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Lim Chhayada
LEARNING OBJECTIVE
• Outline why loan default
• Highlight the extent of problem loans
• Explain why the business cycle is important for
problem loans
• Define problem loans, provisions and regulatory
issues
• Discuss the capital issues of problem loans
• Restructure problem loans
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INTRODUCTION
The loss may occur as a result of many factors,
from poor management of the borrower to the
timing of the business cycle.

The primary issue of problem loans is that they

can impair the value of a financial institution.

It is expected that some loan will become problem,

but the aim of a financial institution is to manage
the problem in such a way as to reduce the loss of
value to shareholders.
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CAUSES OF DEFAULT
A default is defined here as a loan for which the repayments
are overdue.
Lending institution may experience defaults and problem
loans for the following reason.
lack of compliance with loan policies
lack of clear standards and excessively lax loan term
inadequate control over loan officers
Loan growth in excess of the bank’s ability to manage
Inadequate systems for identifying loan problem
Insufficient knowledge about customers’ finance
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PROBLEM LOAN
• How lenders should manage their problem loans:
• What are the various types of problem loan? How do we
define them?
• How do lenders manage the impact of problem loans
on profitability?
• Making this issue more difficult, most financial institutions
handle it in a different way.
• For bad loan is liquidation (selling the borrower’s assets)
• Financial institutions are using advanced management
techniques such as dynamic provisioning. 5
THE BUSINESS CYCLE
A bank’s experience with problem loan can
normally be tracked by examining the
business cycle.

• Recovery and expansion

• Boom
• Downturn
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PROBLEM LOANS AND PROVISION
• When a borrower misses a repayment on a
loan.
• The missed payments is a temporary situation
or one that threatens to be permanent.
• Internationally, if the situation persists for
longer than ninety days, then the loan is
defined as an impaired asset or nonperforming
loan.
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PROBLEM LOANS AND PROVISION
• When a lending institution recognizes a problem loan, it
needs to raise provisions.
•A provision is recognition that income may not be
received on a loan.
• Lendinginstitutions raise three types of provision when
loans become impaired:
o Specific provision
o General provision
o Bad debt write-offs
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REGULATORY ISSUES
Term of payment in arrears amount of provision(%)

▪ Up to 90 days 0

▪ 90 days to less than 182 days 40

▪ 182 days to less than 273 days 60

▪ 273 days to less than 365 days 80

▪ 365 days and over 100

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DYNAMIC PROVISIONING
• First, the quality of the data need to be
good.
• Second issue one that is always important
when historical data are used to forecast
future events.

Bank do not want to damage their reputation

by admitting excessive bad debt.
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DEALING WITH DEFAULTS
We identify three type of potential default
situation and develop principles for dealing
with these situations.
• mild financial distress

• moderate financial distress

• severe financial distress
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MILD FINANCIAL DISTRESS
• Mild financial distress occurs when
companies experience temporary cash
flow shortages.
• As long as the loan does not stay in
arrears for longer than ninety days.
• In many instances, the cash flow
shortages are temporary and may be
rectified within days.
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MILD FINANCIAL DISTRESS
A number of remedies can be used in this instance
• The simplest approach is for the bank to agree
to an extension on the repayment, in
recognition of the temporary nature of the
situation.
• In most instances, the bank would charge
penalties to ensure there are disincentives to
prevent the situation arising again.

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MODERATE FINANCIAL DISTRESS
• In the case of moderate financial distress a
temporary cash flow shortage again.
• If the bank were to wind up the borrower then it
would generate a loss in the process.
• This loss would depend on the value of any
offered collateral.
• Or the lender to restructure the loan if more
beneficial than offered collateral.
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MODERATE FINANCIAL DISTRESS
Example
Little Company owes Big Bank $300. The
owner of Little Company has some special
skill to run the firm for $15. These special
skill result in the firm being worth $315 with
a probability of 0.8, otherwise zero. The
liquidation value of the firm is $200
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MODERATE FINANCIAL DISTRESS
The first option is to liquidate. Its
expected value is zero, so it would
prefer to liquidate and receive nothing.
Big Bank would receive $200 - a loss of
$100 – in liquidation, which is the
difference between the loan amount and
liquidation value.
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MODERATE FINANCIAL DISTRESS
The second option is to restructure the loan
to give the owner the incentive to continue.
The restructure is determined by calculating
the break-even amount of the loan, which
we will call x – that is, the circumstance
under which Little Company would continue:

0.8(315-x)+0.2(0) -15 = 0 17
THE CAPITALIZATION APPROACH
A loan of $296.25 would be better than
liquidation value of $200 and the owner
of Little Company would have the
incentive to continue. In these
circumstance, the bank loses $3.75
rather than $100.

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SEVERE FINANCIAL DISTRESS
• It normally funds its way into the provision
for doubtful debts of a bank.
• Severe financial distress is characterized
by a missed debt payment as well as the
borrower having an economic worth less
than the repayment schedule.
• The normal course of action is to wind up
the firm.
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EXAMPLE FROM THE LAW
• In many cases, restructure of debts will not be
possible and liquidation of the company will be the
only course of action.
• In most cases, a lender appoints a liquidator to wind
up a company that is not in a position to repay its
debt. If lender is secured, then actions will be taken
to sell the security to repay the lender.
• The situation is not so easy if the lender is not
secured. The liquidator assesses the amount that
can be recovered from asset sales. 20
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