A net charge-off (NCO) is the difference between the amount of gross charge-offs and any recoveries of delinquent debt. An NCO can be thought of as the debt owed to a company or organization that is not likely to be recovered. The debt is written off initially as a gross charge-off; however, if any amount of the debt is recovered at a later date, the amount is subtracted to arrive at net charge-offs.
A charge-off is a debt that is considered to be unlikely to be collected by the debtor (lender). It can be due to several reasons, such as a deterioration in the borrower’s credit health or the debt payment’s been delinquent for a long time. Usually, a charge-off results in a write-off of the debt from the balance sheet; however, it is not always the case.
A charge-off for the creditor (borrower) can significantly affect credit scores, credit ratings, and future borrowing ability. In the future, the creditor may find it difficult to secure debt or may need to pay a higher rate of interest to compensate for the additional risk that they pose. Outstanding debt is deemed uncollectible, typically if the debt payment is past the due date for 180 days or greater.
Charge-offs remain on a credit report for seven years, so the impact of charge-offs can affect borrowing capacity for a significant amount of time.
How Net Charge-offs Work
Most debtors lend out money with the expectation that they will not be able to recover 100% of the loans they’ve issued. Therefore, it is common practice to establish a loan loss provision commonly in the form of “provision for credit losses (PCL).” The provision is estimated based on historical data from creditors, the economy, and forecasted expectations for collections. The estimation for uncollectable amounts is written off as a gross charge-off.
However, if debtors are able to recover some of the amount that’s been charged-off, then it can net the recoveries against the gross charge-offs to arrive at net charge-offs. The loan loss provision is reduced by the amount of the net charge-off at the end of the accounting period and is subsequently refilled for the next accounting period based on new estimates for loan losses.
Company A books gross charge-offs that represent 3% of total loans outstanding. Some 0.5% of the total loans outstanding end up being repaid. What is the net charge-off?
The net charge-offs are the difference between gross charge-offs and the amount of loans paid back.
Therefore, the net charge-offs are 2.5% (3.0% – 0.5%) of total loans outstanding.
The amount is applied to the loan loss provision in the accounting statements.
Importance for Banks
The estimation of the provision for credit losses (PCLs) is very important for banks. It is because the banks’ entire business models are based upon lending and borrowing. Generally, banks create profit by borrowing funds at a certain interest rate from depositors and lending out the funds at a higher interest rate. Therefore, they are able to profit off the interest rate spread between borrowing and lending; it is captured with the financial metric “net interest margin (NIM).”
Since deposits and loans make up the majority of a bank’s balance sheet, estimating charge-offs is very important so that a bank can lend out money while still being able to repay depositors if needed. Banks estimate their PCLs by analyzing their individual balance sheets and the riskiness of the loans outstanding. Additionally, the banks forecast the economic environment and how likely it is that creditors will settle their loans.
Banks monitor their net charge-off rate, which is the ratio of loan losses to total loans. It is a financial metric that can be used to compare the loan book quality of banks among each other. However, differences in net charge-off rates may stem from different business mixes.
For example, a bank that focuses more on business loans and credit card loans will generally generate a higher net interest margin because the loans come with a higher interest rate. However, the loans are riskier, and the net charge-offs will generally be higher.
Another bank may focus more on residential mortgage loans and other secured borrowings. The loans will generate a lower net interest margin, due to having a lower interest rate. They are also safer because they have an asset backing them; therefore, the charge-offs will be lower.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: