Introduction
The definition of non-performing loans (NPLs) exists on a standardised characterisation of “past due” loans, typically defined as a certain number of days past the due date. For example, 90 days past due commonly applies as a threshold for determining whether a loan is non-performing. This standardised definition can be seen as rigid and inflexible, as it needs to consider other factors that may affect the likelihood of loan repayments, such as the borrower’s creditworthiness or the underlying collateral. As a result, some loans that may not be at high risk of default may be classified as NPLs, while others at greater risk may not exist in the NPL category. Despite this potential rigidity, the standardised definition of NPLs serves an essential purpose in prudential compliance. It allows regulators to identify loans at risk of default and take appropriate action to mitigate potential losses. In situations where agency costs are high, meaning that the incentives of the borrower and the lender are misaligned, the NPL definition’s rigidity can help prevent excessive risk-taking and ensure that banks are not overexposed to potential losses. Overall, while the standardised definition of NPLs may have limitations, it is an essential tool for prudential compliance and can help to protect against excessive risk-taking in loan underwriting. To improve the effectiveness of NPL regulation, consider alternative definitions or approaches that take into account additional factors that affect loan repayment. This paper critically analyses the rigidity of NPLs and their warrant in averting risks and non-compliance as covered by the standardised “past due.”
The Causes of Non-Performing Loans in Banking and Economic Crises
High levels of non-performing loans (NPLs), or loans that are in default or about to fail, are a common feature of many banking crises. According to the literature, high NPL levels hurt bank balance sheets, hinder loan growth, and delay output recovery. These are crucial policy matters since some nations are still coping with the non-performing loans (NPLs) brought on by the Global Financial Crisis (GFC) and the European sovereign debt crisis. In contrast, others are highly vulnerable due to leverage.
Therefore, sound ex-ante macro prudential and macroeconomic policies can contribute to preventing NPL difficulties during banking crises. In addition to preventing a negative feedback loop between governments and banks, sound fiscal and monetary policies can assist in generating the financial resources required for crisis interventions. Contrarily, sound monetary and prudential policies can assist in limiting bank risk-taking and controlling excessive loan growth. Exchange rate flexibility can also accelerate economic recovery by lessening the impact of financial and natural shocks. Strong institutions can help create effective bank supervision and regulation, solid corporate governance, and a legal environment that promotes the resolution of NPLs. Reliable NPL statistics are essential for predicting and estimating the scope of NPL issues and developing policy solutions. An obstacle to cross-country comparisons is the need for a uniform NPL definition. Recent guidelines from the Basel Committee (BCBS 2017), European Banking Authority (ECB 2017) and IMF (2006) intend to encourage this harmonisation. Loan-level data on non-performing loans is limited, particularly for smaller and non-publicly traded banks. In addition, bank-level data on non-performing loans is also scarce.
The leverage ratio limits excessive lending to bank capital, the liquidity ratio requires banks to retain a certain level of liquid assets to cover short-term expenses, and other micro-prudential laws are all numerically calibrated. Since such numerical calibrations are not a precise science, they can modify in response to broader economic conditions that influence the demand for credit. An even more radical approach to think about these actions is that, in these unprecedented times, financial regulators have begun to prioritise social welfare as a purpose to which the use of powers is oriented and have increasingly responded to societal demands.
A common component of banking and economic crises is non-performing loans because they can strain the financial health of banks and the overall economy. When a significant number of loans in a bank’s portfolio become non-performing, it can reduce its profits and make it more difficult for the bank to raise capital or secure funding. This condition could lead to a banking crisis in which the bank cannot meet its financial obligations and may need to be bailed out by the government. At the same time, when a large number of loans in the overall economy become non-performing, it can lead to an economic crisis. Crisis can happen for various reasons, including economic downturns, natural disasters, and over-leveraging by borrowers. In an economic crisis, non-performing loans can reduce the availability of credit, which can slow economic growth and lead to higher unemployment. There is a strong connection between output growth and post-crisis NPLs. Higher and unresolved NPL issues link to more severe post-crisis recessions. Negative NPL dynamics result from several significant risk variables, including excessive credit expansion, high corporate debt with short maturities (high NPLs and slow resolution), fixed exchange rates, and high government debt.
Non-performing loans are often obstacles to resolving banking and economic crises. First, non-performing loans can be difficult and time-consuming to fix. The lender must either work with the borrower to restructure the loan or take legal action to recover the outstanding debt. NPLs can take a significant amount of time and resources, which can delay the resolution of the crisis. Additionally, non-performing loans can be difficult to value accurately, as assets that have declined in value or may be challenging to sell may hack them—making it difficult for banks to raise the capital they need to resolve the crisis. Finally, non-performing loans can create a negative feedback loop, in which the financial strain on banks leads to reduced lending, more non-performing loans, and so on. NPLs can make it difficult to break the cycle and resolve the crisis.
The Systemic Impact of NPLs
At the micro level, non-performing loans can negatively affect individual borrowers and the banks that lent them the money. For borrowers, defaulting on a loan can lead to negative credit scores, making it difficult to obtain credit in the future. It can also lead to legal action from the lender, including seizing collateral (if any) and gar garnishing. For banks, non-performing loans can lead to reduced profits, as the bank is not receiving interest payments on the loan. This crisis can strain the bank’s financial health and, if left unchecked, can potentially lead to bankruptcy. Additionally, non-performing loans can reduce the bank’s overall value, making it difficult to raise capital or secure funding from other sources.
Non-performing loans have a detrimental impact on the economy at the macro level. For instance, they may cause banks to curtail lending, reducing the amount of credit available to consumers and businesses. It thus hinders economic expansion and raises unemployment. Non-performing loans can also strain the financial system, as banks may need to be bailed out by the government to remain solvent leading to increased government debt, which can negatively affect the economy. Additionally, the adverse effects of non-performing loans can compound from other economic factors, such as rising interest rates or inflation. The most likely explanation for the connection between NPLs and GDP reduction is that both macro variables indicate a decline in the national income available for loan repayment. This reason is also why current account deficits and NPLs are related, particularly in nations where international trade is a significant source of national income. According to Rajha, currency depreciation and NPLs are associated. Combining these elements, Minsky presents a model that may have larger applications and echoes of Minsky based on their empirical research of NPLs in CESEE nations:
During economic growth, a country’s economy may be characterised by high, potentially overheated GDP growth and a favourable international environment in which financial investors have a positive outlook for the country’s future financial and economic developments. This can lead to higher national stock index levels, a more robust national currency, and lower non-performing loans. However, as a credit to the private sector grows faster than GDP, underwriting standards may become lax. When the economic boom ends, there may be a drop in the stock market, a slowdown in GDP growth, a weaker currency, and an increase in non-performing loans.
When non-performing loans increase on a bank’s balance sheet, the bank’s capital may decrease on the liabilities side.This is particularly true if the bank has a low coverage ratio (the ratio of loan loss provisions to non-performing loans). Generally, banks should have provisions aligned with their initial expectations of loan recovery and credit pricing. If they do not, the losses from non-performing loans may be so significant that they cannot be offset by income, leading to a decrease in the bank’s capital to the minimum required level or very close to it. When the bank and the broader financial system are in trouble, the bank may need to be recapitalised. However, raising capital during a crisis can be difficult, as investors may hesitate to invest in new shares when profits decline and economic conditions are unfavourable.
Factors in Banking Crises
The three elements of a balance sheet (equity, liability, and assets) are often linked to the three common factors contributing to banking crises. The first factor is a lack of equity investment to cover losses, also known as the excess leverage problem (high total assets relative to equity). The second factor is using short-term funding to finance long-term investments, known as the maturity mismatch and illiquidity problem. The third factor is a decline in asset values due to the pursuit of higher returns, which can lead to a banking crisis. This issue appears on the records of the majority of banks as non-performing loans. Other factors that can contribute to banking crises include:
Over-leveraging by banks: When banks take on too much debt relative to their capital, they become more vulnerable to economic downturns and other risks increasing the likelihood of a banking crisis.
Economic downturns: Economic downturns can lead to a decrease in loan demand, making it more difficult for banks to earn profits. At the same time, economic downturns can increase the likelihood of defaults on loans, leading to non-performing loans and straining banks’ financial health.
Natural disasters: Natural disasters can cause significant damage to property and infrastructure, leading to defaults on loans and non-performing loans. This can strain the financial health of banks, particularly if the bank has a large number of loans in the affected area.
Mismanagement by banks: Banks that are poorly managed, either due to incompetence or fraud, are more likely to experience financial difficulties and potentially face a banking crisis. This can include things like poor lending practices, inadequate risk management, and inadequate capitalisation.
When banks cannot grow their assets without lowering their quality, they reach a critical point in the loan cycle. At this point, the banking system shifts from cash-flow-based lending (where loans are given based on the expected cash flow from productive investments) to collateral-based lending (where loans are provided based on the value of their underlying security). After this shift, the quality of the assets becomes highly susceptible to a decline in the value of the collateral. And Minsky asserted that certain banks began to practice Ponzi banking during the height of lending booms shortly before they collapsed, making loans that they had doubts about whether loans will be repaid but continued to make because they could sell assets. This “Minsky moment” emerged during the most recent financial crisis due to the packaging of loans into securities and selling those securities to off-balance sheet conduits and exceptional purpose companies.
