What are non-performing loans (NPLs)?

12 September 2016 (updated 14 January 2021)

Non-performing loans

One of the priorities of the ECB’s supervisory work is to prevent and address non-performing loans within the European banking system. What are these loans, and why are they bad?

Let’s first look at what the banking business is. One of a bank’s core tasks is to provide loans that allow companies to invest and create jobs, and individuals to buy things like cars or houses. The bank then earns money from the interest it receives on these loans.

When the borrower remains financially healthy and pays the agreed instalments and interest as scheduled, the loan is said to be performing. But there is always the risk that the company or individual will not be able to repay within the agreed timespan. If this happens or looks likely to happen, the bank must classify the loan as “non-performing”. Non-performing loans are often called “bad loans”.

When does a loan become non-performing?

A loan becomes non-performing when there are indications that the borrower is unlikely to repay the loan, or if more than 90 days have passed without the borrower paying the agreed instalments. This may happen when an individual loses their job and therefore cannot repay their mortgage as agreed, or when a company experiences financial difficulties.

Banks need to look closely at the loans they have granted and identify at an early stage those loans that are at risk of becoming non-performing. This is called “recognition of non-performing loans”.

Why are non-performing loans bad?

Non-performing loans are a fact of life for banks, as people losing their jobs and companies running into financial trouble are, unfortunately, regular events. But they always entail costs for the bank, so banks need to keep the level of bad loans at a minimum.

Non-performing loans weigh on banks in two ways. They weaken banks’ profitability because they generate losses which reduce the amount of money banks earn from their credit business. To prepare for these losses, banks also need to book provisions. This means they have to put aside money to cover the losses they expect to incur. The money is then no longer available to provide new loans or to absorb other losses. This further reduces banks’ earnings and weakens their condition.

A bank with too many non-performing loans cannot properly provide companies with the credit they need to invest and create jobs. If this happens to many banks on a larger scale, it can affect the economy as a whole.

How can a bank avoid accumulating non-performing loans?

First and foremost, banks should avoid extending overly risky loans from the outset. They should follow sound lending criteria and properly assess the creditworthiness of borrowers to ensure that loans are only granted to customers who are likely to repay them.

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. Then the bank still has tools available to remedy the situation. In some cases, simply advising the client about his or her finances can be enough to prevent the loan from becoming non-performing.

Banks should also book sufficient provisions early enough.

Will the coronavirus crisis lead to more non-performing loans?

The coronavirus crisis has been an unprecedented shock to the economy, and many companies struggle to keep operating. Not all of these companies will survive the crisis, and not all households will be able to repay the loans they have taken out before or during the pandemic. This means that an increase in non-performing loans is unavoidable as not all loans will be paid back in full.

To minimise this increase, the ECB has repeatedly stressed that, even in difficult times, banks should only lend to customers who are likely to pay back. It has also reminded banks to keep a close eye on the risks to identify and tackle non-performing loans early on.

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What can a bank do to reduce its stock of non-performing loans?

Besides booking sufficient provisions, banks should actively try to resolve non-performing loans.

One possibility is to renegotiate the terms of the loan, for instance by giving the borrower more time to repay. This could enable an individual or a business with temporary problems to survive financially and, ultimately, to 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 some of their money.

In some cases banks can also shift their non-performing loans to a “bad bank”. Bad banks are asset management companies, typically set up by the government, for the specific purpose of dealing with non-performing loans. They allow banks to purge their balance sheets of non-performing loans and restore their lending capacity more swiftly. The bad bank then takes care of recovering the money lent, selling loans to investors, or other actions.

What can the supervisor do?

Supervisors have a keen interest in addressing non-performing loans because they weaken banks and present a risk to their soundness. The ECB has made this issue one of the focus areas of its supervisory work and has provided banks with extensive guidance on non-performing loans and its expectations.