Adversely Classified Asset Details

Loans are a bank's most important asset; they are a primary source of its future income. When the bank issues a loan, it needs to know that the borrower will repay the loan fully and on time. Unfortunately, not all loans perform as well as the bank would hope. Bad loans appear on a bank's financial reports, increase the bank's tax liability and require the bank to spend time and money on attempts to collect payment. To make their financial reports look healthier, a bank may decide to write off so-called "toxic" loans.

In the United States, National Bank Examiners have drawn up national guidelines for a risk classification system that helps banks rate adversely classified assets. The guidelines identify four categories:

  • Loss: There is no realistic hope of collecting this loan. It is a write-off.
  • Doubtful: The bank has reason to believe that it is doubtful that full repayment of the loan will happen.
  • Substandard: These loans represent a potential loss to the bank unless the bank corrects the problem.
  • Special Mention: Although the bank has no reason to believe that the client will not repay the loan, there are potential problems because of insufficient collateral, a change to the client's credit rating, or insufficient documentation.

When a borrower stops paying the monthly principal and interest payments on their loan, they become non-performing. Although technically listed as an asset, this loan is not an asset to the bank. Usually, a bank will classify a loan as non-performing after 90 days have passed without the bank receiving a payment. There are actions that the bank can take to recover its money, such as: foreclose on a home if the non-performing loan is a mortgage or sell the loan at a discount to a debt collection agency.

Adversely Classified Asset Example

Paul borrowed $5,000 from his bank five years ago. For the first two years, he paid the installments on time and in full. After that, the bank flagged the loan 'Special Mention' because Paul had had some difficulties repaying a loan ten years prior. Then, two years ago, Paul lost his job, his repayments became infrequent, and then stopped completely. After three months, the bank classified Paul's loan as non-performing.

The bank attempted to talk to Paul to reschedule his repayments, but with no success. His loan was then labeled as doubtful and, as no progress was made, quickly became considered as a loss. To remove Paul's loan from its assets, the bank sold it to a debt collection agency at a considerable discount. A debt collection agency works on averages and hopes to collect enough bad loans to profit on the discounted price that it bought the loans for.

When a bank decides to give a client a loan, it accepts that there are risks involved. People's circumstances change, and the bank hopes that a sufficient percentage of its clients will repay their loan as agreed. A bank with loans on its books that no longer represent an asset needs a provision against debt and removes the loan from its books.