What are ‘Non-Performing Loans’ and ‘Loan Loss Provision’?

Non-performing loans (NPLs), also known as bad loans, are loans that are in default or at the risk of defaulting when they are not serviced back by the borrower according to the agreed-upon terms. 

The definition and treatment of NPLs can vary by country — the specific rules and regulations governing NPLs are determined by local banking authorities and international financial standards.

Nepal’s central bank — the Nepal Rastra Bank (NRB) — mandates loans whose scheduled payment has not been received for three months or more to be treated as NPL. Loans that are not serviced for a period of 1 to 3 months are considered performing. 

The NRB’s new rule states that NPLs can be recatergorised as performing only if the borrower repays both principal and interest for six consecutive months after they settle their previous overdue.

Loan non-performance can arise for various reasons, including economic downturns, financial distress of borrowers, and poor loan management practices.

When monitoring the economy and financial system, NPL is considered a crucial indicator. A higher ratio of NPL means the banks will have to set aside higher provisions for loan loss (see below what is a loan loss provision), reducing the capital for banks to provide further loans, thus affecting banks’ profitability and sustainability. It also indicates whether a crisis is hovering over banks. 

An International Monetary Fund (IMF) study in 2019 found out of 88 banking crises in 78 countries since 1990, a large majority of them (81%) exhibited elevated NPLs exceeding 7%.

All in all, higher NPLs, higher the economic risk since the financial system is a key component of the modern economy.

Managing non-performing loans is a crucial aspect of risk management. Regulatory authorities often require financial institutions to classify and report NPLs accurately and set guidelines for the provisioning of loan loss to manage risks. 

A loan loss provision is an accounting measure that banks and financial institutions set aside to cover potential losses that may arise from loans or other credit-related assets that may not be fully repaid by borrowers.

Based on the performance of loans, the NRB mandates the following loan loss provision rates: