What are Non-Performing Assets and How to Resolve Them?

What are Non-Performing Assets (NPAs)?

Non-performing assets, often called non-performing loans, are debt instruments arising when borrowers fail to meet their agreed-upon repayment obligations for more than 90 days, leading to the loss of interest income, as well as loan principal, for the lender.

These assets can include mortgages, corporate loans, personal loans, and other forms of debt. Non-performing assets are classified based on the default duration.

According to data from the Central Bank of Kenya (CBK), by the end of April 2022, there was a significant increase in loan defaults, with 14.1% of all loans issued being defaulted. This delinquency marked the highest yearly surge in defaults within 12 months.

NPAs are a cause for concern for financial institutions as they can negatively affect the lender’s profitability, liquidity, and overall financial stability.

Categories of NPAs

NPAs can be broadly categorized into different groups based on their nature and characteristics.

The main categories of NPAs include:

a) Mortgage defaults

When borrowers fail to pay their mortgage installments over an extended period, such as 90+ days, their mortgages become non-performing assets.

Mortgage defaults can occur due to financial distress, economic downturns, or other reasons that prevent borrowers from fulfilling their repayment obligations.

b) Corporate loan defaults

This category includes business loans for various purposes, such as working capital, expansion, or capital investments. When a corporate loan becomes a non-performing asset, it has negative implications for both the borrower and lender.

For the borrower, a corporate loan default can damage the company’s creditworthiness, making it more difficult to obtain future loans or access other financial services. It may also result in litigation from the lender and harm to the company’s reputation.

c) Personal loan defaults

Personal loans are funds borrowed for various personal purposes, such as education, medical expenses, home renovations, debt consolidation, or other financial needs that individuals may have.

Lenders face a higher risk of non-repayment since these loans are not tied to specific assets that can be easily repossessed. The risk of personal loans becoming NPAs is even higher when there is no security or collateral attached to the facility.

d) Unpaid credit card debt

A credit card becomes categorized as a non-performing asset when it remains outstanding for an extended period. This delinquency occurs when the cardholder fails to make the minimum payments required or defaults on the debt entirely.

Non-payment or defaulting on credit card debt can result in a negative credit rating, making it difficult for the customer to obtain credit in the future.

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How to Resolve NPAs – Recovery Mechanisms

Resolving NPAs and implementing effective recovery mechanisms are crucial for the stability and health of the banking sector. It is important to note that the resolution of NPAs is a complex and time-consuming process that requires a combination of various strategies tailored to each specific case.

Let’s look at how to handle non-performing assets.

1. Loan restructuring

Lenders can proactively work with borrowers to restructure loans, adjusting repayment terms and schedules to ensure continued cash flows and avoid classifying loans as non-performing.

This approach allows borrowers in financial distress to manage their debts effectively and provides them with an opportunity to settle their obligations.

2. Collateral liquidation

When assets collateralize loans, lenders can seize and sell the assets to cover their losses up to the market value of the collateral. This mechanism allows lenders to recover a portion of their funds and mitigate the negative impact of NPAs on their books.

3. Debt-to-equity conversion

Lenders have the option to convert a portion of bad loans into equity, which may appreciate over time and allow for the recovery of the principal lost in the defaulted loan.

Debt-to-equity conversion, also known as Strategic Debt Restructuring (SDR) gives lenders an ownership stake in the borrower’s business and aligns their interests with the borrower’s success.

The lender thus takes control of the borrower’s business management and implements the necessary restructuring measures.

This approach allows lenders to actively participate in the revival of stressed businesses and increase the chances of loan recovery.

4. Selling NPAs

Banks can sell non-performing assets to specialized loan collection companies or asset reconstruction companies (ARCs) at discounted prices, particularly when recovering losses through other means is not cost-effective.

These companies specialize in recovering NPAs and employ the most effective strategies to maximize collections.

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5. Bankruptcy and insolvency proceedings

In cases where the recovery of NPAs becomes challenging through conventional means, lenders can initiate bankruptcy or insolvency proceedings.

This approach involves legal action against defaulting borrowers, leading to liquidation or reorganization of their assets to repay the outstanding debt.

6. Prudential norms and risk management

Strengthening prudential norms and risk management practices is crucial to prevent the emergence of NPAs. Banks should adhere to regulatory guidelines and implement robust credit risk management frameworks.

These measures include conducting thorough due diligence before issuing and sanctioning loans, effective loan monitoring, stress testing, and establishing early warning systems to detect signs of potential default.

7. Loan Recovery Tribunals (LRTs)

Loan Recovery Tribunals are specialized forums established to facilitate the expeditious recovery of NPAs. These tribunals have the power to adjudicate and enforce recovery proceedings against defaulting borrowers.

They provide a legal platform for lenders to present their cases and secure favorable judgments to recover dues.

Conclusion

Non-performing assets pose significant challenges to the financial health and stability of lenders. Resolving NPAs requires a comprehensive approach encompassing loan restructuring, collateral liquidation, and debt-to-equity conversion.

It can also entail selling NPAs to specialized companies, initiating bankruptcy proceedings, asset quality reviews, enhanced risk management practices, and the effective utilization of loan recovery tribunals.

By employing these strategies, lenders can mitigate losses, restore the health of their loan portfolios, and contribute to a more resilient financial system.

It is essential for financial institutions to continuously monitor and address NPAs through proactive measures to maintain stability, support economic growth, and foster confidence in the banking sector.

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Victoria Munyi

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