IMPACT ON REPORTED EARNINGS, BALANCE SHEETS AND RATIOS

Interpreting reported NPL and NPL cover ratios is fraught with uncertainty and ambiguity. The use of common ratios to compare asset quality and NPL cover between banks in different countries is plagued with definitional issues related to problem loans, provision accounts and loans:

Provision accounts. There are also differences in the definitions and use of specific and general provision accounts. There are also differences in practices within the same accounting standards that may have a material impact on derived ratios. Loans. The definition of gross or total loans as reported on the balance sheet varies between countries. The most common differences relate to whether or not interest receivables, lease financing and commercial paper are included in the definition of loans. Other differences may arise depending on how banks treat exposures to other banks and financial institutions.
This proliferation of definitions and varying degrees of conservatism in defining loans as impaired makes meaningful comparisons of NPL levels and cover between banks in different countries, and even within the same country, difficult.
A further complication is created when banks report related ratios without giving either clear definitions of numerator or denominator or their absolute values. They always try to paint themselves in the best possible light. Banks may include interbank assets in the definition of loans they are using as the denominator. Analysts then have to make the necessary estimates to adjust the numbers accordingly.
The ratios that can be calculated are constrained by what information is available but the following ratios are the ones that are most commonly used and referred to. The NPL cover ratio is sometimes referred to, albeit inaccurately, as provision cover.
When NPL levels are low these ratios provide a reasonable measure of asset quality but are paid little attention. A qualification on provisioning ratios is required, however. As we have already noted few banks provide fully for expected losses on current loans but only act when loans are recognized as impaired or non-performing. As NPL levels start to rise these ratios become the focus of analyst and investor attention but become increasingly difficult to interpret and may not provide a realistic measure of asset quality.
Using them blindly can be very misleading particularly when the use of common accounting standards and NPL definitions would appear to make such ratios between banks directly com- parable. Investors and brokerage sales people do not like analysts to give answers that start with “it depends how you look at it”. A low NPL level may reflect any of, or a combination of, the following:

Better asset quality. The bank has been more conservative in its lending approach. Hard, but indirect, evidence for this could be loan growth well below that of the industry as a whole at a time when credit was expanding rapidly or a below average level of loans to sectors regarded as highest risk. Less conservative approach to NPL classification. We have already looked at how, even when definitions of impaired or non-performing loans appear to be completely objective, there is almost always an element of judgment. A more conservative approach to classification will lead to higher reported NPL numbers.

Speed of write-offs. The faster that a bank moves to write off NPLs the lower will be the reported level of NPLs. Provision levels as a percentage of loans will also fall. The impact on NPL cover is less predictable. If the provisioning level for the loans written off is greater than its average NPL provisioning level then its NPL cover will fall. This could occur if the bank acted to write off NPLs that were either unsecured or had the lowest level of collateral cover.
On the other hand, if the bank writes off those NPLs that were best secured reported  NPL cover would be likely to increase.
Foreclosed assets. If a bank acts to foreclose on pledged security for NPLs but does not sell these assets immediately then while NPLs will fall the level of foreclosed assets will rise. Restructuring. The rules on restructured loans being reclassified as performing loans vary significantly between countries. Some regulators allow these to be immediately reclassified as current while others require that borrowers adhere to the terms of the restructuring agreement for a defined number of months. The greater the level of restructured loans and the faster these are allowed to be classified as current the lower will be the reported NPL
level.
Bank management comments are rarely of any help to analysts. I’ve never come across an example where management has admitted that low reported NPL levels and high levels of provisioning cover are due to window-dressing. It is therefore virtually impossible to determine whether or not they are lying. Even when an analyst believes that management are being “economic with the truth” the best he or she can do is to point to indirect evidence that reflects a culture of creative accounting and past sharp practices.
Other related ratios that may be disclosed usually concern collateral cover. They tend to be highlighted by banks where a high proportion of their loans are “fully” secured. The usual definitional problems apply and their usefulness is highly dependent on the appraised value of the pledged security and the ability of the bank to realize that appraised value. Other ratios using NPL aging profiles, when reported, may also be derived.

Tags: BALANCE SHEETS AND RATIOS, IMPACT ON REPORTED EARNINGS