Non-Performing Loans

Non-performing loans often lead to banks failing to operate and perform their functions. They have an adverse effect on the bank’s balance sheet, and they may even damage the bank’s ability to return deposits back to its clients, thus disrupting all its operations. Non-performing loans were the primary causes for the major crises in 21^st century, including the Big Recession and subsequent Greek crisis as well as stagnation in Italy. The number of non-performing loans in a bank is one of the most important indicators of its performance; nevertheless, such loans pose threats but, at the same time, give promises for the stability and swiftness of the functioning of the banking industry.

A non-performing loan (NPL) is a loan, for which payment has not been received within the specified period. Such a delay in payment is a direct violation of the loan agreement, in which the consequences are generally indicated as fines and penalties. A non-performing credit is the amount of money, for which the debtor has not paid the planned payments for at least 90 days. This loan can have a status of being in default or close to it. As soon as the loan becomes non-performing, the probability that it will be repaid in full is considered significantly low (European Central Bank, 2016b). Non-performing loans are reflected in one’s credit history, which adversely affects the issuance of the subsequent ones. Creditors prefer to perform transactions with responsible borrowers since they want to avoid risks. After all, the higher the credit risk is, the worse the credit conditions are that also include a higher interest rate, followed by credit limits on the amount of funds or duration of the loan (European Central Bank, 2016a). Banks and many private lenders use finance from the deposits of individuals and legal entities as finance for lending. Thus, they are debtors and creditors simultaneously. Therefore, a high number of non-performing loans can cause a situation where the lenders cannot fulfill their own obligations (International Monetary Fund, 2015). In such a way, non-performing loans cause severe disruptions in the working process of the banking industry.

Non-performing loans are often transferred or sold to other banks, creditors, or special debt collection agencies. Their cost depends on the time of delay, the solvency rating of the debtor, and other factors. After a certain period of time, which is normally 90 days, the case of such a loan can be sent to a court (International Monetary Fund, 2015). The lender attempts to reduce the difference between the debt and the price, for which the debt has been sold, or the amount of the refund, with all fees extracted. Furthermore, collector agencies try to make a profit by returning the payment from the borrower in full or in the amount as close to the maximum as possible. A performing loan provides the bank with the income from interest rates, required to have profit and the ability to provide new loans. When customers do not fulfill their agreed repayment procedures within 90 days or more, the bank should allocate more capital, assuming that the loan will not be returned. Thus, banks may lower their losses from non-performing loans, but the latter still reduce banks’ ability to provide new ones.

Non-performing loans put the banking industry under several threats. Firstly, the bank, which has too many non-performing loans on its balance sheet, faces the problem of reduced profitability due to it no longer being able to earn enough revenue from issued credits. In addition, the institution will have to reserve some money as a safety net in the case it needs to write off the entire loan in time (European Central Bank, 2016a). When loans become non-performing, they damage the liquidity of banks and negatively affect their incomes. To be successful in the long term, banks need to keep the level of non-performing loans at a minimum so that they could still profit from the provision of new loans to customers (Muasya, 2009). Therefore, the first threat of non-performing loans to the banking industry is banks’ reduced profitability and stability.

Secondly, a bank, which has a high ratio of non-performing loans, cannot provide credits for other companies that need investments to function and create new jobs. If this happens to many banks on a large scale, this will affect the economy as a whole and, consequently, all individual members of society. Reducing investment in the companies that could potentially become big and successful enterprises leads to a smaller number of newly created jobs, which, in its turn, results in a negligible or decreasing pace of the economy growth. The banking system is affected directly by any fluctuation in economic situation (Friedman, 2016). Therefore, banks should try to avoid excessively risky loans from the very beginning, correctly assessing the creditworthiness of their borrowers. At the same time, the bank should have a relevant monitoring system to establish as soon as possible debtor’s financial difficulties, which will allow the bank to resolve the situation. In some cases, simply consulting a client about their finances may be sufficient to prevent a loan from becoming non-performing one. Therefore, the second threat that NPLs pose is that the banking industry as a whole fails to provide an investment in the fields where it is necessary.

On the other hand, NPLs offer several promises for the development of the banking industry. Firstly, calculating the overall level of reserves in terms of non-performing loans shows how well a bank can handle credit risk and what can be done to change that. A due analysis of the non-performing loan portfolio can indicate the trends in macroeconomic situation and show how the banking system can be improved in order to prevent acquiring more non-performing loans in the future. All data on NPLs should be specifically analyzed in order to determine whether the situation is reversible, what exactly can be done to increase the likelihood of a loan repayment, and whether plans to collect funds have been fulfilled (International Monetary Fund, 2015). The reserve level ought to be analyzed as well since is it sufficient for the bank to cope with outstanding loans. It should be clearly defined how the deterioration of the quality of assets affects the profit and loss of the bank. In such a way, the system automatically detects banks that cannot sustain themselves and ensures that such banks do not lend more money to the entities or individuals who have a high chance of not returning such loans (World Bank, 2017). Thus, non-performing loans serve as indicators that show whether a bank operates normally and if it can sustain its own expenditures.

Secondly, non-performing loans offer a chance to evaluate and develop banks’ criteria of selecting clients. Thus, banks obtain more information on the clients who fail to return their loan. Consequently, they find new methods of checking their debtors’ reliability. Each loan, whether successful or not, contributes to this system and ensures it self-development. The possibility of a loan becoming non-performing forces banks to refrain from risky operations. This factor is supposed to prevent the creation of bubbles at certain markets, as the large amount of risky debts not supported by any feasible profit promises can cause market disruptions or assets compiling in a field where they do not result in any growth (World Bank, 2017). Therefore, non-performing loans give the banking industry more information to develop new methods and selection criteria for further operations.

Thirdly, non-performing loans also sustain the banking system since they decrease the potential levels of inflation rate and limit the influence of commercial banks on the national banking system. When a bank gives a credit to a customer, this creates wealth in the system that later has to be returned to the bank in order to maintain balance. If all credits were returned to banks, the latter would be able to give safely as many credits as possible, which would result in money losing its original value and the economy uncontrollably spinning upwards, without any feasible support of such processes. The banking system is based on the principle of its own fallibility, which is ironically the only thing that keeps its parts together. NPLs also tend to be a certain buffer during economic cycles. The number of unemployed citizens and that of non-performing loans correlate directly. When the economy starts stagnating, more people find themselves in the position when they cannot return their loans. However, the fact that they had that money, which they had never returned to banks, distributes wealth in society during a crisis in a different manner. Therefore, in some way, non-performing loans are necessary to sustain the banking system.

To conclude, the banking industry has abused its ability to influence economy and put it under great risks that have resulted in major crises. The latter showed that the banking industry had to be held accountable for its actions. Each particular bank does not benefit from non-performing loans at all, which forces it to choose carefully its investment portfolio of companies, legal entities, and individuals. Non-performing loans pose a threat since the banking industry might fail to provide investments in the fields where they are needed. Yet, at the same time, the possibility of non-performing loans is a reminder to banks and other lending institutions that they should avoid risky operations and strengthen the system.