The management of credit risk entails the necessity of the analysis of the way the quality of the credit portfolio evolves in time. The rating of the quality of assets reflects the potential risk of loans, of investment and of other assets, as well as of the off-balance sheet transactions. The evaluation of the quality of assets must be also analyzed depending on their level of provisions, also it is necessary to consider all other risks that can affect the capitalization of the assets of the bank, including the operational, market, reputation and strategy risks

Andrieș, Alin Marius

Cocriș, Vasile

Popescu, Maria

English

Danubius University, Romania: Danubius Journals

 E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  59      The impact of quality of loans on the performance of banks  Andrieş Alin Marius1, Cocriș Vasile2, Popescu Maria3  1Alexandru IoanCuza University of Iasi, alin.andries@uaic.ro 2Alexandru IoanCuza University of Iasi, vcocris@uaic.ro 3Alexandru IoanCuza University of Iasi, mariutza_82@yahoo.com   Abstract. The management of credit risk entails the necessity of the analysis of the way the quality of the credit portfolio evolves in time. The rating of the quality of assets reflects the potential risk of loans, of investment and of other assets, as well as of the off-balance sheet transactions. The evaluation of the quality of assets must be also analyzed depending on their level of provisions, also it is necessary to consider all other risks that can affect the capitalization of the assets of the bank, including the operational, market, reputation and strategy risks. Keywords:performance, banks, non-performing loans   1 Introduction  The management of credit risk entails the necessity of the analysis of the way the quality of the credit portfolio evolves in time. The rating of the quality of assets reflects the potential risk of loans, of investment and of other assets, as well as of the off-balance sheet transactions. The evaluation of the quality of assets must be also analyzed depending on their level of provision, also it is necessary to consider all other risks that can affect the capitalization of the assets of the bank, including the operational, market, reputation, strategy risks and others. The management’s capacity is reflected by the extent to which it manages to identify, follow and control these risks. Credit risk analysis can be realized from two perspectives:  – Individual credit risk through which the probability of insolvency of the debtor or of non-reimbursement of the amounts employed by him is captured. The assuming by the bank of the individual credit risk entails that, that bank introduces in costs, the losses resulting on due date from the non-payment of the obligations its debtor has.  – Global credit risk which gives expression to the probability of deterioration of the quality of the employed bank assets. The global risk of insolvency is an increasing function of the mass of granted loans, of the interest rate and of the national economic environment. Moreover, with the increase of the volume of loans, the  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  60 cases of insolvency increase in accelerated proportion, expression of the fact that the increase of the proportions of the loan brings within the debtors a growing number of persons, potentially insolvent. Also, the increase of the interest rate, on the background of an overheating of economy constitutes another factor for the amplification of global insolvency. Preoccupied with countering the negative effects that the occurrence of this risk might have, banks have reacted by constituting, over time, a system of complex actions, through which its management is founded.  2 The effects of non-performing loans on the activity of the bank  As mentioned before, non-performing loans are costly for the banks. The provisions constituted by increasing expenses only show us part of the negative effects. Aside from these, there are other aspects, less visible, but with the same negative effect on the profitability of the bank. Here are some examples: a) deterioration of the bank’s image and reputation. As known, a bank’s success is ensured by the trust it inspires to its investors and clients. Based on this, the bank can attract funds from the market and develop its activity.  