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Not All NPLs Are Created Equal

December 18, 2015

By Walter Yao

As most banking institutions are primarily engaged in making loans, credit quality is a key aspect of an institution’s overall soundness. Arguably the most widely used measure for gauging the quality of an institution’s loan portfolio is the reported nonperforming loan (NPL) ratio. In the United States, nonperforming loans are defined as loans past due more than 90 days and nonaccrual loans (i.e., loans on which a bank has ceased to accrue interest). But not all countries use the same definition. Technically, an NPL is a regulatory rather than an accounting concept. As such, the NPL definition is typically determined by the regulatory authority or authorities within each jurisdiction. This can lead to misunderstandings as NPL ratios are not necessarily comparable across borders and definitions can change over time.

Prior to the 1997-98 Asian Financial Crisis, Asian regulators most commonly used loans180 days past due as the benchmark for determining nonperforming loans. Since then, Asian economies have come a long way in enhancing the disclosure of nonperforming loans and tightening reporting standards. Today, most have adopted the more stringent 90-day benchmark to better reflect their banks’ credit quality.

Take Japan as an example. In 1999, Japanese authorities introduced a set of comprehensive disclosure requirements in response to criticism that insufficient disclosure requirements might have contributed to the under-reporting of problem credits during the Asian financial crisis (a Bank for International Settlements (BIS) paper published in October 2001 provides a good summary of the issue). Regulators from Japan currently require banks to disclose three different types of nonperforming loans. 

The table below shows the various asset quality measures used by regulators in several Asian economies.

Table 1: Asset quality measures reported by banks in different jurisdictions

China Chinese banks report “nonperforming loans” that are defined as the sum of “substandard,” “doubtful,” and “loss” loans. In addition, they report rescheduled loans, as well as overdue loans in four categories, based on the length of time they have been past due.

Source: China Banking Regulatory Commission; China Construction Bank and Industrial Bank 2014 Annual Report
Hong Kong Hong Kong banks report “loans overdue more than 3 months and rescheduled loans” and their internally classified loans (i.e., pass, special mention, substandard, doubtful, and loss).

Source: Hang Seng Bank and Shanghai Commercial Bank 2014 Annual Reports
Taiwan Taiwanese banks report nonperforming loans that are defined as “loans for which the principal or interest has been in arrears for three months or more, and those loans which the principal or interest has not yet been in arrears for more than three months, but with regard to which the bank has sought payment from primary/subordinate debtors or has disposed of collateral.”

Source: Taiwan Financial Supervisory Commission
Korea Korean banks report nonperforming loans that are defined as “substandard,” “doubtful” and “estimated loss.” The NPL ratio is also referred to as the “substandard and below” ratio. In addition, Korean banks report the “delinquency ratio” which is defined as loans delinquent for more than a month.

Source: Hana Financial Group and Shinhan Financial Group 2014 Annual Reports
Japan Japanese banks report three types of nonperforming loans, namely, “risk management loans,” “loans disclosed under the Financial Reconstruction Law,” and “loans subject to self-assessment.” For the definition of each NPL category, please refer to the BIS report below.

Source: BIS Paper No 22: Non-performing loans and the real economy: Japan’s experience
China Chinese banks report “nonperforming loans” that are defined as the sum of “substandard,” “doubtful,” and “loss” loans. In addition, they report rescheduled loans, as well as overdue loans in four categories, based on the length of time they have been past due.

Source: China Banking Regulatory Commission; China Construction Bank and Industrial Bank 2014 Annual Report
Hong Kong Hong Kong banks report “loans overdue more than 3 months and rescheduled loans” and their internally classified loans (i.e., pass, special mention, substandard, doubtful, and loss).

Source: Hang Seng Bank and Shanghai Commercial Bank 2014 Annual Reports
Taiwan Taiwanese banks report nonperforming loans that are defined as “loans for which the principal or interest has been in arrears for three months or more, and those loans which the principal or interest has not yet been in arrears for more than three months, but with regard to which the bank has sought payment from primary/subordinate debtors or has disposed of collateral.”

Source: Taiwan Financial Supervisory Commission
Korea Korean banks report nonperforming loans that are defined as “substandard,” “doubtful” and “estimated loss.” The NPL ratio is also referred to as the “substandard and below” ratio. In addition, Korean banks report the “delinquency ratio” which is defined as loans delinquent for more than a month.

Source: Hana Financial Group and Shinhan Financial Group 2014 Annual Reports
Japan Japanese banks report three types of nonperforming loans, namely, “risk management loans,” “loans disclosed under the Financial Reconstruction Law,” and “loans subject to self-assessment.” For the definition of each NPL category, please refer to the BIS report below.

Source: BIS Paper No 22: Non-performing loans and the real economy: Japan’s experience

This table also shows that the definition of nonperforming loans and the level of disclosure vary from jurisdiction to jurisdiction. Therefore, when reviewing a bank’s disclosed NPL information and conducting a comparative analysis, users of financial statements should first know the definition of nonperforming loans in each specific jurisdiction. Failure to factor into these differences may lead to inaccurate conclusions about the relative credit quality of the banking sector in each economy. 

This matters for U.S. regulators too. In fact, as part of the supervisory process pertaining to foreign banking organizations that operate in the United States, U.S. regulators analyze the consolidated financial strength of the foreign bank to ensure that the head office can provide appropriate financial support to the U.S. operation in case of need. The review includes understanding the key accounting and regulatory standards. Obviously, the NPL definition needs to be taken into account when assessing the asset quality of the foreign banking organization.

In summary, it is important to understand how an NPL is defined, especially when comparing financial statements from banking institutions in different countries. From a regulatory perspective, having a more comprehensive disclosure requirement and using a more uniform definition of nonperforming loans would greatly enhance the transparency and effectiveness of the cross-border supervisory process. That being said, it’s important to keep in mind the nonperforming loan ratio is only one of several gauges of asset quality. An overall assessment of credit quality goes beyond just focusing on the NPL ratio.