How Banks Define Ideal Loans and Problem Loans

Inevitably, despite the safeguards most banks build into their lending program, some loans on a bank’s books will become problem loans.

Usually this means the borrower has missed one or more promised payments or the collateral pledged behind a loan has declined significantly in value.

Problem loans lengthen the loan cycle and the bank misses opportunities to extend loans to many potential customers. Problem loans require close supervision and in some cases require legal actions.

The bank faces liquidity crisis because planned cash flows have not come in as scheduled and this may create doubt in the depositors mind. Hence, it is essential to identify problem loans at the earliest and take necessary actions.

According to Professor A. R. Khan: “Problem loans refer to those which the borrowers do not return as and when required in spite of repeated reminder and are not able to show any acceptable reasons for such failure.”

There are different opinions regarding whether or not a loan will be called problem loan if the borrower has proper reason for the default.

Some opine that a loan cannot be called a distressed one if the borrower has both the ability and the willingness to repay the loan and will certainly repay as soon as the reason for default is pulled out, though the borrower has missed one or more promised payments.

However, if the reason for default is not likely to be removed in the near future the loan will be called problem or distressed loan.

If the borrower has both the ability and the willingness to repay the loan it is called a good loan. Bank loans can be divided into two categories,

  1. Ideal Loan, and
  2. Problem Loan

These sections are described below;

Problem loan

The loans which cannot easily be recovered from borrowers are called Problem loans. When the loans can’t be repaid according to the terms of initial agreement or in an otherwise acceptable manner, it will be called problem loans.

In other words, problem loans refer to those which the borrowers do not return as & when required in spite of repeated reminders & are not able to show any acceptable reasons for such failure.”

Ideal Loan

As all of the bank’s loans are not considered as ideal loan; in the same way, all of the bank’s loans are not treated as problem loans. There are borrowers who have both willingness and ability to repay the loan at the time of taking the loan.

But with the passage of time both willingness and ability of repayment may be negative, which ultimately results in problem loans.

Let’s consider the following four scenarios. Loan classification may be shown through the following ways:

  • Willingness to repay + Ability to repay= Ideal loan.
  • Unwillingness to repay + Ability to repay= problem loan.
  • Willingness to repay +inability to repay =problem loan.
  • Unwillingness to repay + Inability to repay= problem loan

The following figure depicts the above-mentioned scenarios:

The willingness & ability of the borrowers to repay the loan may change over time after the loans are made to then. On the other hand, Bankers may also make mistakes in the process of lending.

Point of distinctionIdeal Loan / Good loanProblem loan / Bad loan
Nature of the loanThe loan installments are being paid regularly and in accordance with the repayment schedule as specified in the loan agreementOne or more installments have been missed and no reasonable excuse has been shown.
Nature of borrowerThe borrower has both ability and willingness to repayThe borrower has neither willingness nor ability to repay or has only ability or only willingness to repay
Loan supervisionMinimum supervision suffices. Hence, supervision cost is low.Maximum supervision is necessary. Hence, supervision cost is high.
Credit analysisResults from a very good and efficient credit analysisResults from a poorly conducted credit analysis
Relation between banker and borrowerRelationship of trust, mutual understanding, and cooperationRelationship of distrust and doubt often leading to civil case in the court
Effect on loan cycleSpeeds up the loan cycle and enables the bank to extend credit to many potential customers.Slows down the loan cycle and the bank misses out opportunities to extend credit to many potential customers.
Effect on money supplyResults in increased derivative demand deposit by way of multiple credit creation which in turn increases the money supply in the economy.Results in bad debts and shrinks the ability of the bank to lend credit and thereby decreases the money supply in the economy.
Effect on profitLow supervision cost and expanded creation of derivative demand deposit result in increased profitHigh maintenance cost coupled with bad debt losses results in decreased profit
Effect on liquidityThe bank enjoys sound liquidity as it gets the cash flows as plannedThe bank faces a dearth of liquidity as cash flows do not come as planned

Ideal Loans are all banks darling. Bankers lending policy should proper in-order to detect problem loans.