Non Performing Loan (NPL)

In the simplest terms, a loan is a contract where a borrower agrees to pay back a specific amount of money over time, usually with interest. But what happens when that contract is broken? When a borrower stops making payments for an extended period, that loan changes its status in the bank’s books. It becomes a Non-Performing Loan (NPL).

A loan is typically classified as non-performing when the borrower is 90 days late on their payments. At this point, the bank can no longer expect to receive the full interest income it originally planned for.

Why NPLs matter to the financial system

While one person missing a payment is not a disaster for a bank, a high volume of NPLs can create a systemic problem. If too many loans stop performing at the same time, it clogs up the bank's ability to function.

• Banks are required to set aside extra cash (called provisions) to cover the potential loss of an NPL. This means they have less money available to lend to new, healthy businesses.

• Because the bank is not receiving interest on these loans and must spend money on debt collection or legal fees, its overall profits drop.

• When banks have too many NPLs, they often become more cautious and stop lending as much. This can make it harder for small businesses and families to get the credit they need to grow.

How regulators manage NPLs

The European Banking Authority (EBA) keeps a very close eye on the NPL ratios of banks across Europe. A high NPL ratio is often a warning sign that a bank's lending standards might have been too loose in the past.

1. NPL ratio:

This is the percentage of a bank's total loans that are non-performing. Regulators prefer to see this number as low as possible.

2. Forbearance:

Sometimes, if a borrower is in temporary trouble, a bank might change the terms of the loan to help them catch up. This is known as forbearance. However, even with these changes, the loan might still be flagged as a risk.

3. Secondary markets:

Banks often sell bundles of NPLs to specialized companies at a discount. This allows the bank to clean its balance sheet and focus on new lending again.

Interesting facts

• While 90 days is the standard for the EU, some regulators may flag a loan even earlier if it is highly likely the borrower will not be able to pay. This is a core part of the EBA Guidelines on the definition of default under Article 178 of the Capital Requirements Regulation.

• After the financial crisis, some European countries had NPL ratios of over 40%. Today, thanks to stricter rules, the average ratio across the EU is significantly lower.

• A loan can become an NPL even if the borrower hasn't missed a single day of payments. If a bank’s internal risk systems flag that a customer is facing severe financial distress, such as filing for bankruptcy, the bank must legally reclassify that loan as non-performing immediately.

• While NPLs are a problem for banks, they are a massive business for others. There is a global secondary market where specialized investment firms, often called distressed debt funds, buy billions of euros worth of these loans. They purchase them at a steep discount and then work directly with borrowers to find a way to settle the debt.

• During the 2020 pandemic, European banks built a massive wall of provisions, setting aside billions in anticipation of a wave of NPLs. Because of government support programs, many of those loans stayed healthy, leaving banks with a significant "capital buffer" once the crisis passed.

Further reading

To understand more about how banks manage risk and stay stable, you can read our entries on the Liquidity Coverage Ratio (LCR) and the Minimum Requirement for Own Funds and Eligible Liabilities (MREL). For the official regulatory view, visit the EBA page on credit risk.