How is a bank’s credit quality measured?


Under the current accounting standard for provisions (IFRS 9), introduced in 2018 and based on expected losses, the provision for losses (and therefore the coverage ratio) and the cost of risk reflect expectations which depend on the quality of the portfolios and the macroeconomic environment. The NPL ratio includes real-life customers fault but also customers who, although up to date with their payments, are to some extent likely to default (due to the industry in which they operate, the future situation of the customer, etc.), and potential impairments are thus expected. The three measures should be considered together to provide a clearer picture of an entity’s risk profile and credit quality: in isolation, the indicators can lead to wrong conclusions. Let’s look at them in detail.

Most Used Indicators To Measure Credit Quality

NPL ratio

The NPL ratio is the ratio of non-performing loans To total credit extended by entity, expressed as a percentage.

Non-performing loans (numerator of the ratio) are unpaid or overdue balances (for more than 90 days) and balances in payment but bearing a high probability of default for various reasons (certain refinancing arrangements or customers belonging to particularly vulnerable sectors). Banks must constantly monitor their wallets and set up early warning systems to identify these loans as non-performing as soon as possible. Such would be the so-called subjective defect or “unlikely to pay” loans. The more precise the entities’ early warning tools, the better prepared they will be to face a crisis.

As with any ratio, the NPL ratio depends on the evolution over time of the numerator (non-performing loans) and the denominator (total loans) relative to each other. So, as long as non-performing loans grow at a slower rate than total loans, the ratio does not increase, and vice versa. This is what happened in 2020 and the first half of 2021 in Spain, for example, through the deployment of a package of economic policy measures aimed at mitigating the impact of the COVID-19 crisis. Specificallymoratoriums and grace periods authorized new delinquency to remain contained during the pandemic, despite the fact that the banks are reclassifying their current customers in advance in unpaid balances, due to the still high uncertainty about their behavior in the coming quarters.

When the special support measures end, depending on the cumulative effects on households and businesses and the strength of the economic recovery, system non-performing loans will suffer more or less. Together with the performance of total credit, this will determine the ratio of non-performing loans to total loans.

The coverage ratio

The coverage rate is the ratio between the balance sheet provisions for potential losses of value on the volume of non-performing loans, expressed as a percentage. The ratio makes it possible to identify the volume of doubtful debts which is the subject of provisions.

The way in which provisions are recognized amended with the entry into force on 1 January 2018 of the new international accounting standard IFRS 9. IFRS 9 a a prospective approach and requires the recognition of provisions in accordance with expected loss concept. The model variables include the macroeconomic outlook and knowledge of the entities of their loan wallet and their customers, and their expectations about the future behavior of customers’ ability to honor their payments. On the other hand, the old standard required the constitution of provisions based on the losses suffered, that is to say when the loan was already classified as non-performance (which was the case when there were three unpaid installments, i.e. 90 days).

Thus, the provisions accumulated in the balance sheet (numerator) must take into account a waiting for portfolio depreciation. However, the direct comparability of the total coverage ratio between banks is limited, as it would be necessary to go into the detail of the coverage of the bank. different types of wallet. Banks with more weight in secure portfolios on collateral (such as mortgages) may have a lower coverage ratio compared to banks with fewer guaranteed portfolios or with more weight in business segments or sectors more exposed to COVID-19, but this does not necessarily mean that they are more exposed to future impairments.

Cost of risk

The cost of risk is the ratio of provisions recognized by an entity over a given period (annualized) at average volume of the loan portfolio during this period, usually expressed in basis points (100 basis points equals one percentage point). Example: if an entity has an average portfolio in a given year of 100 million euros and recognizes provisions of 4 million euros in the income statement for that year, its cost of risk will be 400 basis points , i.e. it expensed 4% of the total portfolio.

Like hedging, the cost of risk is a indicator of expected losses, and measures the effort that an entity makes over a period of time to protect itself against estimated future losses in its loan portfolio.

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