IV. «Problem loans», «Bad
loans» and «Non-performing loans»: definitions and
recommended practices
There is no harmonization of asset classification rules at an
international level. The definition
of problem loans or asset impairment varies across countries
(Lis, Pagés and Saurina, 2000). The differences among countries increase
when examining loan loss provisioning rules and practices (for illustration
see appendix 1: Loan loss provisioning in selected emerging markets).
«Problem loans» is used synonymously with «Non-Performing
Loans», «Problem Loans» or «Bad Loans».
Fuchita (2004) distinguished «Bad Loans» from «Bad
Loans Problems». While arguing that
the narrowest definition of «Bad Loans» might be
«a loan which fails to meet certain obligations to pay interest
and/or principal», he said it is bad loan problems we have to focus
on instead of bad loans per se. This meets our view since we are
working on «Problem Loans
Management Practices» and feel no need to emphasize on
«Problem Loans» definitions.
In this part we will present the practices recommended by
institutions like the World Bank,
the International Monetary Fund, the West African Monetary Union
and the Bank of Ghana for a successful dealing with problem loans.
The next section presents standard practices
recommended by the World Bank, the International Monetary Fund, the
West African Monetary Union and the Bank of Ghana for acceptable management of
problem loans.
1. World Bank
According to the World Bank12, the five basics that a
bank must have in order to successfully
deal with problem loans are:
1- A validated and properly functioning system of
credit quality control and asset classification
2- The needed reserves to write off all portions of the
identified losses
3- The removal of these assets from the line organization which
underwrote them and their transfer to a specially trained group of
collectors
4- The usage of a well-functioning legal system to help force
collection
5- The stoppage of making, or renewing, bad loans
12 Richard H. Daniel, «An Alternative
to Government Management Companies: The Mellon Approach»,
World Bank
Conference on Corporate Restructuring: International Best
Practices, March 22-24, 2004.
22 MBA in Banking and Finance
The recommended loan classification and provisions requirements
of the World Bank are as follows:
|
Classification
|
Loan Classification System
|
Provision
Requirement
|
|
Standard, or pass
|
When debt service capacity is considered beyond any doubt.
In general, loans and other assets fully secured (including
principal and interest) by cash or cash-substitutes (e-g banks
certificates of deposit or treasury bills and notes) are usually
classified as
standard, regardless of arrears or other adverse credit
factors.
|
General loss reserve, if disclosed
1 - 2%
|
|
Specially mentioned, or watch
|
Assets with potential weaknesses that may, if not checked
and
corrected weaken the asset as a whole or potentially
jeopardize a borrower's repayment capacity in the future. This, for
example, includes credit given through an inadequate loan agreement, a lack of
control over collateral, or without proper documentation. Loans
to borrowers operating under economic and market conditions
that negatively affect the borrower in the future should receive this
classification. This applies also to borrowers with an adverse trend
in their operations or an unbalanced position in the balance
sheet,
but which have not reached a point where
repayment is jeopardized.
|
Specific provision
5 - 10%
|
|
Substandard
|
This classification indicates well-defined credit weaknesses
that
jeopardize the debt service capacity, in particular when the
primary sources of repayment are inadequate and when the bank must
consider other sources of repayment such as collateral, the sale of a
fixed asset, refinancing, or fresh capital.
Substandard assets
typically take the form of term credits to borrowers
whose cash flow may be not sufficient to meet currently maturing
debts or loans, advances to borrowers that are significantly undercapitalized.
They may also include short-term loans and advances to borrowers for which
the inventory-to-cash cycle is insufficient to repay the debt at
maturity. NPAs13 that are at least 90 days overdue are
normally classified as substandard, as are renegotiated loans and
advances for which delinquent interest has been paid by the borrower
from his own funds prior to renegotiations and until sustained
performance under a realistic repayment program has been achieved.
|
Specific provision
10 - 30%
|
|
Doubtful
|
Such assets have the same weaknesses as the substandard
assets,
but their collection in full is questionable on the basis of
existing facts. The possibility of loss is present, but certain event that may
strengthen the asset defer its classification as loss until a more exact status
may be determined. NPAs that are at least 180 days past overdue are
also classified as doubtful unless they are sufficiently secured
|
Specific provision
50 - 75%
|
|
Loss
|
Certain assets are considered uncollectible and of such little
value
that the continued definition as bankable assets is
not warranted. This classification does not mean that an asset has
absolutely no recovery or salvage value, but rather that it is neither
practical nor desirable to defer the process of writing it off, even though
partial recovery may be possible in the future. NPAs that are at least one year
past overdue are also classified as losses, unless such assets are
very well secured.
|
Specific provision
100%
|
Loans classified as `pass' and `watch' are reviewed twice
per year and loans classified as
`substandard', `doubtful' and `loss' are reviewed at least each
quarter.
13 Non-Performing Assets.
23 MBA in Banking and Finance
2. International Monetary Fund (IMF)
For the IMF, the existence of both financial and non-financial
early warning systems plays an important role in problem loans management since
they may prevent the bank from losses if actions are taken in time to
develop a remedial strategy. In addition, loan documents must contain
clauses that allow the bank to examine the books of the borrower.
There are two essential work-out strategies recommended depending on the
assessment of the problem:
- If the problem area can be corrected, banks are
encouraged to restructure the loan by increasing collateral, revising
repayment and/or changing management.
- If the problem area cannot be corrected, banks must exit the
business by selling collateral and taking legal action.
The loan classification of the IMF is quite similar to
the World Bank's one but with the following classes:
- Sound
- Weak
- Substandard
- Doubtful
- Loss
| 