Western European banks had significant losses from impaired US RMBS during the crisis. In this way, the current crisis differs from that the West has recently experienced, which were brought on by external factors, manifesting as non-performing loans on the balance sheets of central American and European banks due to balance of payment issues in an emerging nation. Non-performing loan (NPL) levels are generally declining, although banks in the United States and Western Europe exposed to US residential mortgage-backed securities experienced significant asset quality degradation. In contrast, countries outside the Eurozone and those in Southeastern, Eastern, and Central Europe (CESEE) continue to have high levels of NPLs, which have continued to rise in 2014/2015.
More ambiguity exists in the relationship between profitability and non-performing loans. If a company’s profitability reflects how well it manages its assets, the bank will issue fewer non-performing loans. Retained earnings increase as a result of profit flow, which improves the capital position of banks. Alternately, more significant profits (better rewards) may indicate greater riskiness, which, over time, would result in more non-performing loans. Cost-effectiveness and NPLs have a complicated relationship. An organisation may be efficient, including in loan origination, if it has a low cost-to-income ratio. However, it may also be a sign that the company needs to invest more in its underwriting procedure, eventually resulting in NPLs.
Ex-post losses to bank equity and systemic crises result from insufficient LLPs ex-ante. Recapitalising banks during a crisis is less effective than raising LLPs before concerns. On the other hand, cheap LLPs and delayed loan loss recognition worsen pro-cyclical lending during boom times. Additionally, pre-crisis delays in LLP identification may have caused banks to restrict lending during busts due to the possibility of increased insolvency from further asset expansion. As a result, the credit crunch that follows may make the recession worse.
Strategic Trade-Offs from Provisioning for NPLs
Provisioning for non-performing loans (NPLs) refers to setting aside money to cover potential losses from NPLs. This is done to ensure that the bank has enough capital to absorb the losses and remain solvent. Provisioning for NPLs involves strategic trade-offs, which can affect the bank’s profitability and ability to lend to other customers. Banks must carefully consider these trade-offs to balance the need to maintain financial stability with the need to support economic growth. Provisioning for NPLs can involve trade-offs, affecting the bank’s profitability and ability to lend to other customers. One strategic trade-off from provisioning for NPLs is the potential impact on the bank’s profitability. When a bank sets aside money to cover potential losses from NPLs, it reduces the amount available for other purposes, such as making new loans or paying dividends to shareholders. This can reduce the bank’s profitability and make it less attractive to investors.
Another strategic trade-off from provisioning for NPLs is the potential impact on the bank’s ability to lend. When a bank sets aside money to cover potential losses from NPLs, it reduces the capital available for making new loans. This can limit the bank’s ability to lend to other customers, adversely affecting the economy, such as reduced credit availability and slower economic growth.
Higher loan loss provisions and their early recognition would seem preferable, given the potential systemic effects that NPLs could have. However, to make a sufficient provision for NPLs, banks must consider their complex strategic choices. These strategies and several rules govern banks and other financial institutions’ activities in their specified jurisdictions. Such include:
Tax Treatment
Accounting provisions are taxed differently depending on the jurisdiction. Banks can use all accounting adjustments in some states to reduce taxable income. Others only permit particular forms of the condition, typically when a loss is more likely to occur. Furthermore, some tax authorities only allow loss costs once the underlying loan has been wiped off. Some banks may prefer specific methods of recognising loan losses or tax-deductible losses in specific periods because of the potential for realising a tax benefit.
Accounting Classification
How banks categorise their loans is a problem related to business models. In the past, bank loans were maintained until maturity and carried at book value while being subject to impairment testing. However, many banks now sell and securitise their loans in addition to buying the loans of other banks. These loans may then be listed on the balance sheet at fair market value. Where and when provisions and losses are recorded in financial statements depends on the actual accounting label assigned to them, even if the economic impact of losses on loans for banks is the same regardless of how they are classified. When loans are valued relatively, the amount of credit loss charged to the income statement corresponds to the loss that the market anticipates, not the company itself. In a recession, the market forecast may be worse—sometimes much worse—than the bank’s expectation, which could lead to more significant losses. In other words, even if two organisations have the same quantity of loans on their books, the valuation of loans and hence their level of provisioning will differ because business models across firms vary, including their plans to buy, hold, or sell loans.
Business Models
A bank’s degree of non-performing and impaired loans will reflect the amount of LLPs on its balance sheet. These, in turn, represent the company’s preferred business model. The business models of some banks are riskier than those of others. There are conservative banks that only make loans whose principal and interest they anticipate will be debtors will fully repay to reduce credit risk, LLPs, and NPL. Prudent banking in the UK in the not-too-distant past meant banks made an effort to minimise loan losses. The negative of this behaviour was that bank earnings were lower than they may have been since loan origination levels were lower. However, it had significant benefits for financial stability and systemic risk.
On the other hand, UK banks have recently boosted their risk appetite to reap more significant financial rewards. As a result, if credit risk, NPLs, and LLPs are profitable, they have greater tolerance. Banks may now make loans even if the amounts collected from borrowers are less than the shares pledged to be repaid in the loan contract. This is done by balancing the marginal revenue from loans against the marginal costs from provisions, impairments, and losses. The result is a more volatile financial system that is also more profitable and credit-rich.
