A problem loan is often referred to as a problem credit, or an impaired asset since, counterintuitively, loans are an asset for a creditor (as opposed to a liability for the borrower).
In simple terms, a problem loan is one that poses a “challenge” for a lender. It may occur when the borrower ceases to make interest or principal payments (delinquency) or where repayment of the loan, as per the terms of the credit agreement, becomes otherwise less likely.
Problem loans are specific to a borrower’s loan(s) or its risk rating with the financial institution. A problem loan is not the same as a “problem borrower,” which may include poor communication with their relationship team or reputational risk for the lender, among other things.
A problem loan occurs when repayment, as per the terms of the credit agreement, is in doubt or when the likelihood of recovering the full principal outstanding, in the event of a default, becomes unlikely.
An expired risk rating can create a problem loan for a lender, even though the payments may remain current (meaning the loan is still “performing”).
A problem loan has important, credit-specific characteristics – it is not the same as a “problem borrower,” which is a much broader definition of potential client issues.
Understanding Problem Loans
Some of the causes of a problem loan include (but are not limited to) delinquency (a missed payment), an expired or deteriorating risk rating, a covenant breach (either technical or financial), or by virtue of a loan reaching its maturity without being renewed. All of these characteristics make full repayment, or full recovery, much less likely. They also often impact a lender’s profitability, as the firm may be required to hold more capital against the impaired asset(s).
Federal regulators in the United States use two categories to “risk grade” problem loans. These are:
Criticized loans (sometimes referred to as especially mentioned) – Criticized loans exhibit some weakness in “safety” (weak debt service coverage ratio, high leverage, and/or poor liquidity) or “soundness” (deteriorating collateral values). Criticized loans are typically still performing.
Classified loans – Such loans are either classified as:
Substandard – Substandard loans are either “unsafe” or “unsound,” meaning very weak ratios or inadequate collateral coverage.
Doubtful – Doubtful loans are both “unsafe” and “unsound.” Loan loss is considered extremely likely with Doubtful credits.
Lending is a very low-margin business, meaning that firms must extend high volumes of credit in order to make meaningful revenue. After accounting for the cost of funds, operating expenses, and provisions for credit loss, net margins are even tighter still. Maintaining a low proportion of problem loans is paramount for a lender to be able to operate profitably, which is why banks work through considerable qualitative and quantitative due diligence for prospective borrowers.
How Institutions Can Identify Problem Loans
Once credit is extended, however, the due diligence process is not over; ongoing monitoring – at least annually, but sometimes quarterly or even monthly – is an important part of maintaining a healthy credit portfolio.
Monitoring tools include, but are not limited to:
Annual reviews of a borrower’s financial results, typically within some pre-agreed period after the borrower’s fiscal year-end.
Requiring borrowers to provide quarterly or monthly margin reports for operating credit, as well as other interim financial reporting (where necessary).
Monitoring day-to-day account activity for things like frequent overdrafts or returned payments.
Experienced loan officers and credit analysts can often identify potential problem loans more quickly by observing patterns of behavior by management (like a high dividend payout ratio) or weak internal controls (like slow collections or inadequate oversight of account access).
Options to Rectify a Problem Loan
Clients exhibiting problem loan characteristics are not usually forced into liquidation right away. There are widely believed to be five reasonable options when approaching a potential problem loan. These are:
Ignore the problem(s).
Refinance the exposure.
File for bankruptcy.
Work it out.
Each alternative presents advantages and disadvantages to one of the two parties (either the borrower or the lender). In general, seeking a workout solution is (arguably) the only “win-win” alternative.
Sometimes a borrower starts to demonstrate problem loan characteristics, but reporting is in order, and the loan is performing. A lender may wish to monitor that borrower more closely before making a decision about the final outcome. In such instances, they will typically use what’s called a watch report.
The watch process requires more robust interim reporting by the client, which helps the relationship team highlight the most important borrower characteristics and credit-specific information that senior risk managers need in order to stay up to speed on the client’s progress towards more stable operations.
If you are interested in learning more about Problem Loans, we recommend CFI’s Problem Loans Course. This course examines the unique challenges these loans present for a financial institution and how lenders can be more proactive in identifying potential problem loans.
Thank you for reading CFI’s guide to Problem Loans. To keep learning and developing your knowledge base, please explore the additional relevant resources below: