Forbearance is a broad term used to denote a situation where a lending contract or other bilateral credit relationship has become problematic (in the sense of unexpectedly deviating from contractual cash flows due to the actions of one counterparty) leading to lender granting concessions or modifications that it would otherwise not consider.
Forbearance is a common strategy for Credit Risk Management of banking products. It is a distinct feature of bank based lending (as distinct from market based lending) where the ongoing bilateral relationship between the lender and the borrower permits the amendment of contractual terms.
There is no formal international definition of this term, and it is therefore described and used in different ways across jurisdictions and banks around the world (See BIS proposal below). In Wholesale Lending/Corporate Finance the concept is usually denoted as Restructuring
Types of forbearance
The concessions granted in the forbearance process are special contractual terms and conditions provided by a lender (creditor) to a counterparty (borrower) facing financial difficulty so that the counterparty can sufficiently service their debt. The main characteristic of these concessions is that a lender would not extend loans or grant commitments to the counterparty, or purchase its debt securities, on such terms and conditions under normal market conditions
Forbearance concessions may be granted by one of the following mechanisms:
- changes in the conditions of the existing contract (e.g., adjustments to repayment schedules, principal amounts or interest rates), giving more favourable terms for the counterparty
- a supplementary agreement, or a new contract to refinance the current transaction
- the exercise of clauses embedded in the contract that enable the counterparty to change the terms and conditions of its contract or to take on additional loans, debt securities or off-balance sheet items at its own discretion
Not all concessions lead to a reduction in the Net Present Value of the loan, and therefore a concession does not necessarily lead to an accounting recognition of a loss by the lender.
Examples of contractual modifications linked to forbearance
- extending the loan term or Credit Agreement
- changing the type of credit agreement
- rescheduling the dates of principal or interest payments
- granting new or additional periods of non-payment (grace period, payment holiday)
- changing (reducing) the interest rate, resulting in an effective interest rate below the current interest rate that counterparties with similar risk characteristics could obtain from the same or other institutions in the market
- capitalising arrears
- forgiving, deferring or postponing principal, interest or relevant fees for all or part of the instalment repayment over one or more periods
- debt consolidation
- changing an amortising loan to an interest payment only
- releasing collateral or accepting lower levels of collateralisation
- allowing the conversion of debt to equity of the counterparty
- deferring recovery/Debt Collection actions for extended periods of time
- easing of covenants
- adapting currency conversions
BIS Guidelines for a harmonized definition of forbearance
Forbearance occurs when:
- a counterparty is experiencing Financial Difficulty in meeting its financial commitments
- a bank (creditor) grants a concession that it would not otherwise consider, whether or not the concession is at the discretion of the bank and/or the counterparty.
Issues and Challenges
- Forbearance may enable borrowers experiencing temporary financial difficulties to continue repaying their debt, maintain their business or stay in their property. Forbearance also allows lenders to maximise the recovery value of borrowers’ assets, reduce the potential of a fire sale and avoid bankruptcy costs and provisions. Therefore, forbearance can be a tool for sound risk management of problem loans by reducing credit risk and credit losses.
- The restructuring process may become confrontational if the views of lender and borrower regarding the ability of borrower to overcome their financial difficulty diverges. In that case the lender may pursue a liquidation strategy which in the eyes of the borrower aims to benefit the creditor at the expense of the debtor.
- Forbearance can also be used to mask borrowers’ underlying difficulties by, for example, extending maturities and capitalising interest arrears without giving careful consideration to borrower’s individual circumstances. In these instances, forbearance gives cause for concern as it can place borrowers and banks in a steadily deteriorating position without supporting action. It can also be a strategy to bring down non-performing/problem exposures to avoid negative attention and repercussions. This can become damaging in the case of a widespread and persistent (systemic) deterioration in portfolio quality, as institutions may choose the forbearance solution that means less risk for them as opposed to the most suitable solution for the borrower, for instance by being reluctant to repossess collateral and take write-offs (“forbear rather than foreclose”).
- ↑ D403: Prudential treatment of problem assets - definitions of non-performing exposures and forbearance
- ↑ A concession is at the discretion of the counterparty (debtor) when the initial contract allows the counterparty (debtor) to change the terms of the contract in its own favour (embedded forbearance clauses) due to financial difficulty