Nonperforming Loan (NPL)
Candlefocus EditorThe specific definition of a nonperforming loan can differ across financial institutions, economic regulations, and jurisdictions. Generally, it is most commonly used to describe loans in which borrowers are 90 days or more delinquent in their payments. In some interpretations, nonperforming loans can also include loans for which the borrower is current on their payments but is unlikely to maintain such payments due to reasons such as economic downturn, borrower’s liquidity, or the borrower changing their mind about repayment.
Nonperforming loans can have a significant impact on banks. They can cause a dent in bank capital and force it to face an asset write-down, which limits its balance sheet. This can also push the bank’s profitability downward, tarnishing its reputation and creating a ripple effect across both the bank’s financials as well as its internal and external processes. Banks also risk being classified as failing institutions if their NPL rates rise above standard levels.
The ultimate goal for banks is to improve their NPLs contingent, and to do so they need to focus on activities such as loan modifications, securitizations, debt restructuring, credit line extensions, and loan sales. When restructuring loans, banks can use various financial instruments to make the terms favorable to the borrowers and clear the debt burden.
In some cases, when banks are unable to contain the NPLs, they tend to opt for loan sales. Banks sell NPLs to asset management companies, vulture funds, or hedge funds—all of which can help banks free up their capital for better returns and focus on performing loans.
In summary, nonperforming loans are one of the key ways financial institutions measure the efficacy of their loan procedures. Moreover, understanding the NPLs of the banking sector in a particular country is important for investors when deciding where to make investments in commercially-oriented markets. A high rate of NPLs can be indicative of more systemic risks that can trigger larger economic downturns. As a result, nonperforming loans are an important factor to consider when making macro-economic decisions.