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Banks, like other businesses, run on profit. A major source of profit for the banks is the interest paid by the borrowers of loans. This includes cash advances, overdrafts, payday loans, secured loans, and unsecured loans, among many others. The interests levied on these loans are paid monthly by its customers which form one of the avenues of income for the bank.
When a customer defaults in the payment of interest or stops paying interest altogether, then the loan is said to become a Non-Performing Loan ("NPL"). According to the IMF guidelines, a loan becomes an NPL in the following instances:
- If interest payment on the loan has not been made for 90 days or more.
- If interest amounting to 90 days' worth or more has been capitalized, refinanced, or rolled over.
- There is evidence to re-classify the loan as an NPL (ex.: in case of bankruptcy).
NPLs are a major liability to a bank. In the presence of NPLs, banks are required to set aside a portion of their revenue as bad debt provisions in case they are required to write off the debts. Additionally, higher numbers of NPLs in the book of accounts may be seen as a red flag to potential investors, which may bring down the stock value of the banks. Thus, they are seen to be the drivers of the banking crisis. If unmanaged for a long period of time, these NPLs can lead to a decrease in profits for the bank, and ultimately lead to a financial crisis in a region, due to the direct correlation between banks and the economy. Beyond banks, NPLs adversely affect the interests of future borrowers, as these borrowers are left with limited options of loans.
NPLs are inevitable in a bank, but their occurrences can be reduced through strict due diligence and careful record tracking. The borrowers bank account will show red flags if its status is followed regularly. Certain types of loans such as unsecured loans, or loans granted on personal guarantees are harder to recover, thus rising the risks of NPLs. The impact of NPLs on the overall loan portfolio can be mitigated by concentrating on high-risk loans and implementing early intervention measures, such as restructuring. High level Artificial Intelligence softwares are also being developed to understand and predict NPLs.
The United Arab Emirates sees a high presence of NPLs, as compared to other countries in the region. The presence of a robust real estate and construction sector, accompanied by aggressive lending, may have resulted in this phenomenon. The UAE also allows loans to be granted on personal guarantees, wherein companies borrow loans on the guarantees of individuals. These personal guarantees are often unusable when loan recovery procedures are initiated.
When a loan turns into an NPL, the bank will initiate certain recovery processes. If the loan was borrowed against an asset as collateral, the bank will take possession of such assets and attempt to dispose of them for monetary value. Banks may also sell their NPLs to collection and outside investors. Recent developments have shown that the UAE has a strong market for the sale of NPLs. Although this may be a time-consuming process, such a sale can allow the reduction of losses faced by the banks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
