Usually bank’s loan portfolios contain hopeless and poorly paid-back loans, which are called “non-performing” loans. Such loans are written off into a bank’s expenses. Both losses from non-performing loans and written off loans give the bank its total loan loss. According to the Generally Accepted Accounting Principles (GAAP), the bank writes a loan onto its expenses and shows it on the balance sheet as “non performing loan” in next cases:

Bank has sent reminders to the borrower, and there is no response Bank has sued a case against the borrower to a court Borrower’s bankruptcy bankrupt

Most financial institutions have internal credit rating systems. These systems form an important part of their infrastructure for managing credit risks. Such systems are the starting point for a determining the level of interest rates and credit limits on an individual exposure bases; on portfolio basis, they are used in simulations to qualify credit risks and to calculate the capital required for internal management purpose.

An example of classification of loans and their risk levels:

No essential risk – Extremely high degree of certain of repayment Negligible risk – High degree of certain of repayment Some risk – Sufficient degree of repayment Better than average risk- There is certainty of repayment, but substantial changes in the environment in the future may have some impact on this certainty Average risk – There are no problems in foreseeable in the future, but a strong like hood of impact from changes in the environment Tolerable risk – There are no problems in foreseeable in the future, but the future cannot be considered entirely safe Lower than average risk – There are no problems at the current time, but the financial position of the borrower is relatively weak Needs to preventive management – There are problems with lending terms or fulfilment, the borrower’s business condition are weak or unstable, or there are other factor requiring careful management Needs serious management – The borrower is in serious financial straits and “effectively bankrupt”

Generally, loans to borrowers who are “in danger of bankruptcy” and those who are in the “bankrupt” and “de facto bankrupt” categories are defined as non-performing loans. When this situation occurs it is hard for lenders, especially when the collateral market value is now less than the given amount of the loan before. Thus, even the bank forecloses the collateral:

In the bank’s balance sheet the value of the property is less than given amount of loan There is unpaid loan with interest There will be additional costs for the bank to hold, manage and market the property