The implications of NPLs on bank balance sheets

The problems NPLs create for the banking sector are evident in the period since the start of the GFC in 2007, with the persistence of NPLs being a reason for the delay in the recovery from the crisis.[1] Rottke and Gentgen noted that ‘while non-performing loans are a phenomenon that is permanently present in the balance sheets of banks and other lending institutions, the significant rise of non-performing loans in banks’ balance sheets and the emergence of a non-performing loan market are a temporary phenomenon’. Generally, a loan is considered non-performing when customer’s payments are past due: this can be interpreted as an early warning signal of banking crisis. Indeed, the classification of loans represents a key indicator of the bank’s credit quality.

The fundamental problem is that the balance sheet counterpart of NPLs on the assets side may have a negative impact to bank capital, particularly for claims: one key ratio to track is the proportion of LLPs to NPLs (coverage ratio) constructed and commonly used by credit rating agencies. The aim should be to have a level of provisioning commensurate with the initial expectations of the rate of recovery on loans (and therefore the pricing of

The regulation of non-performing loans 313 credit).[2] If this is not so, then the scale of losses may be so large that they cannot be covered by income, bringing a bank’s capital below (or close to) the minimum required. At that point, banks might have to recapitalise when the system may be facing a distressed scenario where it is difficult for a bank to raise capital as profitability is deteriorating and general economic conditions are weak. This can have macroeconomic consequences, as the burden of debt felt by some results in their decreasing spending, with reduced income down the line for others, including even those not indebted. Demertzis and Lehmann argued that ‘efforts to reduce and remove NPLs from the balance sheets of creditors must simultaneously remove excess debt from the balance sheets of debtors’. However, adequate provisioning for NPLs requires overcoming complex strategic incentives that banks have to either seek to keep LLPs low, or to avoid writing NPLs off from their balance sheets.

The timing of losses taken as a result of provisions or write offs, and the level of LLPs set aside for future NPLs on the balance sheet, are often part of a bank’s strategy to smooth reported earnings and reported capitalisation. Specifically, the Basel Common Equity Tier 1 (CETI) and Tier 1 capital adequacy ratio numerators include common stock and retained earnings. Higher level of LLPs can be accounted as losses and can reduce retained earnings: this may affect the CETI and Tier 1 capital ratios with negative consequence for maintaining an adequate standard of LLPs. These factors are complicated by a Basel III CETI capital requirement of 7% (comprising the minimum CETI requirement of4.5% plus a mandatory capital conservation buffer of 2.5%) of risk-weighted assets. In this context, LLPs have the effect of reducing CETI and therefore the numerator of those ratios.

Since write offs mean that some loans and the provisions against them disappear from the balance sheet - and as some loans tend to have higher provisions raised against them as a proportion of the gross amount of the loan - it follows that a bank that elected to write off relatively more of its highly provisioned problem loans would show lower provisions as a percentage of overall loans. Full information about write offs, and further data on when a bank deems that such write offs take place are critical for users of financial statements to compare overall provision numbers from bank to bank. On this view, Jassaud and Kang pointed out that banks have delayed writing off highly provisioned loans as this would lower their overall provisioning ratio and possibly their credit rating. It is noted that the International Accounting Standards (IAS 39) were not explicit on exactly when and how to

write off uncollectible loans. In this case, and in all situations, the more LLPs and related accounting policy decisions such as write offs are left to management discretion, the more difficult it becomes to compare meaningfully cross-firm and cross-border NPL and LLP figures.[3]

  • [1] Mwanza Nkusu, ‘Nonperforming Loans and Macrofinancial Vulnerabilities in Advanced Economies’ (2011) IMF Working Papers No. 161, 20-21. 2 Nico B. Rottke and Julia Gentgen, ‘Workout Management of Non-performing Loans: A Formal Model Based on Transaction Cost Economics’ (2008) 26 Journal of Property Investment & Finance 59-60. 3 Karlo Kauko, ‘External Deficits and Non-performing Loans in the Recent Financial Crisis’ (2012) 115 Economics Letters 196. 4 Anne Beatty and Liao Scott, ‘Do Delays in Expected Loss Recognition Affect Banks’ Willingness to Lend?’ (2011) 52(1) Journal of Accounting and Economics 19-20.
  • [2] It can be observed that for collateralised lending, provisions under US GAAP and IFRS are net of the recoveries on liquidating collateral: when the provisions are compared to the gross amount of the non-performing loan, they can be adequate even if less than 100% if there is adequate collateral. 2 Perry Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last Resort (Princeton University Press 2010) 7. 3 Maria Demertzis and Alex Lehmann, ‘Tackling Europe’s Crisis Legacy: A Comprehensive Strategy for Bad Loans and Debt Restructuring’ (2017) Bruegel Policy Contribution, No. 2017/11, 1, available at chttps:// 10419/173107/1/PC-l l-2017.pdf>. 4 Paul J. Beck and Ganapathi S. Narayanamoorthy, ‘Did the SEC Impact Banks’ Loan Loss Reserve Policies and Their Informativeness?’ (2013) 56(2) Journal of Accounting and Economics 64-65; see also Iftekhar Hasan and Larry D. Wall, ‘Determinants of the Loan Loss Allowance: Some Cross-Country Comparisons’ (2004) 39 Financial Review 129, 151-152. 5 Jose Gabilondo, Bank Funding, Liquidity, and Capital Adequacy. A Law and Finance Approach (Edward Elgar 2016) 102-103. 6 The precise effect or size of the reduction is indicated by the interaction of the accounting rules on provisioning with the capital framework. 7 Nadège Jassaud and Kenneth H. Kang, ‘A Strategy for Developing a Market for Nonperforming Loans in Italy’ (2015) IMF Working Paper No. 15-24, 16.
  • [3] Provisions are no longer based on an ‘incurred loss’ (IAS 39) concept (i.e. taken against loans where an objective ‘loss event’ has occurred) but are based on forward-looking rules (IFRS 9) that involve an assessment whether ‘significant deterioration’ has occurred. 2 The definition of capital was first harmonised under the Basel I Accord of 1988 through a soft law instrument. See Basel Committee on Banking Supervision, ‘Report on International Convergence of Capital Measurement and Capital Standards’ (July 1988), available at . 3 United Nations System of National Accounts 2008, available at . However, the UN statistical definition of a non-performing loan leaves scope for firm discretion since the meaning of certain terms such as ‘objective evidence of impairment’ is not precisely defined. 4 Basel Committee on Banking Supervision, ‘Sound Practices for Loan Accounting and Disclosure’ Basel Committee on Banking Supervision Paper (July 1999) 35, para 91. 5 Basel Committee on Banking Supervision, ‘International Convergence of Capital Measurement and Capital Standards’ Revised Framework (2004). 6 Basel Committee on Banking Supervision, ‘Sound Credit Risk Assessment and Valuation for Loans’ (June 2006), available at . In a further Consultative Document issued in December 2014 on revisions to the standardised approach for credit risk, the BCBS suggested a definition of non-performing, whose threshold includes (among other criteria) 90 days past due for loans, and 30 days past due for securities. The purpose of these criteria is to calculate a ‘non-performing asset’ (NPA) ratio when assessing exposures to other banks. At the time of issue, the proposals in this consultation were described by the BCBS as ‘at an early stage of development’.
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