From the deponents’ point of view, trust is the main reason for choosing a bank. Without the certainty that they will receive their money back on the first request, no one will no longer deposit money to a certain bank, even if the interest offered are very attractive. The trust in a bank is tied to its reputation – a subjective perception from the persons who come into contact with the bank and which is created based on a heterogeneous mixture of factors that refer to the size of the financial institution and quality of the products and services. The rumors about the inappropriate management of these funds and the existence of a significant portfolio of non-performing loans determine clients to withdraw their deposits, which in the end lead to incapacity of payment and bankruptcy. In the banking environment it is appreciated that the value of each bank rests on three pillars: capital, management and reputation. As such, the loss of reputation constitutes maybe the greatest risk for a bank, and its effects might be: • loss of the trust of deponents – leading to the withdrawal of deposits and being able to generate the decrease of incomes, increase of costs concerning attracting resources, crisis of cash and finally, even the bankruptcy of the bank; • loss of the support of shareholders – which can be manifested including through their refusal to participate to the increase of the social capital when the bank goes through financial difficulties; • loss of the trust of the supervision authority – having as extreme consequence the withdrawal of the functioning authorization. Reputational risk – the risk of registering financial losses as a result of the disappearance of the public’s trust – represents the main channel of contagion through which system risk is manifested. The problems emerged at one or several banks – and which would normally affect only these – can lead to the perception that the entire system is in danger, engaging requests for withdrawal of deposits to other banks as well. To the extent that some of these find themselves in difficulty as well, the withdrawals tend to get amplified, gaining accents of panic and leading to the escalation of the problems until the entire system can be endangered. b) increase of administrative expenses. A non-performing loan requires a great attention from the employees of the bank. Thus, banks, especially the large ones, were obligated to constitute specialized departments to follow and recover  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  61 non-performing receivables. Practice shown that the time consumed with following a non-performing loan is the same with the one for following ten current loans. c) decrease of the morale of employees. A bank that becomes unprofitable because of non-performing receivables is in impossibility of remunerating its employees, even more, there are situations when they are fired (a typical example was with the Banca Agricola). In this situation, the best employees „leave the ship”. The bank finds itself in the situation to pay for training other employees who take their place or to offer higher salaries in order to attract employees from outside the bank. d) increase of the expenses destined for the initiation and performing of judicial procedures for the recovery of receivables. The great banks, aside from a considerable law department, also created a body of administrators for the recovery of non-performing loans. There are also situations when, following the repos, a lower value is recovered owed to the fact that the court expenses have priority. e) increase of expenses owed to the introduction of new procedures or regulations. In the situation of the existence of a high portfolio of non-performing loans, the commercial bank becomes an object of the controls performed by the National Bank, being necessary numerous reports and explanations given to the control organs that represent additional expenses for the bank, its employees having to work for the control organs. Also, the bank has to take additional prudential measures for granting new loans, which can lead to the loss of some clients unsatisfied with the delays caused by the new measures which imply the centralization of competencies. Of course, the non-performing loans produce numerous problems for the business environment as well, leading to financial blockage and implicitly to the increase of costs through the necessity of new sources attracted as a result of the decrease of money circulation, owed to blockages. The end is maintaining the economy in a prolonged recession, and the solution can only be eliminating the non-performing loans producers. As shown, loans are classified, according to their quality, into five categories. There are included in the category of non-performing loans, the loans classified as „substandard”, „doubtful” and „loss”. Loans, even arrear, do not become non-performing unless the conditions for their integral reimbursement and for the paying of interest and commission owed are no longer ensured.  This means that the taking of special measures will be necessary, if needed even the initiation of judicial procedures for the recovery of receivables. Certainly, the beneficiary of a non- performing loan can only be for the bank a non-performing client, who now or in the future is not or will not be able to pay his debts in time. From these short definitions, both the potentiality and the certainty of the existence of the non-performing loan are noticed. That is why, the early finding of the so-called warning signs that show that the loan has become a problem and its recovery is absolutely necessary before the debt accumulates is so important.  