Write-Offs
Write-offs are inferred from the accounting identity that states that provisions at the end of a period are equal to requirements at the beginning of the period, plus or minus any additional clauses or write-backs, plus or minus the impact of reductions in the loan portfolio (such as the sale of loans or the maturation of loans), plus or minus write-offs. When a bank no longer expects to receive repayment of the loan principal, the debt is written off, and the loans and provisions against them are removed from the balance sheet. A bank that chooses to write off more of its highly provisioned problem loans will have a lower provision-to-gross-loan ratio than a bank with the same number of highly equipped problem loans that does not write off as many loans because some loans have higher provisions as a percentage of their gross amount. However, credit rating agencies frequently utilise the combined ratio of LLPs to gross loans or NPLs to evaluate banks’ riskiness. A larger aggregate provisioning ratio reduces banks’ perceived risk, all else equal. Therefore, even though they ought to, banks are incentivised to keep heavily provided loans.
Regulatory Capital
Given current regulatory capital requirements, banks have strategic reasons to desire to keep LLPs low. Common stock and retained earnings are included in the Common Equity Tier 1 (CET1) and Tier 1 capital adequacy ratios established by the Basel Committee. Higher LLPs diminish retained profits and, as a result, the CET1 and Tier 1 capital ratios because they are treated as losses in the period they are recognised. Hamadi et al. suggest a trade-off between keeping appropriate LLPs and reporting more excellent Common Equity Tier 1 and Tier 1 capital ratios. Although LLPs permanently reduce retained earnings, specific provisions may be eligible for an “add-back” to Tier 2, or a lower tier, of regulatory capital if certain conditions are met. In some circumstances, the availability of such an add-back may affect the choices made by banks. The question of whether the restrictions on adding back provisions into the capital will prevent banks from establishing timely and appropriate forward conditions for losses has generated a lot of discussions. Hamadi et al. contend that pro-cyclical lending increases rather than declines with a capital increase, particularly in the form of “add-backs” from LLPs.
Rules Governing Banks and Other Financial Institutions in Key Jurisdictions
The regulatory and accounting treatment of asset quality refers to the rules and standards banks and other financial institutions must follow to accurately report their assets’ quality. This is important because the quality of a bank’s assets can affect its financial health and stability. In terms of regulation, there are various rules and standards that banks must follow to accurately report the quality of their assets. The regulatory and accounting treatment of asset quality is an essential aspect of financial reporting and regulation, as it helps to ensure the accuracy and transparency of information about the quality of a bank’s assets. In turn, it helps to promote financial stability and protect investors and other stakeholders.
Basel III
Basel III capital requirements, introduced in the aftermath of the global financial crisis, specify the minimum amount of capital banks must hold to cover potential losses from their assets. Covered includes provisions for non-performing loans (NPLs), loans that have gone into default or are close to bankruptcy.10 The new Basel III banking regulations aim to prevent the buildup of excessive leverage in the banking sector to avoid destabilising processes of deleveraging that can harm the broader financial system and economy. The regulations will also include a non-risk-based leverage ratio (LR) requirement. While requiring banks to hold more capital through the LR has some advantages, there are concerns that it may encourage increased risk-taking by banks.”
Several factors make an LR requirement advantageous. Most critically, highly leveraged banks have less capacity to absorb losses and may be less shock-resistant. This is especially concerning if, as was the case in the lead-up to the financial crisis, an excessive buildup of leverage affects the whole banking industry. An LR requirement guarantees that banks with a high percentage of low-risk-weighted assets have more loss-absorbing capacity by limiting the overall level of leverage institutions can reach. Therefore, the LR may offer a more effective way to control overall risk and guard against uncommon (and highly linked) losses in the financial system that is not entirely covered by the risk-based capital framework.
Highly leveraged banks that failed or were in trouble during the financial crisis were nevertheless displaying healthy risk-based capital ratios. Thus, the LR can address model risk difficulties in determining risk weights or even the blatant manipulation of risk weights by offering a straightforward non-risk-based capital requirement. The crisis has demonstrated that complex notions for measuring risk can occasionally fail, and there are also signs that banks intentionally maximise risk-weighted assets (also known as “gaming”). The IRB technique requires firms to offer their estimations of the chance of default, loss given default, and exposure at default for those portfolios for which banks elect to design systems to follow this approach.
When an obligor is 90 days past due or is unlikely to fulfil its credit commitments to the banking group without the bank resorting to measures like realising security, it is said to be in default. The following actions by the bank are examples of indicators of unlikeliness to pay:
-putting the credit obligation on non-accrued status;
-making a charge-off or account-specific provision as a result of a significant perceived decline in credit quality after the bank took on the exposure;
-selling the credit obligation at a material credit-related economic loss;
-the bank has filed for the obligor’s bankruptcy or similar order in respect of the obligor’s credit obligation to the banking group;
-the obligor has sought or has been placed in bankruptcy or similar protection;
-or the obligor is likely to result in a diminished financial obligation due to the material forgiveness or postponement of principal, interest, or (where relevant) fees.
