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Bank credit is the main source of funds necessary to ensure the activity of various sectors of
national economy. Bank credit has an important role in promoting international economic relations and
also has a significant role in raising living standards. It is true that credit can be very useful and can
generate many benefits but also credit can be very dangerous when is not used in accordance with its
principles and requirements of financial and economic balance. A risk can be the so-called over-
crediting which lead to large economic, financial and monetary disequilibrium. Another risk can be
under-crediting that stipulates the use of credit in order to finance some economic activities that are
insufficiently grounded and this may cause structural disequilibrium in entire economy. Crediting
activity can generate not only good credits but also bad one because of the wrong management risk.
Bad credit is a term used to describe a poor credit rating.
Non-performing assets, also called bad credits, are credits, made by a bank or finance company,
on which repayments or interest payments are not made on time. Banks usually treat assets as bad if
they are not serviced for some time. If payments are late for a short time the credit is classified as past
due. Once a payment becomes really late (usually 90 days) the credit is classified as bad. The issue of
bad credits has gained increasing attentions in the last few years. The immediate consequence of large
amount of bad credits in the banking system is bank failure. Many researches on the cause of bank
failures find that asset quality is a statistically significant predictor of insolvency and that failing
banking institutions always have high level of bad credits prior to failure. It is argued that bad credits
are one of the major causes of the economic stagnation problems. If these credits are kept existing and
continuously rolled over, the resources are locked up in unprofitable sectors thus, hindering the
economic growth and impairing the economic efficiency.
There are many factors that could generate the appearance of bad credits. The appearance of
bad credits is rather the result of action of more combined factors than only one single. Many of these
factors are out from the sphere of control of the bank. A single factor - the mistakes committed by the
bank employee - can be kept at a minimum, only if the credit officer analyzed attentively each stage of
the crediting process. It is known that there are many causes that can favor the appearance of bad
credits but still the most important remains the unqualified bank staff. The main causes of appearance
of bad credits are presented in the next scheme (scheme 1.1.1):
Scheme 1.1.1
The main causes of appearance of bad credits
I II III
Inappropriate financial
analysis Inadequate initial Economic Recession
capitalization
Wrong guarantee of
Inappropriate
credit
financial control
Incorrect or incomplete
documentation
Source: elaborated by the author
Categories
Good Of Bad
Credits Credits Credits
Under- Substandar
Standard supervision d Doubtful
Compromised
Further we will analyze more thoughtfully the bad credit category. Each bad credit according to
the level of risk must be included by the bank in one of the next groups:
* Substandard credits- this are credits which are granted to the customers with a satisfactory
economical-financial situation, but now the worsening trend of activities is obvious and there also
exists a risk of inability to fully repay its debt to the bank. There exists the risk that losses will be
higher than the credit and this risk can be caused by one of the next factors: the financial situation of
the debtor is unfavorable or it is worsening; credit insurance is insufficient or it is worsening; other
unfavorable factors, concerning the debtor's inability to repay the loan in accordance with existing
conditions for repayment. Typically, substandard credits take the form of long term credits granted to
customers of whose cash flows might be insufficient for satisfying their obligations or the outstanding
credits, and also take the form of short term credits granted to customers that are significantly
undercapitalized. Substandard credits could also include short term credits granted to customers for
which the cycle stocks-receipts are insufficient for credit repayment at maturity. Such credits require a
special attention from the bank management, because exists the probability that the bank will face
losses if shortcomings will not be removed.
* Doubtful credits- are uncertain loans in terms of repayment of loans and interest payment. Borrowers’
activity is unprofitable so they can not ensure the necessary funds for honoring their debts. Probability
of loss is extremely high, but there are important factors, concrete and well argued and soon they will
be able to contribute on improving the situation of loan repayment.
* Compromised credits (losses) - are those loans that present a risk to the bank. Unprofitable activity of
the borrowers determines their incapacity to honor their obligations to the bank and consequently the
bank will not be unable to protect against the risk of non-payment. The amount of resources necessary
for reservation in accounts of reduction for losses on credits is formed from the amount of credits from
each category of classification in the following sizes:
A – Standard – 2%
B –Under-supervision – 5%
C – Substandard – 30%
D – Doubtful – 60%
E – Compromised – 100%
According to reimbursement deadlines established through contracts the credits can be:
- Current, on which the set terms through contract and the related interests haven’t reached the maturity
or the rates have been paid to the terms agreed in the contract;
- Credits with delayed maturity, on which the due rates or the interest haven’t been paid at the
contractual deadline, being delayed by up to 30 days;
- Outstanding credits, on which the interest rates of the credit exceeded the deadline with more than 30
days.
Table 1.2.1
Source: elaborated by the author based on the book Money, Credit, Banking by Basno
Caesar, Dardac Nicolae, Constantin Floricel, E.D.P. Bucharest, 1999
Types of
Warning Signals
2. Management signals
• Previous bankruptcy;
• Missing or frequent changes in the structure of society;
• The company is fragmented into smaller departments interconnected operational poorly;
• Changes in attitude toward the bank or toward the credit officer, especially the lack of cooperation;
• Ungrounded answers at the bank signals;
• Changing the management personnel, the owners or the key personnel;
• Illness or death of the key staff;
• Problems with labor force;
• Failure of business planning;
• Misunderstandings between the management or between partners;
• Venturing into new, uncertain operations;
• Negative publicity.
These clauses must be respected because otherwise it can result the contract termination.
The appearance of many bad credits can be avoided by a prompt identification of the difficulties
and through their remediation. When the credit officer confronts with the appearance of a bad credit, he
must take immediate actions according to the bank rules. The bad credits management procedures must
be specific for each credit and customer individually.
Crediting activity is the most important banking operation. The way the bank allocates the
funds that it manages can decisively influence the economic development at local or national level. On
the other hand, any bank assumes some risks when grants credits and, obviously, all banks are currently
recording losses on credit portfolio, when some borrowers do not honor their obligations. Whatever the
level of risk assumed would be, credit portfolio losses can be minimized if crediting operations are
professionally organized and managed. It is important to analyze each credit according to the risk in
order to know its quality and in which group to include a specific credit. According to the risk an
analysis of credit portfolio can provide information about the accuracy of models of estimation the
credit risk, and this in the stage of granting credits it’s a post-fact of analytical action. For estimating
the overall level of credit risk, assumed by the bank, it can be calculated the insurance coefficient
against the credit risk by reporting the risk fund formed through the breakdowns of those five types of
credits classified on reduction for losses on assets and the provisions for losses on conditional
engagements:
Fund risk
K1 = * 100% (1)
Credit portfolio
This coefficient can be used for detecting the credit risk in the collaboration stage with the
debtor, at the moment of evaluating the minimum amount of the fund risk. A positive trend in credit
risk management at a portfolio level constitutes the reduction of this coefficient over the analyzing
period of the banking activity. According to the international requirements of crediting the global fund
risk must be < or = to 15%, because the credit portfolio is very risky. The situation of this indicator
between the limits 10-15% will describe exposure of the credit portfolio at a high risk, between the
limits 5-10% will be at an acceptable level and till to 5% is a safe portfolio.
The level of credits classified as bad represents the total sum of credits classified in the
categories substandard, doubtful and compromised. A comparison of the level of credits classified bad
over an analyzing period it will indicate the negative trends in the credit portfolio quality and this may
require an increase in the breakdowns on reduction for losses on assets and the provisions for losses on
conditional engagements.
Bad credits
K2 = * 100% (2)
Credit portfolio
In order to be more clearly, we must compare the value of bad credits with Total
Normative Capital and Total Assets.
Bad credits
K3 = * 100% (3)
TNC
Bad credits
K4 = * 100% (4)
Total Assets
A current rule, in Republic of Moldova, at the actual moment, consists that if the total credits
classified as bad exceed 50% from the TNC, then the quality of assets is categorically lower.
Another helpful analysis of the coefficient is to compare the level of expired credits with total
credits. Normally, when the expired credits represent 20% or more from the credit portfolio of the
bank, then the quality of assets is lower and any percentage over 40% it’s a serious problem for the
bank.
Expired credits and those in conditions of non accumulating interest are:
• Doubtful and compromised credits;
• Credits with the expired term of 60 days or more;
• Credits payable at sight, at which the first payment of interest it was expired;
• Credits repaid by equal partial payments, on which the amortization rate of the credit was
expired.
Expired credits
K5 = * 100% (5)
Credit portfolio
By analyzing these formulas we can draw a conclusion about how well a bank conducts its
activity, how looks her credit portfolio and if it is a safe one.