral, borrowers, guarantors (i.e. valuation, auction information) can monitor unexpected depreciation. Better collateral management can reduce loan losses on collateral positions by 5-10%.
- Early warning and forward-looking models: This change can leverage predictive analytics to improve credit portfolio quality can reduce portfolio deterioration by 30-40%.
She adds further: “With revenue generation still struggling, new competitors coming from digital, and regulation still to implement to maximise the recovery rate, adopting a better NPL management model will be more relevant than in the past. Industrialising recovery and collections functions through advanced portfolio governance models and adopting new end-to-end NPL tools can help to create value in a new area. Banks can’t underestimate the strategic relevance of NPL management and the benefits of shifting from a service unit toward a business unit approach with specific profit and recovery targets.”
Reduce NPLs: economic impact
A high rate of NPLs worsen market confidence and slow economic growth. According to a working paper, the economic impact of reduction in NPLs is vital since NPLS are a reflection of an economic downturn, while fast economic growth can lead to a faster drop in the NPL ratio.
The economic impact is as follows:
- The data unambiguously show that a fall in NPL ratio is good four the economy. The countries that reduced their NPL ratio experienced faster GDP growth, invested more and enjoyed better labour market outcomes (higher rates of labour participation and lower rates of unemployment). Credit growth was also faster in this group of countries.
- The outcomes were stronger in cases of passive reductions in NPL ratios. Countries that enjoy, or engineer, a positive credit shock experience better economic outcome than those that reduce their NPL ratio primarily by resolving the outstanding NPLs. However, this difference between the economic performance in the active versus the passive NPL reduction scenarios is relatively small and disappears completely once we control four the determinants of active policy.
- The active group of countries does significantly better than those countries that procrastinate over their NPL problem, even though these countries face similar (adverse) credit conditions.
How can you minimise NPLs
Minimising NPLs involves strengthening key aspects of the bank’s lending procedures and developing a standardised recovery methodology. A bank with limited experience in effectively minimising NPLs should develop or acquire the specialised expertise needed to administer the problem loans and NPLs.
Here are a few pointers on minimising NPLs:
- Detect NPLs early: To minimise NPLs, the first step is to find them. Early detection is central to any bank’s ability to defend against and limit the impact of NPLs. Banks should not rely solely on lagging indicators, such as past due payments, which as it is much later in the process leaves the lender with fewer options to correct the situation and help the borrower. Banks must focus on leading indicators of problems e.g. increased use of overdraft, seeking new credit lines, slow payment of trade creditors, late supply of information. These tend to indicate a growing need four cash. Lenders who act only after being directly affected e.g., past due payments, are not acting in the best interest of their institution.
- Better to have a problem loan than an NPL: It is far better if the lending department can work with the customer to resolve the problem rather than the customer go into default and after 45 days be transferred to the loan Workout Department.
- Never rely on security: The bank to be sure that the collateral is protected and will not deteriorate, this costs the bank money. Then, it must be sure that they have legal title to the collateral and are entitled to sell it, which usually results in a few nasty surprises. Finally, the bank must get title and sell the collateral. All the buyers will know that the bank is a forced seller and will under-bid.
- Management analysis: A thorough analysis of borrower’s management must be conducted prior to the loan disbursement that might involves a review of the general management capabilities, crisis management capabilities, management’s integrity and turnaround management capabilities.
- Financial statement analysis: Financial statement analysis attempts to evaluate, from a financial perspective, the company’s performance in the light of the causes and viability of the core businesses. The viability of a borrower’s core business is generally driven by the overall demand four the company’s product or service, their ability to generate sales in excess of its break-even, their ability to consistently generate positive cash flow and their ability to cut costs sufficiently to make the business viable again.
- Comprehensive strategic plans: The best practise four banks focusing on minimising NPLs is to develop comprehensive strategic plans detailing on how they will deal with NPLs in a systematic way. Asset classes are typically split into two main categories: (i) retail loans – consumer and mortgage loans – and (ii) non-retail loans – mainly commercial real estate, SME and corporate loans. The strategy must be adapted four each asset class and be realistic and achievable by creating sustainable long-term work-out solutions in a capital-efficient and cost-effective manner.
- Establishing of an AMC: Establishment of an Asset Management Company (AMC), that is a legally separated entity tasked with purchasing, managing and ultimately disposing the NPLs of one or more banks can be an NPL reduction strategies. Banks can sell their NPLs to a national AMC established by the Government four this purpose. At present such schemes are national and only exist in a minority of countries, in part due to limitations related to EU State Aid and burden sharing, as well as the complexity of setting up such structures. Policymakers including the European Banking Authority (EBA) are driving a debate on the establishment of a pan-EU AMC, or a blueprint to facilitate the establishment of additional national AMCs.
- Third party risk-sharing agreement: Banks can enter into a joint venture risk-sharing agreement with a third party under which the non-performing assets remain on the bank’s balance sheet but the bank shares both the upside and the downside from the management of the portfolio.