EBA ITS
The European Banking Authority (EBA) is responsible for developing and maintaining the regulatory framework for the banking sector in the European Union (EU). As part of this responsibility, the EBA has established a set of requirements for supervisory reporting by banks and other financial institutions. These requirements are designed to ensure that the EBA and national supervisory authorities have access to high-quality, comparable, and timely information from institutions, which they can use to monitor the risks and vulnerabilities in the banking sector.
The EBA’s supervisory reporting requirements cover various topics, including the institutions’ capital and liquidity positions, their exposures and risk-weighted assets, their funding and lending activities, and their performance and financial results. Institutions are required to report this information regularly, using standardised templates and reporting formats specified by the EBA. In addition to the standard reporting requirements, the EBA may require institutions to submit additional information on an ad-hoc basis, depending on the specific risks and vulnerabilities identified in the banking sector. This information may be used by the EBA and national authorities to assess the institutions’ compliance with relevant regulations and to take any necessary supervisory actions. The EBA’s supervisory reporting requirements are an essential part of the EU’s regulatory framework for the banking sector. They play a crucial role in ensuring the stability and resilience of the financial system (for both banks and financial institutions).
IFRS
Regarding accounting, there are various standards and guidelines that banks must follow to accurately report the quality of their assets. For example, the International Financial Reporting Standards (IFRS) specify the rules for recognising, measuring, and disclosing financial instruments, such as loans, in the financial statements of banks and other financial institutions. This includes rules for classifying and measuring the expected credit losses on loans, which determine the provision for NPLs. According to IFRS 9, a shift to Stage 2 and subsequent recognition of lifetime credit losses are often anticipated to occur before the financial instrument becomes past due or other borrower-specific default events occur. Banks’ credit risk analyses should consider that the factors that lead to credit losses deteriorate for months or even years before any objective evidence of delinquency appears. Credit impairment results in a move from Stage 2 to Stage 3 under IFRS 9. However, depending on the extent of collateralisation, Stages 2 and 3 calls for lifetime loss provisions, and lifetime losses increase over time as creditworthiness declines. As of the effective date of IFRS9, it is anticipated that at least all Stage 3 exposures will be covered by this NPL advice. Banks should therefore have a clear policy that includes well-developed criteria to discern rises in credit risk for various types of loan exposures (such measures should be disclosed) to assess the importance of an increase in credit risk. The credit risk assessment should analyse the default risk without considering the implications of credit risk mitigants like collateral or guarantees.
“Default” CRR
Article 178(1)(b) of the CRR states that the competent authorities may increase the past-due term for some parts from 90 to 180 days. However, the ECB’s Regulation (EU) 2016/445 ignores the option to recognise defaults for specific portfolios only once they are 180 days past due. Exposures that are impaired or defaulted must automatically be classified as NPEs. The CRR and IFRS distinguish between the economic triggers associated with unlikeliness to pay and breaches of established payment commitments (past due payments).
Role of Central Banks from A Combined Legal and Economic Perspective
From a legal perspective, central banks’ role is to ensure that the banking system operates safely and soundly and complies with the law. This includes overseeing the management of non-performing loans (NPLs), loans that are in default or close to bankruptcy. Conducting monetary policy to attain price stability (low and stable inflation) and assist in managing economic fluctuations is a crucial function of central banks. Over the past few decades, significant modifications have been made to the policy frameworks within which central banks conduct their operations.
Central banks must modify the money supply through open market operations to implement monetary policy. For instance, a central bank could lower the amount of money by obtaining funds from commercial banks by selling government bonds under a “sale and repurchase” deal. These open market transactions aim to influence short-term interest rates, affecting longer-term rates and total economic activity. The monetary transmission mechanism is less efficient in many nations than in advanced economies, especially in low-income nations. Countries should create a framework to enable the central bank to target short-term interest rates before switching from monetary to inflation targeting.
In the wake of the global financial crisis, central banks in industrialised nations relaxed monetary policy by lowering interest rates until they nearly reached zero, which constrained their ability to lower policy rates further (i.e., limited conventional economic options). To further reduce long-term rates and loosen monetary conditions as the threat of deflation increased, central banks engaged in unconventional economic measures, such as purchasing long-term bonds (particularly in the United States, the United Kingdom, the euro region, and Japan). Even below zero, some central banks lowered short-term rates.
