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 a liquidity crisis because planned cash flows have not come in as scheduled and this may create doubt in the depositor’s mind.
Hence, it is essential to identify problem loans at the earliest and take necessary actions.
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 a 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,
- Ideal Loan, and
- Problem Loan
These sections are described below;
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 the initial agreement or in an otherwise acceptable manner, it will be called problem loans.
Identifying Problem Loans Early
Detecting Problem Loans is for loan officers and other credit professionals who need to understand the ways to minimize problem loans and to deal with them once they surface.
The course is appropriate for junior to mid-level commercial lenders, credit review and credit policy officers, and junior workout officers.
Importance of identifying problem loans early;
- Maintaining Profitability of Bank.
- Providing Client Support.
- Saving Lending Institution Image.
Maintaining Profitability of Bank
Problem loans must be identified early because they can affect profitability.
Repayments with interest are the primary income source of lending institutions. If repayments are not made regularly, the ability to make a profit is severely affected.
Providing Client Support
If the bank can identify a problem loan early, it will be able to take steps to support a client to pay.
For instance, the banker may call them and offer them the option of paying part of the repayment immediately and part later.
Saving Lending Institution Image
If the bank is slow to identify and follow’ up on late repayments, it sends a specific message to borrowers.
The bank sends the message that it is ‘soft’, that it will not take immediate action, and that late payment or non-payment is a viable option for them.
To work towards zero delinquency, the bank must avoid this image at all costs”.
Indications of Problem Loans
If the loan can be identified earlier as problem loans before it actually happens, regulating monitoring along with some other measures can prevent the loans from being problems loans.
For identifying the “potential” problem loans, we have to know the symptoms of a problem loan.
The symptoms of problem loans can be classified in the following way:
- Preparation of irregular and delayed financial statements.
- Refusal of a large insurance claim.
- Creating hindrances to the main source of income
- Diminishing deposit balance.
- Inability to pay the debt of creditors other than the bank.
- Non-repayment of the loan installments as repayment dates.
- Entering into big loan contracts frequently with institutions and persons other than the existing bank.
- The continuous decline in the market price of the shares of the borrowing company.
- Sudden rise or fall of large size deposit withdrawals.
- Excessive cash dividend payouts from reserve fund or even from the capital.
- Al the end of the cycle, creditors are not completely paid out.
- Concentration changes from a well-known major customer to one of lesser stature.
- Loans are made to or from officers and affiliates.
- Unable to clean up bank debt, or cleanups are affected by rotating bank debt.
- Investment in fixed assets has become excessive.
- Sudden death or accident of chief executive of the business
- Avoiding communication with the lending bank.
- The borrowing organization is not operating smoothly due to some conflicts between the executives and the board members.
- Bitter relationship between borrower and lending bank.
- The occurrence of theft, fraud, robbery and/or hijacking in the organization of the borrowers.
- Conflicts among the heirs of the owners of the borrowing organization.
- Pretending in the manner that payable are paid.
- Financial reporting is frequently “down-tiered” due to changes in financial management.
- Delayed responses to financial transaction.
- Suppliers cut back terms or request cash on Delivery (COD).
- Distribution or production methods become obsolete.
- The company has grown dependent on trouble customers or industries.
- The board of directors is no longer active in making crucial business decisions.
- Lack of depth in managerial decision making.
- Financial control mechanisms are weak.
Qualitative indicators as well as quantitative indicators provide valuable information to the bank about the problem or make repeated requests for increasing or deferring the installment date.
After getting this preliminary indication, banks may seek information regarding the above -mentioned qualitative and quantitative factor. Then, the bank can be certain about the problem loan.
How Banks Deal with Problem Loans
Problem loans cause delinquency and loss to the lending institution. Having identified which loans are problematic, the banker needs to do the following:
- Create Policies and Procedures for Dealing with Problem Loan.
- Distinguish Between Can Pay versus Won’t Pay.
- Develop a Relationship with the Client Up-Front.
- Prompt and effective follow-up.
