Non-Performing Loans (NPL): Definition, Causes & Impact

A non-performing loan (NPL) is a loan in which the borrower is in default and has not paid the monthly principal and interest repayments for a specified period. Non-performing loans occur when borrowers run out of money to make repayments or get into situations that make it difficult for them to continue making repayments towards the loan.

Usually, banks classify loans as non-performing loans when the repayments of principalPrincipal PaymentA principal payment is a payment toward the original amount of a loan that is owed. In other words, a principal payment is a payment made on a loan that reduces the remaining loan amount due, rather than applying to the payment of interest charged on the loan. and interest are due for more than 90 days or depending on the terms of the loan agreement. As soon as a loan is classified as an NPL, it means that the likelihood of receiving repayments are significantly lower.

However, a borrower may start making repayments to a loan that has already been classified as a non-performing loan. In such cases, the non-performing loan becomes a re-performing loan.

Summary

• A non-performing loan (NPL) is a loan in which the borrower has not made repayments of principal and/or interest for at least 90 days.
• When a bank is unable to recover non-performing loans, it can repossess assets pledged as collateral or sell off the loans to collection agencies.
• When a bank has too many non-performing loans in its balance sheet, it poses cash flow problems for the bank since it is no longer earning income from its credit business.

How Banks Handle Non-Performing Loans

Generally, non-performing loans are considered bad debts because the chances of recovering the defaulted loan repayments are minimal. However, having more non-performing loans in the company’s balance hurts the bank’s cash flows, as well as its stock price. Therefore, banks that have non-performing loans in their books may take action to enforce the recovery of the loans they are owed.

One of the actions that lenders can take is to take possession of assets pledged as collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. for the loan. For example, if the borrower provided a motor vehicle as collateral for the loan, the lender will take possession of the motor vehicle and sell it off to recover any amounts owed by the borrower.

Banks may also foreclose on homes where borrowers fail to honor their mortgage obligations, and the repayments become due for more than 90 days. The lender may also opt to sell the non-performing loans to collection agencies and outside investors to get rid of the risky assets from their balance sheet.

Banks sell the non-performing loans at significant discounts, and the collection agencies attempt to collect as much of the money owed as possible. Alternatively, the lender can engage a collection agency to enforce the recovery of a defaulted loan in exchange for a percentage of the amount recovered.

Types of Non-Performing Loans

According to the International Monetary Fund (IMF), a loan can become non-performing in the following ways:

• Loan installments of principal and interest are at least 90 days due, and the lender no longer believes the borrowers will honor their debt obligations. In this case, the loan is written off as a bad debt in the lender’s books of accounts.
• Ninety (90) days’ worth of interest payments are capitalized, refinanced, or delayed due to changes in the loan agreement.
• Payments of principal and interest are less than 90 days overdue, and there are reasons to doubt that the borrower will not pay the outstanding loan in full.

Impact of NPLs on Banks

When a lender records a large percentage of its outstanding loans as non-performing loans, it can hurt the financial performance of the lender. Banks mainly make money from the interest they charge on loans, and when they are unable to collect the owed interest payments from NPLs, it means that they will have less money available to create new loans and pay operating costs.

The money represents an income that is potentially lost, and it affects the profitability of the lender. Not only does it affect the lender, but it also leaves potential borrowers with fewer options to get loans from the lender.

Holding a high number of NPLs relative to the total assets of a company poses a huge risk to the company. Potential investors are interested in investing in companies with healthy books of accounts. When the percentage of non-performing loans increases, the lender’s stock price will also go down. The NPLs a bank holds in its books, the less attractive it is for potential investors because its future profitability will suffer if the lender will not earn an income from its credit business.

Also, the lender will be required to set aside a portion of its profits as bad debts provisions in case it is required to write off the debts. In the United States, banks with a high percentage of non-performing loans are carefully monitored by the Federal Deposit Insurance Corporation (FDIC)Federal Deposit Insurance Corporation (FDIC)The Federal Deposit Insurance Corporation (FDIC) is a government institution that provides deposit insurance against bank failure. The body was created to protect depositors whose funds are at risk.

Non-Performing Loans to Total Loans Ratio

Banks are required by law to report their ratio of non-performing loans to total loans as a measure of the bank’s level of credit riskCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, and quality of outstanding loans. A high ratio means that the bank is at a greater risk of loss if it does not recover the owed loan amounts, whereas a small ratio means that the outstanding loans present a low risk to the bank.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses.certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Allowance for Doubtful AccountsAllowance for Doubtful AccountsThe allowance for doubtful accounts is a contra-asset account that is associated with accounts receivable and serves to reflect the true value of accounts receivable. The amount represents the value of accounts receivable that a company does not expect to receive payment for.
• Bad Debt ExpenseBad Debt ExpenseBad debt expense is the way businesses account for a receivable account that will not be paid. Bad debt arises when a customer either cannot
• Non-Performing AssetNon-Performing AssetA non-performing asset (NPA) is a classification used by financial institutions for loans and advances on which the principal is past due and on which no
• Probability of DefaultProbability of DefaultProbability of Default (PD) is the probability of a borrower defaulting on loan repayments and is used to calculate the expected loss from an investment.