Non-Performing Loans

What do you mean by Non-Performing Loans?

Non-performing loan (NPL) refers to the loans in default because the borrower has not paid the timely principal amount and the interest repayment for a specified duration. Though, the elements of non-performing status can differ based on the terms of the agreement for a specific loan. Based on the industry and category of loan, the period specified on the loan's terms may vary from 90 days to 180 days. 

• Non-performing loan (NPL) refers to the loans in default because the borrower has not paid the timely principal amount and the interest repayment for a specified duration.
• Based on the industry and category of loan, the period specified on the loan's terms may vary from 90 days to 180 days.
• Once a loan is categorised as non-performing, the chances that the debtor will repay the loan availed are considerably low.

• There exists no standard or “accepted” definition of non-performing loans, and it can vary across countries

Frequently Asked Questions:

How do banks classify loans as Non-performing Loans?

Non-performing loans happen when borrowers do not have the money to pay back to the lender or the borrower land up in a situation where it has become difficult for them to repay the loan they had availed.  

Non-performing loans pose a significant challenge to a country’s economy. Once a loan is categorised as non-performing, the chances that the debtor will repay the loan availed are considerably low. Therefore, when a debtor restarts making payments again a NPL, it is a reperforming loan (RPL). This is even when the debtor is yet to pay all the missed payments.

Commercial loans are classified as non-performing in banking when the debtor has not made payments of any interest or principal amount within 90 days. Similarly, a consumer loan is considered NPL when the debtor has failed to make repayments of principal or interest within 180 days. Finally, a loan is considered a default when the borrower fails to meet their obligations and the lender considers the loan to be a breach of an agreement.

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What are the types of Non-Performing Loans?

A debt can be classified into different types of non-performing loan status. The different types of NPLs are:

• Loan, wherein 90 days' worth of interest has been monetised, refinanced, or deferred either because of an agreement or an amendment to the initial agreement. 
• A loan wherein the delay in principal or interest repayments is not more than 90 days, and the lender believes that they will not receive future payments from the debtor.   
• A loan for which the maturity date of the repayment of the principal amount has arrived, but some portion of the loan is yet to be paid. 

How do international organisations such as European Central Bank (ECB) and International Monetary Fund (IMF) determine Non-Performing Loans?

Specific guidelines have been issued by different global financial authorities to determine non-performing loans: 

The European Central Bank (ECB) needs asset and definition comparability to calculate exposure to risks throughout the euro area central banks. While, performing stress tests on participating banks the European Central Bank defines multiple criteria to classify NPL. According to the ECB criteria, loans are defined as non-performing loans when: 

• The borrower has not made any payments of interest or principal within 90 days. 
• Impaired concerning the accounting specifics for US Generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) banks. 
• In default as per the Capital Requirements Regulation (CRR).

The time frame for lenders to hold separate reserves to cover nonperforming loans was defined in an appendix issued in 2018: two to seven years, depending on whether the loan was secured or unsecured.

The total worth of non-performing loans in the books of eurozone lenders was around $1 trillion by the year 2020.   

International Monetary Fund (IMF)

The International Monetary Fund (IMF) has also set up its criteria to classify non-performing loans.

It defines non-performing loans when:

• Borrowers have not paid monthly principal and interest and repayments for at least 90 days or more.
• Interest payments for 90 days or more than 90 days have been capitalized, refinanced, or deferred by an agreement.
• Payments were made before the completion of 90 days, but there is a high degree of uncertainty on whether the debtor will make payments in the future.

What is the difference between Non-performing Loan (NPL) and Reperforming Loan (RPL)?

A non-performing loan or NPL is a loan that is in default, whereas reperforming loans are those that stopped performing once but started performing again. In the reperforming loans, the debtor restarts making payments again on an NPL after being delinquent for at least 90 days. Usually, reperforming loans are the loans where the debtor continues to make payments because of the bankruptcy agreement. 

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An example of non-performing loan can be this. Let us assume that Patrick has lost his job and is thus unable to make the monthly payments. Over 90 days have passed, and he has not made any payment, and the bank now considers it a non-performing loan. In such a situation, financial institutions such as banks move the loan to their non-performing list. 

What are the three important reasons European Banking Authority (EBA) suggested which has led to a reduction in the Non-performing Loans over the past few years?

It must be noted that there is no standard or “accepted” definition of non-performing loans, and it can vary across countries. 

The management of the non-performing loans resulting from the global financial crisis of 2008 remained a sensitive topic in the European Union. Steps have been taken in recent years to ease the burden of NPLs on the banks. As per the European Banking Authority (EBA) report, which was published in November 2019, the quality of the European Union banking sector has considerably improved over the last few years. From June 2015 to June 2019, the total NPLs decreased from over €1.15tn (6% as a percentage of total loans) to €636bn. Furthermore, the NPL ratio dropped to 3%, the lowest ratio after the EBA launched an agreed definition of non-performing loans in the European countries. However, the average coverage ratio somewhat increased from 43.6% to 44.9% over the said period.

Additionally, the EBA report identified three main reasons that led to an overall reduction in NPLs. They are:

1. Clear policy stands of the EBA. 
2. Initiatives undertaken by banks to improve their NPL management capabilities.  
3. Positive economic growth, lowering interest rates, and a drop in the unemployment rate also helped reduced NLPs.  

What are the challenges and difficulties faced by banks in resolving Non-Performing Loans?

• Absence of a standard and globally accepted definition of NPLs. 
• Absence of any standard valuation methodology whereby banks can have provision for losses resulting from NPL resolution. 
• Incentives for financial institutions to understate their non-performing loans to save themselves from the reputational risk of facing higher funding costs in financial markets. 
• Lack of willingness of banks to sell NPLs due to the cost involved in such an exercise.
• The consumer protection regulations.