- Periodic stress testing of loans.
Create Policies and Procedures for Dealing with Problem Loan
A policy is a set of decisions about how your company operates. Policies are written guidelines that help operations.
Procedures are written instructions that tell staff how to implement policies. Each lender must have its policy for identifying problem loans and dealing with problem loans.
These instructions are the procedures that will tell staff what to do to identify problem loans early. Sound policies and procedures protect lenders from loss.
Distinguish Between Can Pay versus Won’t Pay
To is important to distinguish between borrowers who won’t pay and those who can’t pay. If borrowers can’t pay, bankers are wasting time and resources sending letters. If borrowers won’t pay offering soft options is wastage of time, when in fact a more assertive approach would be more effective.
For borrowers who can’t pay consider the following:
- Find out whether they have relatives or children who can pay.
- Be assertive in finding a source of repayment.
- Be firm and unshakable – borrowers must feel it is not worth missing a repayment.
For borrowers who won’t pay consider the following:
- Put in place procedures that protect you from these types of borrowers from the beginning of the loan process.
- Get a list of assets up front so you have some collateral to fall back on if the borrower doesn’t pay.
- Avoid lending to won’t-payers’ if at all possible.
- Do not get trapped in a cycle of sending letters with no intention of following up.
- Take legal action earlier rather than later.
- Make quick use of garnishee orders and emolument attachment orders.
- Emolument Attachment Order: An emolument attachment order is a court order obtained by the lender / any creditor, which instructs an employer to make deductions from the borrower’s salary on a monthly basis until the debt has been settled.
- Garnishee Order: A garnishee order allows the lender to attach money from the debtor’s bank account.
Develop a Relationship with the Client Up-Front
It is worth taking the time at the beginning of the loan process to establish a good relationship with the borrower. This sets the tone for future relations. Lenders need to establish from the beginning that no late.
Prompt and effective follow-up
As soon as repayment is past due, some action needs to be taken. That action needs to be effective in securing the repayment. Procedures should not be devised that waste resources without securing payment.
For example, sending a letter to a rural client, who cannot read, is not an effective procedure. It would be more effective to identify someone who lives nearby to visit the non-payer and secure payment.
Periodic stress testing of loans
Lenders should conduct Periodic stress testing of their loan portfolios to better understand the potential risks. The objective here is to identify those scenarios which, if they did actually occur, could result in severe losses and jeopardize the financial stability of the bank.
Stress testing individual loans can serve as a valuable early-warning system to identify those customers most likely to experience financial stress under adverse economic conditions. Stress testing can give valuable insights into potential future losses; identify key areas of risk exposure within the portfolio.
As all of the bank’s loans are not considered as an 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 the 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 distinction||Ideal Loan / Good loan||Problem loan / Bad loan|
|Nature of the loan||The loan installments are being paid regularly and in accordance with the repayment schedule as specified in the loan agreement||One or more installments have been missed, and no reasonable excuse has been shown.|
|Nature of borrower||The borrower has both ability and willingness to repay||The borrower has neither willingness nor ability to repay or has the only ability or only willingness to repay|
|Loan supervision||Minimum supervision suffices. Hence, supervision cost is low.||Maximum supervision is necessary. Hence, supervision cost is high.|
|Credit analysis||Results from a very good and efficient credit analysis||Results from a poorly conducted credit analysis|
|The relation between banker and borrower||Relationship of trust, mutual understanding, and cooperation||Relationship of distrust and doubt often leading to a civil case in the court|
|Effect on loan cycle||Speeds 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 supply||Results 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 credibility and thereby decreases the money supply in the economy.|
|Effect on profit||Low supervision cost and expanded creation of derivative demand deposit result in increased profit||High maintenance cost coupled with bad debt losses results in decreased profit|
|Effect on liquidity||The bank enjoys sound liquidity as it gets the cash flows as planned||The bank faces a dearth of liquidity as cash flows do not come as planned|
Ideal Loans are all banks darling. Bankers lending policy should allow proper in-order to detect problem loans.