Strategies Used by the Banking Industry to Mitigate Losses on Non-Performing Loans

Only available on StudyMode
  • Download(s) : 132
  • Published : February 7, 2013
Open Document
Text Preview
Strategies Used by the Banking Industry to Mitigate Losses on Non-Performing Loans

In depressed economic times, Banking is an industry that is prone to substantial financial losses, from customer’s closing their depository account to an increase in outstanding loan delinquency. An increase in consumer and commercial loan defaults can damage the integrity of a Bank’s outstanding loan portfolio. Such deterioration can lead to an increase of “Non-Performing Assets”.

Once a loan is nonperforming, (usually when a debtor has not made their scheduled payment for at least 90 days, but there are other reasons why a loan can be deemed “non-performing”) the odds that it will be repaid in full are considered to be substantially lower. The non-performing asset is therefore not yielding any income to the lender in the form of principal and interest payments.

Banks have spent the last several years grappling with nonperforming assets, but perhaps working out problems with bad loans is best left to entities that do not have to answer to a Federal Regulator. This year, more banks have escalated efforts to sell nonperforming assets, and industry experts say the volume of such deals is only going to increase. Meanwhile, a new deal structure is calling for sellers to retain the problematic assets to work them out on their own. (Barba, 2011)

But, even if a loan pays in accordance with its Terms & Conditions, it still can be categorized non-performing for several reasons. Deterioration in financial ratios can cause a loan to be classified non-performing, one of those financial ratios is Loan to Value or “LTV”.

LTV is the outstanding principal balance of the loan divided by the appraised value for real property pledged as collateral for a loan. When the appraised value of the pledged collateral decreases faster than the principal of the loan, the LTV will increase, thereby making this loan a greater risk in case of default.

The benchmark LTV ratio will usually not exceed 75%, the rationale behind this threshold is if the loan does default and, subsequently, the asset disposed of, that the 25% of equity can be used to reimburse the bank for legal fees, court cost, and expenses incurred with liquidating the collateral. This strategy is incorporated in the bank’s lending policy in the effort to “make the bank whole” in a loan default scenario.

When the loan request is not collateral based, the key financial ratio used to determine the borrower’s ability to repay is Debt Service Coverage or DSC. This ratio is calculated using the existing company debt, plus the new loan obligation, divided by the businesses existing cash flow to determine if the total debt can be supported. Covenants in the loan documentation will require the business to furnish Tax Returns and Financial Statements annually to review the borrower’s financial condition to ensure sufficient DSC. If it is determined that the DSC is not sufficient or if the borrower is not in compliance of the Loan Covenant by not supplying the required financial information, the loan can be classified as non-performing.

An increase in the level of non-performing assets increases risk and impacts capital levels that regulators believe are appropriate in light of the ensuing risk in the loan portfolio. Regulators request that the level of non-performing assets be reduced. If these problem assets are not reduced through loan sales, workouts, or restructuring or the level of problem assets continue to rise through decreases in the value of the underlying collateral, or in these borrowers’ performance or financial condition, whether or not due to economic and market conditions beyond our control, could adversely affect the bank’s operations and financial condition. This is why banks are so interested in getting these assets off the books.

Banks that’ve held on to some loans in hopes of a rapidly increasing economic recovery are starting to lose hope. Moreover, the Euro...
tracking img