When non performing loans become special

Banks are in the business of taking risks. Lending inherently carries the risk of default. No wonder, a corporate customer’s credit risk is a function of its probability of default. Lower the default probability, higher the credit/risk grade.

Banking history is replete with instances of a large corporate/group, defaulting on the facilities to the banking system. Some well known instances are those of are an energy company with a market capitalization close to a 100 billion dollars defaulting in 2001, and a big Wall Street player with a trillion dollar balance sheet collapsing in 2008.

Central banks world over, keenly monitor the health of the banking system in a country by assessing the extent of nonperforming loans (NPL’s) at banks, as one of the key indicators. Central banks’ regular audit/examination of a bank’s book, places a special emphasis on NPL’s, whether they have been declared or are still lurking.

Typically when a corporate advance shows signs of stress, banks put them through an early warning mechanism. Such accounts attract greater scrutiny than others. This could be in the form of revisiting the credit grade/risk grade, quarterly reporting to senior management, capping of exposure at current levels, reduction in facilities etc. Such accounts often turn out to be defaulters on contractual obligations to the lender, be it interest or loan principal, default under letters of credit, unpaid bills of exchange, or invocation of bank guarantees. Central banks, do not expect banks to write off these accounts at the first sign of default. The first step may be a 25 percent provision of principal outstanding depending on the security cover, along with suspension of future interest accrual and reversal of past accrued but unpaid interest income. The account gets classified from a standard asset to sub standard, with the terminology differing, depending on the country. If the situation continues to deteriorate, the default continues and recovery is doubtful, the account could move to the next level of classification, with an increase in the extent of provision of principal, again depending on the security cover and the duration of the asset being in default status.  When all signs of hope are lost, the asset is entirely written off as a loss. Litigation begins to enforce security, and otherwise safeguard the bank’s position through legal means.

Are their ‘cast in stone’ norms for classifying a corporate advance under the NPL category? Often, any overdue beyond a certain number of days, say 90 days, attracts the sub standard classification. But ever greening of loans is not uncommon in the global banking system. After all, which bank can afford to call a customer a NPL, with a multibillion dollar exposure, at the first sign of trouble? And such customers typically have exposure to multiple banks. Even central banks sometimes tread warily in such cases. Forcing banks to immediately provide for a stressed corporate, with huge exposure to a large part of the banking system, could have ripple effects on the entire economy and could potentially threaten a country’s sovereign rating. An extreme example was the bankruptcy filing of a well known Wall Street firm in 2008, which nearly brought down the global financial system, with its trillion dollar balance sheet.

Such is the importance of managing stressed assets and NPL’s, that banks have established Special Asset Departments to take over the management from the regular Relationship Managers, who otherwise focus on business development. Special assets are managed by senior bankers, who need to work with the owners/board of the company, to try and negotiate a mutually agreeable settlement, failing which the last resort is litigation for recovery.

The regular Relationship Manager earns interest and fee income for a bank, earning interest spreads and fees in single digit percentages. On the contrary, the Special Asset Manager, upon recovery of capital from a defaulted borrower, has the potential to contribute significantly more to a bank’s bottom-line, say through a one shot settlement of 25 percentage of the outstanding of defaulted facilities, which have been already provided for, in a bank’s books. No wonder those who manage the ‘non performers’ are indeed ‘special’ to a bank, and often the first port of call of a bank’s CEO when she/he visits a corporate banking branch, is the Special Assets Manager!

-The views expressed are personal