The global financial crisis demonstrated that nations must implement specific financial rules to limit risks to the whole financial system. Many central banks have improved their financial stability duties, particularly by adopting macroprudential policy frameworks as part of their mandates to promote financial stability. From an economic perspective, the role of central banks regarding NPLs is to help ensure the financial system’s stability. Central banks can do this by providing liquidity to banks experiencing difficulty managing their NPLs. This can help prevent a crisis caused by the default of many loans.
Central banks can also take a more active role in addressing NPLs by implementing policies and programs encouraging banks to manage their NPLs more effectively. For example, a central bank may require banks to set aside a certain amount of capital to cover the potential losses from NPLs. It may also incentivise banks to sell their NPLs to specialised asset management companies.
The Role of Soft Law and Self-Regulation in Banking and Finance
Rules or standards that are not legally enforceable but that, in reality, are followed by those who are addressed by them or by those who watch them for a variety of reasons (moral persuasion, fear of adverse action, and other “incentives”) are referred to as “soft law.” Since soft law is not legally binding, it cannot be enforced through conventional legal channels. The ‘Hard’ rule is distinguished by formality, whereas soft law is determined by informality. Soft law is observed voluntarily and on one’s terms. Complex law is enforceable through coercion and external imposition. Hard and soft laws can be distinguished by their enforcement.
Soft law and self-regulation are voluntary measures used in the banking and finance industry to address non-performing loans (NPLs). These measures are not legally binding but are designed to encourage banks and other financial institutions to manage their NPLs responsibly and effectively. One example of soft law in the banking and finance industry is the development of industry-wide guidelines or principles for managing NPLs. These guidelines are not legally enforceable, but they can provide a framework for banks to follow when dealing with NPLs.
International financial law requires that those in charge of enforcing it pull off the difficult political balancing act of requiring compliance within global financial markets while avoiding democratic responsibility inside local and international legal institutions. The technical structure of formal lawmaking, at least in the minds of academics, gives “hard” international law an advantage in terms of responsibility and authority. A discipline based on evidence is imposed on national law and politics via the process of creating formal international law through “justification and persuasion in terms of applicable rules and important facts.” Governments will pay the price for their treason if they violate international law “without a defensible stance or reasonable efforts to justify their conduct in legal terms.”
While intergovernmental or official entities make up the majority of those involved in the process of setting international financial standards, and their principles or recommendations can be characterised as “top-down” rules (typically “public law,” rules that emanate from official entities (formal inter-governmental institutions and groupings created at the initiative of governments). The work done by professional associations and market entities, such as ISDA (uniform), can be characterised as “bottom-up” rules.
Self-regulation involves the development of internal policies and procedures by individual banks and financial institutions to address NPLs. These policies and procedures are not required by law, but they can help ensure that a bank manages its NPLs responsibly and effectively. Most industries in the United States are not governed by the government, making self-regulation an essential regulatory aspect in general. However, how they perform is controlled. The commercial sector regulates it.” The fact that self-regulation is pervasive in industries other than finance is telling and, when the ramifications are taken into account, even frightening. However, the non-financial sector is not typically connected with “self-regulation.” This is a result of the reality that most businesses benefit from self-regulation. Therefore, it is unnecessary for authorities and the sector to repeatedly affirm its viability. In 2005, despite the credit rating agencies claims that their rating scales were uniform, collateralised debt obligations were ten times riskier than similarly rated corporate debt. Additionally, legislative hearings and internal communications show that the agencies continued to give inflated ratings while being aware of the risks associated with inaccurate securities ratings, at least since 2003.
International financial standards are even less likely to be created through a strict, formal legislative procedure within an institution with a global treaty framework. Instead, as a cooperative way of making international financial law, the decentralised network of economic actors with various, widely dispersed duties participates in cycles of reciprocity and retribution. Long-term, self-interested, unfriendly regulators can anticipate losing the support of other players in the global financial system. The ability of nations to access international financial markets is jeopardised when they reject an international regulatory consensus, such as a tightening of risk-based capital requirements for banks. It should be no surprise that international financial law enforcement mechanisms closely mimic the reputational instruments that financiers, traders, and other private actors often employ to monitor self-dealing and enforce socially beneficial standards within their communities. The thin shell of rigid formality in international finance law adds the threat of institutional sanctions, such as the rejection or withdrawal of membership in an international organisation.
Governments helped financial organisations obtain TBTF status by supplying them with laws that allowed them to take advantage of their position. In this situation, regulators increasingly relied on internal risk models and credit rating agencies as part of a purported market approach to financial system regulation. Therefore, regulators accepted that self-regulation was the most effective way to control the financial sector. Wilmarth Jr contends that regulators were also subject to “cognitive regulatory capture” due to internalising “the objectives, interests, and sense of the reality of the entrenched interest they are meant to regulate and supervise in the public interest.” Before 2007, regulators like Greenspan disregarded numerous warnings that conflicts of interest at credit rating companies were a problem. Instead, they resorted to rating agencies as a market-based addition to self-regulation. However, the government-sponsored cartel made NRSRO rating demand unresponsive to rating quality, increasing the expense of safe corporate conduct. Thus, the three major rating agencies took advantage of their oligopoly by working with issuers and investors to give unduly favourable ratings.
