Problem Loan Ratio

What Is the Problem Loan Ratio?

The problem loan ratio is a ratio in the banking industry that compares the percentage of problem loans to the percentage of sound loans. In the banking and credit markets, a problem loan is one of two things: a commercial loan that is at least 90 days past due, or a consumer loan that is at least 180 days past due.

A problem loan is also referred to as a nonperforming asset. The problem loan ratio is ultimately a measure of the health of the banking and lending industries, and the economy as a whole. A higher ratio means a greater number of problem loans and vice-versa. Problem loans reduce the amount of capital that lenders have for subsequent loans.

If a bank has 500 loans and 10 of them are problem loans — late commercial loans (90 days past due date) or late consumer loans (180 days past due date) — the problem loan ratio for this bank would be 1:50, or 2%.

Understanding the Problem Loan Ratio

Banks try to keep their problem loan inventories low because these types of loans can lead to cash flow problems and other issues. If a bank is no longer able to manage its outstanding debt, it could lead to the closure of the bank.

Once a borrower begins to be late with payments, the financial institution typically sends notices to the borrower; the borrower is then required to take action to get the loan current. If the borrower does not respond, the bank can sell assets and recover the balance of the loan. Problem loans can often result in property foreclosure, repossession, or other adverse legal actions.

If a company is having difficulty meeting its debt obligations, a lender may restructure its loan. This way, the institution can still maintain some cash flow and may be able to avoid having to classify it as a problem loan.

If borrowers want to negotiate with the bank to make a problem loan current again, a bank representative can meet with them to discuss the outstanding balance.

The problem loan ratio can be broken down by the level of delinquency of loans, such as those less than 90 days past due versus those more severely in arrears.

History of the Problem Loan Ratio

As markets weaken, it is not uncommon for the problem loan inventory to increase as people struggle to make their loan payments. High rates of foreclosures, repossessions, and other legal actions may reduce bank profits.

The Great Recession and the Rise of the Problem Loan Ratio

The problem loan ratio increased across the board during the Great Recession from 2007 to 2009. During this time, the subprime fallout led to a rise in the number of problem loans that banks had on their books. Several federal programs were enacted to help consumers deal with their delinquent debt, most of which focused on mortgages.

Prior to the Great Recession, in the early 2000s, there was an unprecedented run-up in American household debt. There was also a dramatic increase in mortgage lending, especially in the private market. (The share of loans that were insured by government agencies began to decline.) However, as home prices began to fall, it resulted in a massive wave of mortgage defaults as consumers struggled to meet their debt obligations. This steep increase in problem debt greatly contributed to the onset of the recession.

Many consumers were sold mortgage products that were not suitable or appropriate for them. For example, many borrowers were offered hybrid adjustable-rate mortgages (ARM) with very low, initial interest rates that were meant to entice them. While these products may have made homeownership appear affordable at the outset, after the first two or three years the interest rates increased. The structure of these mortgages required many borrowers to either refinance or qualify for an additional loan in order to meet their debt obligations. However, as home prices started to fall and interest rates rose, refinancing effectively became impossible for many borrowers, and, thus, they defaulted on these loans.

Since the 2000s financial crisis and the Great Recession, stricter lending requirements have been introduced. This has helped to curb predatory lending practices — including not properly explaining the terms of a loan to a borrower — and poor regulation of the financial sector.