In the EU, the management of non-performing loans has become a politically sensitive issue following the 2008 global financial crisis, which culminated in a 2017 Council decision to task the European Commission with launching an action plan to address the lack of loans. Loans are not granted. The Action Plan supports facilitating the creation of a secondary market for questionable loans and asset management companies. In December 2020, the Action Plan following the COVID-19 pandemic crisis was revised.
1. What is a delinquent loan?
A non-performing loan (NPL) is a loan in which the borrower defaults on the loan and fails to make monthly interest payments within a specified period of time. Bad debt occurs when borrowers do not have the money to make their payments or are in a situation that prevents them from continuing to make their loan payments. Banks typically classify a loan as delinquent when principal and interest repayments take more than 90 days or in accordance with the terms of the loan agreement. Once a loan is classified as delinquent, it means that the likelihood of receiving repayments is greatly reduced. However, borrowers can start paying back loans that have been classified as bad credit. In this case, the delinquent loan will be converted into a normal loan.
Types of delinquent loans
According to the International Monetary Fund (IMF), a payday loan can become delinquent in the following ways:
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- Principal and interest payments on the loan are due in at least 90 days and the lender no longer believes that the borrowers will meet their obligations. In this case, the loan is written off as a bad debt on the lender’s books;
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- ninety days of interest payments are capitalized, rolled over, or deferred due to changes in the loan agreement;
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- principal and interest payments are less than 90 days past due and there is reason to doubt that the borrower will not pay the outstanding loan in full.
2. How banks treat bad loans
Generally, bad debts are considered bad debts because the chances of recovering bad debt payments are slim. However, increasing bad debts on a company’s balance sheet can affect the bank’s cash flow and its share price. Therefore, banks with non-performing loans on their books can take steps to forcibly recover loans owed to them.
One of the steps a lender can take is to acquire assets that will be used as collateral for the loan. For example, if a borrower offers a motor vehicle as collateral for a loan, the borrower will take possession of the motor vehicle and sell it to recover money owed by the borrower.
Banks can also foreclose when a borrower defaults on a mortgage and payments are more than 90 days late. Lenders also have the option of selling bad debts to collection agencies and outside investors to remove risky assets from their balance sheets. Banks sell bad debts at deep discounts, while collection agencies try to collect as much money owed as possible. Alternatively, a lender may hire a collection agency to forcibly collect a delinquent loan in exchange for a percentage of the amount collected.
Impact of bad loans on banks
When a lender records the majority of outstanding loans as delinquent, it affects the lender’s financial performance. Banks make most of their income from the interest they charge on loans, and when they can’t collect interest on bad debts when they come due, it means they have less money available to create new loans and cover operating costs.
Having a lot of bad debt is a big risk for a company compared to the company’s total assets. When the percentage of non-performing loans increases, the price of the lender’s stock also decreases.
Thus, a non-performing loan (also known as a nonperforming loan) is a type of bank loan for which the borrower may delay payment or have a low probability of repaying it in full. Non-performing loans are a major challenge for the banking industry because they reduce bank profitability and are seen as preventing banks from lending more to businesses and consumers (which, by the way, slows down economic growth).