Impaired versus Non-Performing Loans

Impaired versus Non-Performing Loans

The terminology around problematic loans (and problematic credit relationships more generally) can be quite confusing. There are at least the following expressions (in English): delinquent loans, under-performing loans, defaulted assets, impaired loans, restructured loans, troubled debt restructuring, non-accrual status, non-performing loans, write-offs, provisions, loss allowances etc. etc. Some of those terms have very specific legal, accounting and/or regulatory meaning in the applicable jurisdiction. Others are informally used by the practitioners in the financial services industry. Recent guidance issued by BIS is the first attempt to provide a harmonised set of definitions. Further resources and definitions of those terms are given in the NPL Glossary and the description of the NPL Life Cycle.

The key distinction between the terms Impaired and Non-Performing is that Impairment is an accounting term (affecting how problem lending is reported in Financial Statements) whereas Non-performing is a regulatory term (affecting how problem lending is treated in prudential regulatory frameworks). The accounting and regulatory frameworks are distinct and there is no formal relationship between the categories introduced by the two. In practice one would normally expect impaired assets to be also classified as non-performing, but not vice-versa.

Reasons for multiple terminologies

The lending system (banks and other financial services providers) involves a number of distinct agents either as primary parties involved (the borrower and the lender) in the relationship or as auxiliary entities (auditors, regulators etc). This populated landscape leads to different perspectives and technical jargon when describing the same underlying phenomenon, namely a bilateral credit relationship between a borrower and a lender that does not perform as expected contractually. The following four perspectives capture the main alternative views:

Perspective 1: Repayment status. For example: how many expected payments have been missed? This type of information is captured generally under the term "Delinquency Status". Delinquency has a wide range of states with different significance: One or two payments may be missed by accident, but as time passes and more payments are missed, the delinquency classification implies more serious issues. For example "180-days past due" means there is a serious possibility there is a credit issue.

Perspective 2: Legal status. The loan contract (or other credit product) will typically spell out the legal consequences of delinquency exceeding a certain period. For example the lender may declare the borrower in default and follow up with other legal actions of varying severity. Or they may choose to restructure the loan and effectively introduce a new contractual agreement with the borrower.

Perspective 3: Accounting status. This is a perspective completely internal to the lender. Subject to accounting rules, once the full amount of the loan is not likely to be recovered, the lender must make provisions (set aside money to cover for the loss) and the loan is an impaired asset in the financial reports. Part of the (previously reported as performing) assets must be written-off. The accounting treatment of loans is currently undergoing a major revision as part of IFRS 9.

Perspective 4: Regulatory status. This is yet another perspective internal to the lender. Subject to the different regulatory regions and lender types, regulators may require that lenders hold additional equity (own funds) for the residual risks in non-performing loans.

The above are not exhaustive. For example the tax implications (and view and treatment of problem credit by tax authorities) are yet another perspective.

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