Non Performing Loans (NPLs) are loans that have payment delays of more than 90 days. NPL’s lead to provisions and to credit losses. That is why the level of NPLs, expressed as percentage of total loans, is an important indicator for the health of the financial system in a country. They are closely monitored within banks, reported to regulators, discussed in meetings with IMF officials, presented at international conferences and analysed by rating agencies.
Reporting financial indicators that are significantly worse than they appear in reality is not good for the country. Still, that is exactly what we are doing with NPL levels in Romania. This is an old problem and this is not the first time I draw attention on this matter. Recent meetings made it clear to me – yet again – how the NPL levels affect Romania’s image abroad. So then, what do we do about this? Simple: adopt the international standards so that the Romanian indicator is based on the same method as the one in other countries.
International practice is to stop accruing interest for the provisioned part of a loan. How much of a NPL is provisioned depends on a number of factors, especially collateral. This means that banks no longer show revenues for these (parts of these) loans by means of stopping interest accrual. This practice does not affect the relationship between bank and client. Legally speaking the bank still has the contractual right to claim the full amount, including the accrued interest and penalty interest. The bank just reflects a more appropriate value for this loan in its books.
Romanian regulations oblige banks to keep accruing interest for these already provisioned (part of) loans even though it is increasingly unlikely that this interest will ever be collected. The Romanian indicator contains therefor higher levels of accrued interested which increases the NPL levels in Romanian banks in comparison with other countries. Please note that this accrued interest is immediately provisioned, so this does not affect the Profit and Loss account.
A Simple Example
Let’s take two hypothetical banks with identical portfolios and identical customers that have identical loans with identical behaviour. The only difference is that the banks are in different countries and different rules apply.
In order to keep it simple, we will take one loan in both banks that at the moment the client stops paying has an outstanding balance of 10.000 with an interests rate of 10% and a penalty interest rate of another 10%.
Bank INT stops accruing interest after 180 days which means that the amount of the loan in their books is 11.000, consisting of 10.000 remaining principal and 1.000 interest ((10.000x180x(10+10))/36000) From that moment on the amount of the loan in their books will not change.
Bank ROM does not stop accruing interest and after 360 days the amount in their books is already 12.000. If we now assume for both banks a total loan portfolio of 100.000, Bank INT has a NPL ratio of 10% but Bank ROM has a NPL ratio of 12%.
It is also easy to see that, as time goes by, the NPL level will keep increasing for Bank ROM while it remains stable for Bank INT. After 2 years Bank ROM has a non performing loan of 14.000 with a ratio of 14% and after 3 years of 16.000 with a ratio of 16%. If we were to compound interest the amount would be even higher.
Is there a difference in quality, soundness between these banks? Is Bank ROM in a worse shape and deteriorating over time? Of course not, there is no difference. Even the profits will be identical because the additional interest that Bank ROM accrues is provisioned at the same time.
It is easy to extrapolate this mechanism from an individual loan to a loan portfolios, from the portfolio to a bank and from the bank to the entire banking system.
There Is More….
This is not the only difference between Romanian regulations and international standards that influence NPL levels. The other is in the so called write off policy. It is easy to see that the sooner a loan is written of by a bank, the lower the NPL level will be. This is especially the case in our Bank ROM, where loans keep accruing interest until they are written off. Romanian banks may not write off loans unless they have “exhausted all legal means”. If they nevertheless do so, the expense is considered non tax deductible and some even argue that this would be a gift from the bank to the client that needs to be taxed as income. It is not very difficult to see that the cost of “exhausting all legal means” is in many cases not justified by the expected amount to be recovered. This not only increases the costs of credit in Romania, it also inflates the NPL levels.
Some analysts might be aware of these differences but in my experience most people are not and I have explained this many times over to officials, analysts, head office representatives, politicians, regulators and rating agencies. Banks have been asking for years for a solution and I dedicated a blog entry tackling the issue after yet another unfavourable comparison in the international press in 2010.
How Big Is The Difference?
The real question is of course how big the difference is. The only one that can find out is the National Bank of Romania (BNR) because they are the ones that have access to consolidated data. In my view something needs to be done. Otherwise Romania will soon hit 20% NPL ratio which looks really bad in comparison with neighbouring countries. Countries we are competing with when we want to attract investment and financing.