12 September 2016 (updated 15 March 2018)
One of a bank’s core tasks is to provide loans that allow companies to invest and create jobs. Loans also allow individuals to buy, for example, a car, a house or a new TV. The bank then earns money from the interest it receives on these loans.
Giving out loans is not free from risk, however, as the bank can never be sure that the company or individual will repay the money within the agreed timespan. If the borrower stops paying back the loan or the interest, after a specific amount of time the bank must classify the loan as a “bad debt” or “non-performing”.
A performing loan will provide the bank with the interest income it needs to make a profit and extend new loans, while a non-performing loan, generally speaking, will not.
European supervisors generally consider a loan to be non-performing when there are indications that the borrower is unlikely to repay the loan owing to financial difficulties or if more than 90 days have passed without the borrower paying the agreed instalments. This can happen for example when an individual loses their job and therefore cannot repay their mortgage as agreed, or when a company experiences financial difficulties.
In the worst case scenario, the borrower is completely unable to repay the loan and the bank needs to correct the value of the loan on its balance sheet – sometimes even to zero. This is often referred to as “writing off” a loan.
Non-performing loans are a fact of life for banks, as people losing their jobs and companies running into financial trouble are common occurrences. To be successful in the long run, a bank needs to keep the level of bad loans at a minimum so that it can still earn a profit from giving out loans.
Once the value of non-performing loans exceeds a certain level, the bank’s profitability suffers because it earns less money from its credit business. Banks need to put money aside, i.e. make a provision, as a safety net in case they need to write down or write off the loan at some point in time.
Both the drop in income and the money set aside for the worst-case scenario result in the bank having less money available to provide new loans, further reducing its profits.
A bank with too much bad debt cannot properly provide companies with the credit they need to invest and create jobs. If this happens to many banks on a large scale, it affects the economy as a whole and therefore individual members of society. Reduced investment by companies and a lower number of newly created jobs lead to less growth.
Banks should try to avoid extending overly risky loans from the outset by properly assessing the creditworthiness of borrowers. It is also important to have a proper monitoring system in place so that the bank detects at an early stage when a borrower is facing financial difficulties and can address this.
In some cases, simply advising the client regarding his or her finances can be enough to prevent the loan from becoming non-performing.
A bank has a range of options to reduce the level of bad loans on its books. One possibility is renegotiating the terms of its loan contracts with borrowers. This could mean, for example, giving borrowers more time to repay.
This could enable someone who has lost their job or a business with temporary financial problems to survive financially and, ultimately, pay back the loan.
A bank can also decide to sell its bad loans to investors, who will typically ask for a discount on the value. The bank might make a loss in such a transaction, but a complete write-off would typically produce an even greater loss.
If none of the attempts to find a solution are successful, e.g. because the borrower is insolvent, banks can follow a legal route to try to recover at least part of their money.
Addressing non-performing loans within the European banking system is one of the key priorities of the ECB’s supervisory work. Find here more information on what the ECB has done on this front.