Tools and Processes of Financial Supervision and Crisis Management
Financial supervision oversees and regulates financial institutions to ensure they operate safely and soundly and comply with relevant laws and regulations. This is typically carried out by government agencies or independent organisations, such as central banks or specialised financial regulatory agencies. On the other hand, crisis management refers to the processes and procedures organisations implement to deal with unexpected or potential crises. This includes emergency response plans, contingency planning, and risk management strategies. There are a variety of tools and processes that are used in financial supervision and crisis management, including:
Risk-based supervision: This involves assessing the risks posed by financial institutions and using that information to prioritise and target supervision efforts. This can include risks to the institution, such as insolvency or liquidity problems and threats to the broader financial system or economy. In the context of non-performing loans (NPLs), risk-based financial supervision would involve assessing the level of NPLs at individual institutions and the potential impact of those NPLs on the institution’s ability to continue operating safely and soundly. This information would then be used to prioritise supervision efforts and to develop appropriate strategies for addressing the risks associated with NPLs. For example, suppose a financial institution has a high level of NPLs. In that case, regulators may require the institution to reduce its NPLs by selling off or writing off the loans or implementing more stringent underwriting standards for new loans. Regulators may also require the institution to hold additional capital or liquidity to protect against potential losses from NPLs.Top of Form
Stress testing: This simulation tool is used to evaluate the resilience of financial institutions to potential shocks, such as a sudden drop in asset prices or a sharp increase in interest rates. This can include sudden changes in economic conditions, interest rates, or other market developments. In the context of non-performing loans (NPLs), stress testing could be used to evaluate the potential impact of NPLs on a financial institution’s ability to withstand a sudden economic downturn or other adverse events. For example, a stress test could simulate a scenario in which the economy experiences a sharp contraction and evaluate how the institution’s NPLs would impact its capital levels, liquidity, and overall stability. Stress testing can provide valuable information to regulators and financial institutions by highlighting potential vulnerabilities and allowing them to take corrective action before a crisis occurs. For example, suppose the stress test reveals that a financial institution has a high level of NPLs and would be vulnerable to a sudden economic downturn. In that case, regulators may require the institution to reduce its NPLs or to hold additional capital or liquidity to protect against potential losses.
Early warning systems: These are designed to detect potential problems or vulnerabilities in financial institutions before they become severe and alert regulators to take appropriate action. An early warning system is a tool used in financial supervision to detect potential problems or vulnerabilities in financial institutions before they become serious. This can include an increase in non-performing loans (NPLs), a decline in asset quality, or a drop in capital levels. In the context of NPLs, an early warning system would be designed to monitor the level of NPLs at individual institutions and provide alerts to regulators if the NPLs reach a certain threshold or are increasing rapidly. This information can then be used to take appropriate action, such as requiring the institution to reduce its NPLs or hold additional capital or liquidity. Early warning systems can benefit financial supervision because they allow regulators to identify potential problems early before they become serious. This can help to prevent the development of more severe problems, such as insolvency or liquidity crises, and can help to protect consumers and the broader financial system.
Resolution planning: This involves developing plans and procedures for dealing with financial institutions in danger of failing to minimise the impact on the broader financial system and the economy. This can include developing strategies for liquidating the institution’s assets, transferring its deposits or other liabilities to another institution, or providing financial support. In the context of non-performing loans (NPLs), resolution planning would involve developing strategies for dealing with a financial institution with a high level of NPLs and at risk of insolvency or other problems. This could include selling off the institution’s NPLs to another entity or providing financial support to the institution to help it manage its NPLs and avoid failure. Resolution planning is an essential tool for financial supervision because it can help to minimise the impact of a financial institution’s failure on the broader financial system and the economy. By having the plan to deal with a failing institution, regulators can take swift and effective action to contain any potential damage and protect consumers and investors.
Capital and liquidity requirements: Financial institutions must maintain a certain level of capital and liquidity to support their operations and protect against potential losses. Regulators set these requirements and monitor compliance. Capital and liquidity requirements are regulations that are put in place by financial regulators to ensure that financial institutions maintain a certain level of capital and liquidity to support their operations and protect against potential losses. Capital refers to a financial institution’s funds available to cover losses and absorb shocks. In contrast, liquidity refers to the ability of the institution to meet its financial obligations as they come due. In the context of non-performing loans (NPLs), capital and liquidity requirements would be used to ensure that financial institutions with a high level of NPLs have sufficient capital and liquidity to cover the potential losses from those loans and to continue operating safely and soundly. Regulators would set specific requirements for capital and liquidity levels based on the level of NPLs at the institution and monitor the institution’s compliance with those requirements. For example, suppose a financial institution has a high level of NPLs. In that case, regulators may require the institution to hold additional capital or liquidity to protect against potential losses from those loans. This could include requiring the institution to have a certain amount of money relative to its NPLs, or to maintain a certain level of liquid assets.
