Nonperforming Loan (NPL) Definitions, Types, Causes, Consequences

Nonperforming Loan (NPL) Definitions, Types, Causes, Consequences

Nonperforming loan

In October 2022, the Central Bank of Nigeria (CBN) reported that the Nonperforming Loans (NPLs) ratio had reached 4.8 per cent. This figure is notably lower than the CBN’s target benchmark of 5.0 per cent and is a sign that Nigerian banks are doing a better job of managing their loans. However, experts believe there’s still room for further improvement.

In this article, we will delve into the concept of non-performing loans, and their impact on the banking system, and explore possible methods to reduce them even further.

What is a Nonperforming Loan?

Non-performing loans (NPLs) are loans that are in default or are close to being in default due to the borrower’s inability to make timely payments. When this goes on for a while, the loan stops making any profit for the bank, which is why they call it “non-performing.”

This issue is often seen in the agricultural sector when farmers can’t repay their loans because of things like bad weather, floods, or unexpected problems that lead to poor harvests.

Nonperforming loan (NPL) ratio

The nonperforming loan (NPL) ratio is a financial metric that assesses the quality of a bank’s loan portfolio by measuring the proportion of loans that are categorized as non-performing. Non-performing loans are those on which the borrower has failed to make scheduled interest or principal payments for a specified period, typically 90 days or more.

The NPL ratio is calculated by dividing the total value of nonperforming loans by the total value of the bank’s loan portfolio and then multiplying by 100 to express the result as a percentage. The formula is as follows:

[NPL Ratio = Value of Non-Performing Loans \ Total Loan Portfolio * 100 ]

A higher NPL ratio indicates a higher proportion of non-performing loans in relation to the total loan portfolio, which can be a red flag for investors and regulators. It suggests a potential increase in credit risk and financial instability for the bank.

Banks closely monitor their NPL ratios to assess the health of their loan portfolios and to identify potential risks. Regulatory authorities also use this ratio to evaluate the overall stability and risk management practices of financial institutions. A rising NPL ratio may prompt corrective actions from the bank, such as implementing stricter lending standards, improving credit risk assessment procedures, or setting aside additional reserves for potential loan losses.

Conversely, a lower NPL ratio is generally seen as a positive indicator, signalling a healthier loan portfolio with a lower likelihood of loan defaults. However, it’s essential to consider the economic environment and industry conditions when interpreting the NPL ratio, as economic downturns can impact borrowers’ ability to repay loans, potentially leading to an increase in non-performing loans across the banking sector.

What are the types of Nonperforming Loans?

According to the International Monetary Fund (IMF), loans are considered Non-Performing Loans (NPLs) under three main conditions:

  1. When borrowers haven’t made payments on both the principal amount and the interest for 90 days or more.
  2. When interest payments have accumulated to an amount equal to or greater than the interest due for 90 days, and these interest amounts are added to the loan principal, refinanced, or extended by mutual agreement. For instance, if someone owes $10,000 on a loan with a monthly interest of $200. If they delay or miss $600 in interest payments over three months ($200 x 3 months), the loan becomes nonperforming. It’s a sign that the borrower is struggling to meet their interest obligations, and the loan is no longer performing as expected.
  3. When there is clear evidence to reclassify a loan as nonperforming, even if it hasn’t reached the 90-day past due threshold. For example, this can happen when the borrower files for bankruptcy.

The categorization of NPLs can vary slightly depending on the banking regulations and practices in different regions, but generally, they fall into the following categories:

Substandard Loans

These are loans where the borrower is experiencing financial difficulties, and there is a significant risk that the bank will incur a loss. The borrower may be behind on payments, and the loan is considered to be at a higher risk of default.

Doubtful Loans

Doubtful loans are more precarious than substandard loans. The likelihood of full repayment is highly uncertain, and there is a substantial risk of loss. Banks often classify loans as doubtful when there are serious concerns about the borrower’s ability to meet their obligations.

Loss Loans

Loans classified as loss loans are considered uncollectible, and the bank has determined that there is little or no hope of recovering the outstanding amount. These loans are written off the bank’s books as a loss, and provisions are made to cover potential losses.

Special Mention Loans

Special mention loans are not yet classified as non-performing but are identified as having potential weaknesses. These loans require close monitoring, and banks may take preventive measures to address the emerging issues before they escalate into full-blown non-performing status.

Restructured Loans

In some cases, banks may work with borrowers to restructure their loans when financial difficulties arise. Restructured loans involve modifying the original terms, such as extending the repayment period or adjusting interest rates. While not automatically classified as non-performing, restructured loans may be closely monitored due to the elevated risk of default.

It’s important to note that the specific criteria and terminology used to classify non-performing loans can vary among financial institutions and regulatory bodies. The classification allows banks to assess and manage the level of risk in their loan portfolios and make informed decisions about provisioning for potential losses. Regular monitoring and appropriate action on non-performing loans are crucial for maintaining the stability and financial health of a banking institution.

What is the difference between NPA and NPL?

An NPA refers to any nonperforming asset on a bank’s balance sheet, not limited to just loans. It includes loans, advances, investments, or any other asset where the income due to the bank is not received as scheduled. An NPL specifically refers to loans or advances given by a bank or financial institution that have stopped generating income for the lender. As it is, both are one and the same.

How to Manage and Reduce Nonperforming Loans

In 2020, the Central Bank of Nigeria introduced the GSI guideline, which had a specific goal: to reduce the number of loans that people weren’t paying back and to keep a close watch on those who regularly failed to repay their loans. It was all about making sure the banking system worked smoothly.

In this section, we’ll explore some practical methods that lenders can use to reduce their non-performing loans and improve their financial health:

Repossess and Sell Collateral

Banks can take possession of assets pledged as collateral for the loan, such as motor vehicles, and sell these assets to recover the amounts owed by the borrower.

Foreclose on Properties

In the case of mortgage loans, when borrowers fail to honour their obligations and repayments are due for more than 90 days (about 3 months), banks may choose to foreclose on homes and sell them to recover the outstanding debt.

Sell NPLs to Collection Agencies and Investors

Banks often choose to sell their non-performing loans to collection agencies and external investors. These entities buy these loans at reduced prices and make efforts to recover as much of the owed money as they can.

In Nigeria, AMCON is one of the organizations responsible for purchasing or managing these loans.

Negative impacts of nonperforming loans on banks?

NPLs reduce profits, tie up capital, and lead to higher borrowing costs. They can harm a bank’s reputation and attract regulatory scrutiny, limiting their ability to lend. Managing NPLs also involves extra operational expenses. Therefore, they impact both the financial health and operations of banks and the economy at large.

It’s nearly impossible for a bank to have zero Non-Performing Loans (NPLs) unless they are extremely cautious and don’t make much money from loans. However, loans are a major way banks earn money, along with other services they offer. So, being overly cautious means less income for the bank.

In Conclusion

Banks should not only assess loans but also offer sound financial advice to help borrowers use their funds wisely for a successful return.

However, it’s vital to remember that too many non-performing loans can cause liquidity issues and even threaten a bank’s survival if funds aren’t repaid promptly.

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