What it means
A problem loan is generally one where payments are seriously overdue, often 90 days or more, or where the lender doubts that the borrower will be able to repay. Different banks and regulators define the term slightly differently, so comparisons must be made carefully.
The ratio expresses the problem loans as a percentage of the total loan portfolio. A rising ratio signals that more borrowers are struggling, which will eventually lead to losses for the lender.
Lenders use it as an early warning. If the ratio climbs in a particular sector, such as property or retail, management can tighten lending standards, ask for more security or set aside more money for expected losses.
Investors and rating agencies use the ratio to compare banks. A bank with a low ratio is generally seen as having better credit quality, though a very low ratio may also suggest that it is taking little risk or growing fast and has not yet seen the losses that come later.
It is often read together with the coverage ratio, which shows how much money the bank has put aside against problem loans. A ratio of 5% with provisions covering most of the problem loans is a very different situation from a ratio of 5% with little provision.
Finance teams in non-banking companies also use the idea when they run customer credit. Tracking the share of receivables that are seriously overdue gives a similar signal about the health of sales to customers on credit.
In practice
Real-world examples.
Example
A community bank sees its problem loan ratio rise from 2% to 4% after several local businesses close. The risk committee stops new lending to the affected sector. It also increases provisions to cover expected losses and asks the lending team to review every loan in that sector. The board receives a monthly report until the ratio stabilises.
Example
An investor compares two banks with problem loan ratios of 3% and 8%. She prefers the first because it has better quality, but she also checks the provisions each has set aside. The bank with 8% has covered 90% of its problem loans, which reassures her somewhat. She decides that the second bank is riskier but not unmanageable, and prices her investment accordingly.
Example
A wholesale company sells to retailers on 60-day credit. Its finance team tracks the share of invoices more than 90 days overdue, which reached 6% of receivables. The company stops shipping to the worst customers until they pay. It also changes its terms for new customers from 60 days to 30 days.
Formula
Calculation
Problem loan ratio = problem loans / total loans x 100
Suppose a regional lender has total loans of $600,000,000, of which $30,000,000 are classed as problem loans.
Problem loan ratio = 30,000,000 / 600,000,000 x 100 = 0.05 x 100 = 5%.
If the bank has set aside provisions of $21,000,000, the coverage ratio is 21,000,000 / 30,000,000 = 70%, which means the bank has covered most of the potential loss.Case study
Seen in the real world.
Riverside Credit Union is an illustrative, fictional lender with $400,000,000 of loans. At the start of the year its problem loan ratio was 2.5%, which meant $10,000,000 of problem loans.
A downturn in the local building trade pushed problem loans to $24,000,000 by the year end. The ratio rose to 24,000,000 / 400,000,000 = 6%, and the board called an emergency meeting.
In this illustrative story management stopped approving new construction loans, hired extra staff to work with struggling borrowers and increased provisions by $6,000,000. Over the next year the ratio fell back to 4%, and the quick response limited the final loss. The board also began reporting the ratio by industry every month, so that the next concentration of risk would be seen earlier.
Watch out
Common mistakes.
- Comparing ratios between banks without checking that they define problem loans in the same way, since one bank may count loans overdue by 60 days and another only those overdue by 90 days or more.
- Looking at the ratio alone, without considering how much the bank has set aside to cover the losses.
- Treating a low ratio as proof of safety, when rapid loan growth can hide problems that have not yet appeared because new loans take time to go bad and make the denominator larger.
Questions
People also ask.
What counts as a problem loan?
Usually a loan that is 90 days or more past due or where repayment is doubtful, although the exact definition differs by bank and country.
What is a good problem loan ratio?
Lower is better and ratios of a few percentage points are common in normal times, but acceptable levels depend on the type of lending, the bank's capital strength and the stage of the economic cycle.
How is it different from the non-performing loan ratio?
The two are very similar and often used interchangeably, though some banks include restructured loans in problem loans but not in the non-performing figure.
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