What are bad loans and why they are bad for the economy


One of the main tasks of a bank is to provide loans that allow companies to invest and create jobs. Credits also allow individuals to purchase, for example, a car, a home or a new TV. The bank may earn interest from the interest it charges for these credits.

However, credit is not risk-free as the bank can never be sure that the company or individual will reimburse the funds within the agreed time frame. If the borrower terminates the loan repayment or the interest payment, the bank must classify the credit after a certain period in the “non-performing loans” category.

A performing credit will provide the bank with the interest income it needs to earn profits and lend new loans, which is not generally the case for a bad credit.

When does a credit fail?

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Generally speaking, European supervisors consider that a credit is not performing when more than 90 days have passed without the borrower having paid the agreed rates.

This is often the case when the borrower faces unforeseen financial difficulties, for example when a person loses his job and therefore can not repay a mortgage under the agreed conditions or when a company has financial problems.

In the worst case scenario, the borrower is totally unable to repay the loan and the bank has to adjust the amount of credit on its balance sheet – sometimes even to zero. This operation is often referred to as “removing from the bookkeeping” of a credit.

Why are unfavorable bad loans for banks and how does this affect society as a whole?

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Bad credit is a daily reality for banks, like people who lose their jobs or companies that face financial problems. In order to be prosperous in the long term, a bank must maintain low-performing loans to a minimum to continue earning money from lending.

If the value of non-performing loans exceeds a certain level, the bank’s profitability is impaired, as the earnings from lending activity are lower. Banks need to save money, or make a provision as a safety measure for situations where they need to reduce or cancel the amount of credit at a given time.

Both the decrease in revenue and the saving of funds for the worst case scenario result in a reduction in the available funds for new loans, which further reduces the bank’s profits.

A bank with an excessive amount of bad loans can not properly provide companies with the loans they need to invest and create jobs. A situation where a large number of banks are confronted with this problem on a large scale affects the economy as a whole and, implicitly, the members of society. Reducing corporate investment and lowering new jobs leads to a decline in economic growth.

How can a bank avoid the accumulation of too much volume of non-performing loans?

 

Banks should try to avoid from the outset granting excessively risky loans by properly assessing the creditworthiness of borrowers. It is also important to introduce a proper monitoring system to enable the bank to detect at an early stage when the borrower faces financial difficulties and can solve this problem.

In some cases, simply advising the client on his / her financial situation may be sufficient to avoid credit becoming poor.

What measures can a bank adopt?

 

Banks have a number of options available to reduce the level of non-performing loans in their accounting records. One possibility is the renegotiation with the borrowers of the terms of the credit agreements. This could mean, for example, giving a longer time to borrowers to repay the loan (if possible).

Such a measure could allow a person who has lost his job or a company facing temporary financial problems to survive financially and ultimately to repay the loan.

A bank may also decide to sell non-performing loans to investors, which usually require an update of their value. The bank will record a loss from such a transaction, but removing it completely from the accounting records would generally lead to even greater losses.

If none of the attempts to find a solution are successful, for example because the debtor is insolvent, banks can resort to legal ways to try to recover at least some of the funds.

What measures can the supervisory authority adopt?

 

Addressing the problem of bad loans in the European banking system is one of the key priorities of the ECB’s oversight activity.

Supervisory authorities monitor the overall level of non-performing loans among euro area banks. They also check whether individual banks are adequately managing the degree of credit risk they give and have introduced appropriate strategies, governance structures and processes. These checks are part of the joint supervisory and evaluation process (PES), which is carried out annually for each bank. At the same time, the ECB regularly conducts coordinated assessments of the asset quality of banks that it supervises directly.

High levels of non-performing loans require increased attention from supervisors. Currently, a specialized task force of the ECB’s banking oversight function assesses the situation of banks with high levels of non-performing loans. The purpose of the exercise is to work on a common approach, which can be applied consistently at the level of countries to solve this problem.

 

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