In the realm of banking and finance, loans play a vital role in the economy by providing individuals and businesses with the necessary funds to meet their financial needs. However, lending money always carries a certain level of risk, and it is crucial for banks and financial institutions to effectively manage and classify their loan portfolios. Loan classification is the process of categorizing loans based on their credit quality and the likelihood of repayment. This classification helps institutions assess risk, make informed lending decisions, and determine the necessary provisions for potential losses.
Understanding Loan Classification in Nepal
There are primarily two types of loan classifications: performing loans and non-performing loans.
Performing Loan (सक्रिय कर्जा)
A performing loan refers to a loan where the borrower is making regular and timely payments of both principal and interest. These loans are considered healthy and low-risk for the lender. Performing loans are further categorized into two subcategories:
Pass Loan (असल कर्जा)
A pass loan represents a performing loan that is not overdue or has a delay of up to one month. These loans demonstrate a strong repayment track record, and the borrower meets their payment obligations promptly.
Watchlist (सुक्ष्म निगरानी)
Watchlist loans are performing loans that are slightly riskier than pass loans. They indicate a payment delay ranging from one to three months. These loans require closer monitoring to mitigate the potential risk of default.
Non-Performing Loan (निष्कृय कर्जा)
Non-performing loans are loans where the borrower has failed to make payments for a specified period, typically exceeding three months. These loans are considered higher risk for the lender, as there is a greater chance of default. Non-performing loans are further classified into three categories:
Sub-standard loans represent loans that have been overdue for a period of three to six months. The borrowers of these loans are significantly delayed in meeting their payment obligations, raising concerns about their creditworthiness.
Doubtful loans are loans that have been overdue for a period of six to twelve months. The likelihood of full repayment for these loans becomes highly uncertain, making them riskier for the lender.
Loss loans are loans that have been overdue for more than one year. These loans carry the highest risk of default, and it is highly unlikely that the lender will recover the outstanding amount. As a result, losses are recognized and provisions are made to account for the unrecoverable funds.
Loan Loss Provision
Loan loss provision is a crucial aspect of loan classification. It refers to the amount set aside by banks and financial institutions to cover potential losses arising from non-performing loans. The provision is calculated based on the loan classification and the associated risk level. The higher the risk of default, the greater the provision required.
The provision rates vary based on the loan classification:
- Pass Loan: Not overdue or overdue up to one month, requiring a provision of 1%.
- Watchlist: Overdue up to three months (i.e., one to three months), necessitating a provision of 5%.
- Sub-standard: Overdue up to six months (i.e., three to six months), requiring a provision of 25%.
- Doubtful: Overdue up to one year (i.e., six to twelve months), necessitating a provision of 50%.
- Loss: Overdue for more than one year, requiring a provision of 100%.
Additionally, when loans undergo restructuring or rescheduling, changes in loan timing and terms necessitate adjustments to the provision rates. The provision rates for such cases are as follows:
- Pass Loan: 12.5%
- Sub-standard: 25%
- Doubtful: 50%
- Loss: 100%
These provision rates ensure that banks and financial institutions adequately account for potential losses, safeguarding their financial stability.
A loan may be placed on a watchlist under the following conditions:
- Overdue up to 3 months: If the borrower has failed to make payments on time and the loan remains overdue for a period of up to 3 months, it may be added to the watchlist.
- Extending the loan period without renewing the loan: If the loan’s repayment period is extended without formally renewing the loan agreement, it could be considered a potential risk and added to the watchlist.
- Non-performing loan in other B&FIs: If the borrower has been listed as a non-performing loan in other Banks and Financial Institutions (B&FIs), indicating a history of default, their current loan may be placed on the watchlist.
- Negative cash flow for the last 2 years despite interest and fee payments: If the borrower continues to pay interest and fees on the loan, but their project has consistently generated negative cash flow for the past 2 years, it suggests financial instability and may lead to inclusion in the watchlist.
- Consortium/Syndicate loan of 1 Arab (100 Crore): If a single bank extends a loan amounting to 1 Arab (100 Crore) or more, it should typically be structured as a consortium/syndicate loan involving multiple banks. Failure to follow this practice could result in placing the loan on the watchlist.