Unfortunately, the current legislation in Romania is favorable to the debtor, in the sense that the initiation of judicial procedures automatically means taking off-balance sheet the receivable and putting in expenses the difference for which there is no provision constituted. An exhaustive list of the causes for the emergence of non-performing loans would be impossible to put together. In most cases, a non-performing loan is determined by several factors instead of a single cause. The action of several factors cannot be influenced by the bank.  Finding the causes that provoke non-performing loans and establishing some adequate measures to eliminate these causes largely depends on the method of organization and on the experience of each  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  62 bank in part and ultimately on the training, talent and feeling of the staff engaged in the lending activity.  3. The effects of non-performing loans on the performance of the banking systems  The analysis of the non-performing loans on the bank performance can be performed both at macroeconomic level – at the level of banking system – and at microeconomic level – at the level of commercial banks. In the financial crisis periods the impact of non-performing loans at system level present a greater interest because their level can influence the stability of the banking system and that of the financial system. At the level of the European banking systems the average level of Non-performing loans and of bank Provisions for non-performing loans registered for the period 2004-2009 the following values: Table no.1 Average values of the indicators Non-performing loans and of bank; Provisions for non-performing loans registered for the period 2004-2009 Country Non-performing loans/total loans ratio Bank provisions for non-performing loans Austria 2,4000 70,1833 Belgium 1,9167 53,7833 Bulgaria 2,8333 111,1667 Czech Republic 3,8333 65,4000 Denmark ,4250 70,8500 Estonia 1,3667 140,1200 Finland ,3400 82,1500 France 3,2400 153,1000 Germany 3,5400 50,1333 Greece 5,9000 53,2167 Ireland 2,1833 59,7500 Italy 5,4167 47,1667 Latvia  3,8500 93,8333 Great Britain 1,6000 47,6600 Holland 1,1667 63,5667 Poland 8,3167 58,4400 Portugal 1,8333 76,0333 Romania 6,4667 47,1500 Slovakia 3,4667 88,8167 Slovenia 2,3167 81,1833 Spain 1,9500 198,9833 Spain 1,0500 60,5667 Hungary 2,9833 63,4333 Average 3,0555 80,1739 Source: IMF - Global Financial Stability Report, Financial Soundness Indicators, April 2010  It can be noticed that for the period 2004-2009 the average level of the non-performing loans in  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  63 Romania registered a value superior to the European average level. At the level of the Romanian banking system it is noticed, from the following graph, that the level of non-performing loans registered a continuous growth since 2005 until 2009. This phenomenon was owed, especially, to the significant increase of the level of total loans granted by Romanian banks.  Fig. no.1 Evolution of non-performing loans and of bank provisions for non-performing loans in Romania for the period 2004-2009  At the level of bank provisions for non-performing loans there can be noticed for the analyzed period a significant increase, followed by a decrease at the level of the year 2009. Table no. 2. Average values of the indicators Profit/assets and Profit/capital for the period 2004-2009 Country Profit/assets Profit/capital Austria ,5333 12,3833 Belgium ,1167 5,1167 Bulgaria 2,0000 20,7833 Czech Republic 1,3167 24,5833 Denmark 1,2000 20,6500 Estonia ,4833 7,8667 Finland ,9400 11,7600 France ,4200 9,0400 Germany ,1800 5,1000 Greece ,5833 9,6167 Ireland ,8500 18,9500 Italy ,6400 10,1800 Latvia  ,7833 10,2333 Lithuania ,3333 5,3167 Luxembourg ,6500 14,3500 Malta 1,1600 10,8000 Great Britain ,3167 4,2500 Holland ,2333 8,8333  0 10 20 30 40 50 60 70 2004 2005 2006 2007 2008 2009  Non-performing loans/total loans ratioBank provisions for non-performing  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  64 Poland 1,5333 19,2333 Portugal ,7333 11,9500 Romania 1,5500 13,3500 Slovakia 1,0667 14,0833 Slovenia 1,0000 11,9000 Spain ,8333 16,1167 Spain ,6333 15,8500 Hungary 1,2167 19,7333 Average ,8190 12,6946 Source: IMF - Global Financial Stability Report, Financial Soundness Indicators, April 2010  There can be noticed that the average profitableness registered by the banks in Romania, both the one reported for total assets and the one reported for own capital, is above the average registered by the banks in the European Union.  