Problem Loan Management

UNIVERSITY OF WOLLONGONG IN DUBAI

FIN955: International Banking

Problem LoanManagement

Submitted By:

SaebRadaideh: 4015873

Abdil-Rahman

NaeemSaba: 3959582

Sr. No. Contents Page No.

1. Executive Summary

2. Introduction- What is a Problem Loan?

3. Problem Loans in the U.A.E

4. Causes of Default

A. Borrower Specific

B. Lender Specific

5. Management of Problem Loans

A. Detection of Red Flags

B. Effective Strategies for Problem Loans

Management

6. Conclusion

7. References

1. Executive Summary:

This paper aims at focusing on the problem with loans and the management of these loans by lending institutions. The greatest threat to any bank is the fact that loans and advances are a major part in a bank's assets. The default on such loans and advances can have detrimental effects on a bank, or in other worlds default on loans which can threaten their very existence. To combat such outcomes, a phenomenon called Loan Portfolio Management, which is basically management of loans and advances based on predetermined factors, plays a huge role in the health of lending institutions. The following paper begins with an introduction of some of the issues in the banking sector, specifically loans. In order to make this paper more applicable, we have included statistical data on the United Arab Emirates. Some of the factors that can be seen as a contributing force behind default include but not limited to inadequacies in the lending institutions policies, procedural systems, lack of adherence to some of these systems, and finally due to inefficiencies in the borrower's business. We also discuss some of the causes of default, both from the borrower's prospective and the lenders prospective. When managing problem loans, it is crucial to monitor these loans in order to swiftly find irregularities in order to take on solutions that can reverse the problem. Detection early on of problem loans can be found through early symptoms of a bad loan. Finally we look at some of the approaches that management takes in order to amend problem loans and conclude our findings.

2. Introduction- What is a Problem Loan?

Financial Intermediaries play a vital role between lenders and borrows;this being the situations leads to the issue of the banks facing problem loans that can significantly impact their core stability (Berger A, DeYoung R). Loans are usually categorised into two types , which is either retail or corporate based on borrowers' profiling which stems the determinants from pre-set characteristics such as the size of the loan or of the borrowing entity. Before jumping into the effects of a problem loan, let's first discuss what a problem loan is. Problem loans are types of loans where the borrowers are unable to meet their interest and principle obligations. For example, Commercial loans that are above 90 days overdue and consumer loans that are over 180 days overdue are considered most of the time as problem loans (also called non-performing assets). This being said, some countries look at more qualitative criteria which can include future payment expectancy (Blum J, Hellwig M)

Due to the fact that problem loans are naturally riskier than normal loans, decisions such as pricing and the amount of collateral are needed to be amended.A problem loan can camouflage itself as a normal loan or low risk loan for some time and eventually making the solution harder to attain and sometimes the problem can escalate further (Berger A, DeYoung R).

Loans are finally priced after taking into account the risk premium (compensation for investors who tolerate the extra risk - compared to that of a risk-free asset), expenses and cost of funds.On the other hand, problem loans run the risk of the principle not being paid in full. The time and effort that is applied in the loan recovery in itself is a cost to the entity, due to the fact that this effort can be more useful in other areas, hence an opportunity cost is applicable in problem loans. After loans are issued, detection of the loans turning into problem loans is vital when assessing the credit risk and ultimately fixing the price based on the risk assessed. This process allows the entity to counteract the recovery cost (Berger A, Udell G).

In the case of normal loans, banks do not consider the guarantee of the loan to be extremely important unlike the normal flow of loan repayment. However, problem loans take on a much different role in terms of bank perception. Banks perceive that the most stable form of repayment for problem loans is the collateral tied with the loan. Even in the case of liquidation (bank seizes assets of borrower), the loan might not be paid in full. Potentially frozen assets require vigorous value assessment due to depreciation in the calamitous case of liquidation by the bank. This allows banks to plan ahead and be more aware of potential losses (Pozzolo A). As well as having to note the complexity of the legal procedures that are inherit in the process of utilizing such collateral and their liquidations.

There have been lots of researches on the reasons of bank failures which have found that asset quality is a statisticallysubstantial forecaster of insolvency (e.g. Dermirgue-Kunt 1989, Barr and Siems 1994), and that failing banks always have high level of non-performing loans prior to failure. This has drummed up research interest in the subject of non-performing loans as well.

3. Problem