The Relationship Between Regulated Banking Institutions and Their Regulators
There are numerous organisations in existence that the federal and state governments use to control and monitor financial markets and corporations. These organisations each have a distinct set of tasks and duties that allow them to operate independently of one another while pursuing related goals. The relationship between regulated banking institutions and their regulators is designed to promote the financial system’s stability and integrity and protect consumers and investors from harm. Regulators can take enforcement action against institutions that violate the rules, including imposing fines or other penalties or even revoking the institution’s license to operate.
The relationship between regulated banking institutions and their regulators is oversight and compliance. Regulators are responsible for overseeing and regulating the activities of banking institutions to ensure that they operate safely and soundly, and in compliance with relevant laws and regulations. This includes monitoring the institution’s financial health, assessing risks, and enforcing rules and regulations. On the other hand, banking institutions must comply with the regulations set by their regulators and provide information and access to their records as needed. This can include submitting regular financial reports, providing access to their books and records, and undergoing regular exams or audits.
For example, one of the most renowned regulatory agencies in the US is the Federal Reserve Board (FRB). As a result, the “Fed” is frequently held responsible for economic crises or praised for boosting them. It is in charge of affecting the availability of funds, liquidity, and general credit conditions. Its open market operations, which regulate the acquisition and sale of federal agency securities and US Treasury assets, are its primary weapon for carrying out monetary policy. The number of reserves and the federal funds rate, the interest rate at which depository institutions overnight lend balances to other institutions, can be affected by purchases and sales. The Board also monitors and controls the banking industry to maintain overall financial system stability. The Federal Open Market Committee (FOMC) is in charge of running the Fed. The FRB’s oversight of the commercial banking industry in the United States is one of its primary regulatory responsibilities. The Office of the Comptroller of Currency regulates national banks, but most must be members of the Federal Reserve System (OCC). Because it is the federal regulator for bank-holding corporations, the Federal Reserve oversees and controls several significant banking institutions (BHCs).
State-level bank regulators for state-chartered banks function similarly to the OCC. Together with the Federal Reserve and the FDIC, they exercise oversight. For instance, the Department of Financial Services (DFS) in New York State oversees and controls the operations of more than 1,800 insurance companies with assets totalling more than $4.7 trillion, as well as approximately 1,500 banking and other financial institutions with NY domiciles and assets totalling more than $2.6 trillion. More than 375,000 individual insurance licensees, more than 130 life insurance companies, 1,168 property/casualty insurance firms, about 100 health insurers and managed care organisations, 122 state-chartered banks, 80 foreign branches, ten foreign agencies, 17 credit unions, 13 credit rating firms, nearly 400 licensed financial services firms, and more than 9,455 mortgage loan originators and servicers are among them.
The Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) are more specifically responsible for regulating banking institutions in the UK. The FCA is the primary regulator of financial services firms in the UK and is responsible for overseeing the conduct of firms in the financial services industry, including banks, insurance companies, and investment firms. The FCA protects consumers and promotes fair, transparent, and efficient markets. The PRA, on the other hand, is a prudential regulator, which means that its focus is on the stability and resilience of the financial system. The PRA is responsible for overseeing the financial health of banks, building societies, and other financial institutions and setting and enforcing those institutions’ rules and standards. The PRA works closely with the FCA and other regulators to ensure that the financial system is stable and that consumers are protected. Together, the FCA and PRA are responsible for regulating the activities of banking institutions in the UK and ensuring that those institutions operate safely and soundly. Their work includes monitoring the institutions’ financial health, assessing risks, and enforcing rules and regulations to protect consumers and promote the financial system’s stability.
Conclusion
Using a standardised “past due” characterisation for NPLs can be seen as a benefit in circumstances where there is a risk of excessive risk-taking by loan underwriters and high agency costs. In these situations, a strict and standardised approach to NPLs can help protect the institution’s financial stability and prevent losses due to risky lending practices. By using a standardised “past due” characterisation, institutions can ensure that they are applying consistent rules and standards to all of their loans. Regulation can reduce the risk of losses and protect the institution’s financial stability. Using a standardised “past due” characterisation for NPLs can be seen as a limiting factor because it treats all loans 90 days past due similarly. Regardless of the specific circumstances of the loan or the borrower, this can lead to a one-size-fits-all approach to dealing with NPLs that may only be appropriate in some cases. Using a standardised “past due” characterisation for NPLs can be seen as both a limitation and a benefit, depending on the specific circumstances. It is essential for institutions to carefully consider the trade-offs involved in using this approach and to implement appropriate measures to mitigate any potential adverse effects.
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