Fig. no. 2Evolution of the ROA and ROE indicators at the level of banks in Romania for the period 2004-2009  From the graph above it con be noticed that for the analyzed period the banks in Romania registered a decrease of the ROA and ROE indicators, especially in the year 2009. In order to analyze the connection between non-performing loans and the performances of the banks we will use the regression and correlation analysis.  Table no. 3. Indicators of the correlation analysis  Non-performing loans/total loans ratio Bank provisions for non-performing loans Profit/ assets Profit/ capital Non-performing loans/total loans ratio  Pearson Correlation 1 -,315(**) -,366(**) -,435(**) Sig. (2-tailed)  ,001 ,000 ,000 N 146 115 143 143 Bank provisions for non-performing loans Pearson Correlation -,315(**) 1 ,172 ,171 05101520252004 2005 2006 2007 2008 2009ROA ROE E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  65 Sig. (2-tailed) ,001  ,069 ,069 N 115 115 113 113 Profit / assets  Pearson Correlation -,366(**) ,172 1 ,908(**) Sig. (2-tailed) ,000 ,069  ,000 N 143 113 147 147 Profit / capital Pearson Correlation -,435(**) ,171 ,908(**) 1 Sig. (2-tailed) ,000 ,069 ,000  N 143 113 147 147 **  Correlation is significant at the 0.01 level (2-tailed).  From the table above it is noticed that at the level of the European banking systems there is an inverse relation between the level of non-performing loans and the level of bank performances, no matter the used indicator ROE or ROA. It is noticed thus that an increase of the level of non-performing loans determined a significant decrease of the level of the ROA indicator (value of the Pearson correlation indicator – 0,366) and an even greater decrease of the ROE indicator (value of the Pearson correlation indicator – 0,435). Table no. 4. Indicators of the regression analysis – Dependent ROA variable  Model Unstandardized Coefficients Standardized Coefficients t Sig. B Std. Error Beta   (Constant) 0,151251 0,557198  0,27145 0,786573 Indicator regarding the adequacy of capital  -0,02328 0,043183 -0,0537 -0,53905 0,590982 Capital/Assets ratio 0,190181 0,054924 0,348285 3,4626 0,000773 Non-performing loans/total loans ratio -0,09344 0,034205 -0,26759 -2,73177 0,007381 Bank provisions for non-performing loans 0,0005 0,002031 0,024349 0,246033 0,806132  From the performed regression analysis there can be noticed that the ROA indicator is influenced by the level of non-performing loans and the ratio between the level of capital and the level of assets.  4 Conclusions  In the past decades, most countries in Central and Eastern Europe have adopted structural reforms in view of increasing the size, stability and efficiency of financial systems. The opening towards the outside and the internal structural reforms of the financial sector are two independent processes, both having as purpose the development of a competitive and efficient financial system, in order to facilitate economic growth. The results of the performed analysis show us that, for the analyzed period, at the level of the European banking systems there is an inverse relation between the level of non-performing loans and the level of banks performance. This means that an increase of the level of non-performing loans  E u r o E c o n o m i c a  Issue 3(29)/2011                                                                                               ISSN: 1582-8859   FINANCIAL RELATIONS  66 determined a significant decrease of the level of the ROA indicator and an even greater decrease of the ROE indicator.  5 Acknowledgements  This work was cofinanced from the European Social Fund through Sectoral Operational Programme Human Resources Development 2007-2013, project number POSDRU/89/1.5/S/59184 „Performance and excellence in postdoctoral research in Romanian economics science domain”  6 References Beitel, P., Durr, J., Pritsch, G., Stegemann, U. – Actively Managing the Credit Portfolio. în Banking in a Changing World. New York: McKinsey & Company, 2006 Bessis, J. – Risk management in banking,  John Wiley & Sons Ltd, 2002 Busch, A. – Banking regulation and globalization, Oxford University Press, 2009 Felsenheimer, J., Gisdakis, P., Zaiser, M. – Active Credit Portfolio Management.A Practical Guide to Credit Risk Management Strategies. John Wiley & Sons, 2006 Gregoriou, G., Hoppe, C. – Handbook of Credit Portfolio Management, McGraw Hill, 2008 Ridder, T. – Implementing credit portofolio management, în: Greg N. Gregoriou / Christian Hoppe: „Handbook of Credit Portfolio Management”, McGraw Hill, 2008 IMF - Global Financial Stability Report, Financial Soundness Indicators, April 2010    

The impact of quality of loans on the performance of banks

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The impact of quality of loans on the performance of banks

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