NPL Bad Loans, What Are Non-Performing Loans?

Non-performing loans represent one of the most significant challenges for the Italian banking system. To manage this situation, the Bank of Italy has classified non-performing loans into three specific subcategories: non-performing loans, unlikely to pay and past due exposures.

In our guide, we will analyze in detail what non-performing loans are, how they are classified and what impact they have on the Italian banking system. We will also examine management and recovery strategies. Here is everything you need to know.

What are non-performing loans? Definition of NPL loans

Non-Performing Loans (NPL) are a concern for financial institutions around the world. In fact, they represent credit exposures whose repayment is uncertain or does not occur according to the terms established by the original contract.

The term NPL, an acronym for "Non-Performing Loans", identifies loans that debtors are no longer able to repay regularly or at all. According to the definition of the European Central Bank (ECB), a credit is considered impaired when the debtor has been in default for more than 90 days or when there is a high probability that he will not repay the amount due.

In practice, these are bank credits (mortgages, financing, loans) for which collection is uncertain both in terms of compliance with the deadline and the amount of capital exposure.

The impact of NPLs on the real economy is particularly significant for countries like Italy, characterized by a strongly "bank based" system. Small and medium-sized enterprises, which depend mainly on bank credit, are the most affected by this situation.

The difference between performing loans and impaired loans

performing loans are those regularly repaid that do not present risks for the credit institution. In other words, they are exposures that the bank considers solvent, where the debtor is able to meet the repayment of his debt promptly and according to the pre-established methods.

Furthermore, performing loans are divided into two groups:

• performing: with low credit risk and without losses at the date of first registration;
• underperforming: with credit quality significantly worsened since the date of first registration.

It is also essential to distinguish between gross and net values of impaired loans. The former represents the amount that the debtor must repay to the bank, while the latter is an estimate of how much the bank actually expects to recover.

The impact of non-performing loans on bank balance sheets

Non-performing loans negatively impact the financial strength of banks, generating several critical effects:

• reduction of liquidity: they immobilize financial resources that could be used for other activities;
• increase in losses: banks must set aside resources to cover the risk of loss;
• worsening of reputation: a high level of NPLs can damage the image of the institution and reduce investor confidence.

Therefore, with a NPL Ratio (ratio between gross non-performing loans and total gross loans) that stood at 5.3% in 2020, the Italian banking sector recorded the lowest value since 2009, demonstrating an improvement in the management of this issue.

The three main categories of impaired loans

The European Banking Authority classifies impaired loans into three main subcategories.

• Bad loans: these are exposures to parties in a state of insolvency or in substantially comparable situations. This is the most serious category, in which the debtor is unable to honour their financial obligations. The state of insolvency does not need to be judicially ascertained.
• Unlikely to Pay (UTP): these are loans for which the bank deems complete recovery unlikely without activating measures such as the enforcement of guarantees. These exposures can still be brought back to performing thanks to targeted interventions.
• Overdrawn and/or past-due exposures: these are loans that are past due or that exceed the credit limits by more than 90 days and exceed a predefined relevance threshold.

The life cycle of a non-performing loan

The path that transforms a regular loan into a non-performing loan follows a gradual process, characterized by specific phases that banks monitor carefully. This cycle represents a fundamental aspect in the management of banking risk.

From performing loan to non-performing loan: the warning signs

The transformation of a loan from "performing" to non-performing does not happen suddenly. The first warning sign is generally represented by late payments, which are an early indicator of the deterioration process. In fact, when a customer shows difficulty in meeting the agreed deadlines, the bank intensifies the monitoring of the position.

The main warning signals therefore include:

• late payments up to 90 days;
• insignificant overdrafts on credit lines;
• worsening of the debtor’s economic and financial situation.

It should be emphasized, however, that the reporting of a bad debt position does not automatically arise from the occurrence of specific individual events, but requires an overall assessment of the customer’s financial situation.

The internal classification process of banks

When a bank identifies problematic positions, it starts an internal classification process that involves several phases.

• Positions with initial signs of anomaly.
• Impaired positions that can be managed through concessions or restructuring.
• Impaired positions to be managed from a liquidation perspective.
• Management of guarantees foreclosed as part of the recovery activity.

Banks establish internal policies for the transition of positions from one responsibility centre to another, often with the help of specific indicators. In addition, to assess the effectiveness of management, institutions develop systems of key performance indicators (KPIs) that measure the progress made in recovery activity.

Active management of problem loans

Banks are required to adopt a proactive approach in the management of non-performing loans.

This involves the preparation of short-term (about 1 year) and medium-long term (3-5 years) operational plans, in which objectives for closing positions and actions to be taken are defined.

The main management strategies of banks may include:

• forbearance measures for debtors in temporary difficulty;
• debt restructuring for structural problems;
• reliance on specialized external managers;
• sales on the secondary market.

In which banks carefully assess the debtor’s financial situation before granting any forbearance measure, to prevent such interventions from becoming expedients to delay the classification of an exposure as impaired.

In 2022, the annual flow of new impaired loans in relation to the amount of performing loans (default rate) stood at 1%, significantly down from the peak of 5.3% reached in 2014, demonstrating an improvement in the ability of Italian banks to prevent and manage impaired loans.

Original article published on Money.it Italy. Original title: Crediti deteriorati NPL, cosa sono i crediti non performing?