- Non-compliance with NRB standards: If the borrower’s project fails to meet the standards set by the Nepal Rastra Bank (NRB), the regulatory authority, it can result in the borrower being listed in the watchlist.
Pass Loan Conditions
Loans that are considered as “Pass Loans” or “Genuine Loans” typically meet the following conditions:
- No overdue/overdue up to 1 month: The loan should not have any overdue payments or, at most, have overdue payments for a period of up to 1 month. This means that the borrower has been making timely repayments.
- Loan against the fixed deposit (FD): The loan is secured by a fixed deposit held by the borrower with the financial institution. The fixed deposit serves as collateral for the loan, reducing the risk for the lender.
- Loan against government securities and Nepal Rastra Bank (NRB) securities: The loan is provided against government securities or securities issued by the Nepal Rastra Bank. These securities act as collateral, ensuring the loan’s security and making it eligible for the “Pass Loan” category.
- Loan against gold and silver up to 10 lakhs: The loan is granted against the pledge of gold and silver assets, with the loan amount limited to a maximum of 10 lakhs. This type of loan is commonly offered by financial institutions, leveraging the value of precious metals as collateral.
Loss Loans / Problem loans conditions
Loans that are considered as “Loss Loans” or “Problem Loans” generally exhibit the following conditions:
- The market price of the collateral cannot secure the loans: The value of the collateral pledged by the borrower is insufficient to cover the outstanding loan amount. This means that if the collateral were to be sold in the market, it would not be enough to recover the loan.
- The debtor is bankrupt or has been declared bankrupt: The borrower has been legally declared bankrupt, indicating their inability to repay the loan due to severe financial distress.
- The debtor disappears or is not identified: The borrower is missing or cannot be located, making it challenging to recover the loan or communicate with them regarding repayment.
- The loan is misused (used for a different purpose): The borrower has utilized the loan funds for purposes other than the intended use, potentially indicating mismanagement or fraudulent activities.
- Debtor blacklisted by the Credit Information Bureau (CIB): The borrower has been listed as a defaulter or has a negative credit history in the Credit Information Bureau, suggesting a high credit risk and likelihood of loan default.
- The project/business is not in a condition to be operated or not in operation: The project or business for which the loan was granted is either not operational or in a state where it cannot generate sufficient income to repay the loan.
- Double financial statement submission by the debtor: The borrower submits two different financial statements for the same specific period of time, indicating potential discrepancies or fraudulent reporting of financial information.
- Credit card loan not written off within 90 days of the deadline’s expiry: If a credit card loan remains unpaid beyond 90 days after the repayment deadline, it may be categorized as a loss loan due to prolonged delinquency.
Restructuring and Rescheduling Condition
Restructuring and rescheduling of loans typically occur under the following conditions:
- When a customer submits a written action plan along with the required documents: The borrower provides a detailed written plan outlining how they intend to address their financial difficulties and repay the loan. This plan is usually accompanied by the necessary supporting documents.
- The bank should assure that the customer can repay the loan: The financial institution evaluates the borrower’s financial situation and determines that, with the proposed restructuring or rescheduling, the borrower will have the capacity to repay the loan in the future.
- The customer should pay at least 25% of the total interest until the application submission: As a sign of their commitment to repaying the loan, the borrower is required to make a payment of at least 25% of the total interest accrued on the loan up to the point of submitting the application for restructuring or rescheduling.
- There should be enough collateral: The borrower must provide sufficient collateral to secure the loan. The collateral serves as a guarantee for the repayment of the loan and helps mitigate the lender’s risk.
Effective loan classification and loan loss provision are vital for banks and financial institutions to manage their loan portfolios and mitigate potential risks. By categorizing loans based on their credit quality and likelihood of repayment, institutions can make informed lending decisions and allocate provisions accordingly. Understanding the various loan classifications, such as performing loans (pass loans and watchlist loans) and non-performing loans (sub-standard, doubtful, and loss loans), allows lenders to assess risk and establish appropriate provisions. By adhering to the provision rates based on loan classification and incorporating adjustments for restructuring or rescheduling, financial institutions can maintain stability and navigate potential loan losses more efficiently.
Remember, having a robust loan classification and loan loss provision framework is essential for banks and financial institutions to thrive in a dynamic and ever-evolving lending landscape.
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