A non-performing loan (NPL) is a bank loan that is subject to late repayment or is unlikely to be repaid by the borrower in full. Non-performing loans represent a major challenge for the banking sector, as it reduces the profitability of banks, and is often presented as preventing banks from lending more to businesses and consumers, which in turn slows down economic growth (although this theory is disputed).
In the European Union, the management of the NPLs resulting of the global financial crisis of 2008 has become a politically sensitive topic, culminating in 2017 with the decision by the Council to task the European Commission to launch an action plan to tackle NPLs. The action plan supports the fostering of a secondary market for NPLs and the creation of Asset Management Companies (aka bad bank). In December 2020, this action plan was revised in the wake of the Covid19 pandemic crisis.
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Non-performing loans are generally recognised as per the following criteria:
- Payments of interest and principal are past due by 90 days or more
- At least 90 days of interest payments have been capitalized, refinanced or delayed by agreement
- Payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full.
Challenges and difficulties of resolving NPLs
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In general, the management of NPLs is made difficult due to a variety of reasons:
- Lack of a standard, accepted definition of NPLs, and no strong reporting frameworks
- Lack of any standard valuation methodology whereby financial institutions can provision for losses arising from NPL resolution.
- Incentives for banks and financial institutions to understate their NPLs in order to avoid reputational risk of facing higher funding cost on financial markets
- Unwillingness of banks to sell NPLs because of the costs associated with such an exercise, which could add to the NPL losses. This in turn could hurt their capital adequacy.
- Consumer protection regulations
Policy response and NPL management models
There are two main approaches for dealing with NPLs:
- A decentralized approach involves regulating banks so they take measures to prevent and resolve the NPLs in their loan books, for example by legislating accounting rules for forcing banks to provision against future losses, or by setting up legislative frameworks and other measures to foster a secondary market for NPLs. In this approach, banks are left alone to manage their own bad loans by giving them incentives, legislative powers, or special accounting or fiscal advantages.
- A centralized approach takes the form of a central organization/agency such as a “bad bank” (also called “Asset Management Company”).
In practice, both approaches can be used simultaneously, as illustrated by the European Commission’s action plan on NPLs, while some authors have argued that systemic crisis generally require a more centralized approach.
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Proactive measures to tackle NPLs include:
- Impose more transparency on NPLs reporting by banks
- Accounting framework (such as IFRS9)
- Prudential Supervision of banks including the levels of capital requirements and buffers.
- Proactive incentives for banks to offer forbearance to distressed consumers and other debt relief mechanisms
- Setting up Asset Management Companies (AMCs) or bad banks. These companies use public or bank funds to remove NPAs from the bank books. For example, the Korea Asset Management Corporation purchased as much as 80% of bad loans at market rate following the Asian crises.
- Fostering secondary markets for NPLs that can offer the mechanism and liquidity required to write off bad loans. Many companies see a business opportunity in buying NPL’s. Buying NPL’s from financial institutions with a discount, can be a lucrative business. Companies pay from 1% to 80% of the total loan and become the legal owner (creditor). The discount depends on the age of the loan, secured/ unsecured, age debtor, personal/ commercial debt, area of residence, etc.
- Securitization of NPLs (ie. packaging a bulk of NPLs into a pooled financial product such as a covered bond or asset backed security) may help preserve the market value of the NPL package to a level closer to their nominal or real economic value, thus lessening the cost of selling NPLs for banks.
- Corporate Governance
Non-performing loans in the context of the Covid19 pandemic crisis
Although the 2020 has seen an actual decrease of non performing loans, the issue is expected to represent a major challenge for the banking industry in the post-Covid19 era. The ECB has warned that the amount of NPLs in the Eurozone could reach up to 1.4 trillions euros of bad loans, however academic literature suggest the future rise of NPLs will be primarily driven by the pace of the economic recovery after Covid19, and in particular the level of unemployment. In the context of the Covid19 crisis, the deactivation of debt payment moratoria and tax deferral are also likely to cause an increase of NPLs.
To prepare for the likely new wave of NPLs, the ECB’s Supervisory board chair Andrea Enria has proposed the creation of a European Bad Bank and has imposed a ban on dividend distribution by banks, in a move to pressure banks to proactively tackle NPLs. The ECB has also indicated to work on the development of an “Amazon-style” platform to allow banks and investors to trade NPLs on a secondary market.
Meanwhile the European Commission has revised its action plan in December 2020 by focusing on speeding up the fostering of a secondary market for NPLs and to offer support for national Asset Management Companies. The proposal was met with criticism by civil society groups.
- Narasimham Committee on Banking Sector Reforms
- Default (finance)