Non-performing assets (NPAs) are debt instruments on which borrowers have failed to make the agreed payments for an extended period. As a result of ongoing defaults, NPAs do not yield any income for the lender.
Effects of non-performing assets
NPAs do not yield any income. So, carrying them on your balance sheets creates three burdens for you as a lender. Firstly the non-payment of the interest and/or principle on your loans reduces your earnings and cash flow. Secondly, as a result of the reduction in earnings, your budgets, usually planned far in advance, are disrupted. Finally, loan loss provisions, set aside to mitigate potential losses, cut into the capital you can use to make more loans. This results in further losses of income down the line. The presence of NPAs on a bank’s balance sheets also looks very bad to potential investors. This makes it difficult to raise new capital.
It is quite clear then that, if banks struggle to collect on their NPAs, i.e. convert them into performing assets, they are better off disposing of them. Letting go of NPAs will improve a bank’s balance sheets, as the relative number of performing assets increases. Then, banks will thus be able to attract investment more easily and take control of their financial planning. They can do this without having to worry about how NPAs will derail their projections.
How to get rid of NPAs
The usual way to convert or let go of NPAs is to collect the collateral that the borrower has set against the loan, and attempt to get back at least some of the funds that have been lost. When a bank holds large numbers of NPAs, however, the good bank-bad bank model has proven to be a very effective measure. This is where a bank creates a separate entity (the ‘bad bank’) and transfers its NPAs into it. The ‘good bank’ can continue with normal operations, with a pristine balance sheet, while the ‘bad bank’ can get on with the business of mitigating the losses incurred by the NPAs.
Kore Capital Corporation is a business financing company that specializes in offering lines of credit, particularly through factoring, to firms in several different industries. For more information on how to deal with non-performing assets, as well as our numerous financial services, contact us.