Non-Performing Loans (NPLs)

• The Bottom Line: Non-Performing Loans are the “bad debts” on a bank's books—loans that have stopped generating income because the borrower is behind on payments, serving as a critical barometer of the bank's health and lending discipline.
• Key Takeaways:
• What it is: An NPL is a loan for which the borrower has failed to make scheduled interest or principal payments for a specified period, typically 90 days or more.
• Why it matters: NPLs directly attack a bank's profitability and capital base, acting as a major red flag for poor risk_management and a potential threat to shareholder value.
• How to use it: Analyze the NPL Ratio (NPLs as a percentage of total loans) to gauge the quality of a bank's loan portfolio, tracking its trend over time and comparing it against its peers.

Imagine you lend your friend, Bob, $1,000 to start a small business. You both agree he'll pay you back $100 a month for ten months, plus a little interest. For the first three months, everything is great. The payments arrive on time. Your loan is “performing” perfectly. Then, Bob's business hits a rough patch. He misses the fourth payment. Then the fifth, and the sixth. He's now 90 days overdue. Your once-productive loan is now a source of worry. It's no longer generating income for you; it's a “non-performing loan.” You're now less focused on the interest you should be earning and more concerned about whether you'll ever get your original $1,000 back. A bank operates on the exact same principle, but on a colossal scale with thousands of loans for homes, cars, and businesses. When a significant number of its “Bobs” stop paying, those loans turn into NPLs. They transform from assets that generate steady income (interest) into massive liabilities that drain resources, eat into profits, and can, in a worst-case scenario, threaten the bank's very survival.

“The first rule of banking is not to lose money. The second rule is not to forget the first rule.” - This simple wisdom, often attributed to successful bankers, underscores the critical importance of avoiding the very NPLs that cause losses.

For a value investor, analyzing a bank is not about finding the fastest-growing lender; it's about finding the most prudent and resilient one. NPLs are the arch-nemesis of prudent banking and a direct assault on the principles of value investing.

• Direct Attack on Earning Power: A bank's primary job is to earn a spread between the interest it pays on deposits and the interest it receives on loans. A non-performing loan is a dead weight—it generates zero income while still occupying a spot on the balance sheet. A high NPL level cripples a bank's core profit engine.
• Erosion of the Margin of Safety: When a bank recognizes a loan might go bad, it must set aside money to cover the potential loss. This is called a loan_loss_provision. This provision is a direct expense that reduces the bank's current earnings. If the loan defaults entirely, the bank must write it off, which can permanently destroy a portion of its book_value. A high level of NPLs is a clear sign that the bank's reported book value—a key metric for value investors—may be built on a foundation of sand, offering a very thin margin_of_safety.
• A Barometer of Management Quality: A consistently low NPL ratio is often the hallmark of a disciplined, conservative management team that prioritizes loan quality over reckless growth. Conversely, a rapidly rising NPL ratio signals that management may have been chasing short-term profits by lending to less creditworthy borrowers. As Warren Buffett noted about the banking industry, “It's only when the tide goes out that you discover who's been swimming naked.” NPLs are what the receding tide reveals.

A value investor looks for durable, predictable businesses. A bank with a high and volatile NPL history is neither. It's a speculative bet on recovery, not a sound investment in a quality franchise.

The most common way to measure NPLs is through the NPL Ratio, which contextualizes the problem by showing the size of the bad loans relative to the whole portfolio.

The formula is straightforward:

NPL Ratio = (Total Value of Non-Performing Loans / Total Value of Outstanding Loans) * 100

* Total NPLs: The sum of all loans that are 90+ days past due. This is found in a bank's financial reports (like the 10-K or Annual Report).

• Total Outstanding Loans: The bank's entire loan portfolio.

The result is a percentage that tells you what proportion of the bank's assets are “sick.”

A number in isolation is meaningless. The key is context, trend, and comparison.

• Absolute Level: While there's no universal “magic number,” a general guide for a healthy bank in normal economic times is:
  • Excellent: Below 1%
  • Good: 1% - 2%
  • Concerning: 3% - 5%
  • Red Alert: Above 5%

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• The Trend is Everything: A bank with an NPL ratio that has steadily declined from 4% to 2% is often a much better investment than a bank whose ratio has “improved” from 1% to 1.8%. The direction of the trend is a powerful indicator of whether management is getting risk under control or letting it spiral.
• Compare with Peers: Always compare a bank's NPL ratio to its direct competitors. If Bank A has an NPL ratio of 3%, it might seem high. But if its closest competitors are all sitting at 5%, Bank A is demonstrating superior underwriting. This is a critical part of determining if the bank has a competitive advantage, or economic moat, in its lending practices.

Let's compare two fictional banks to see how NPLs reveal the true quality of a business over time.

At first glance in Year 1, the banks looked similar. Growth First Bank might have even been favored by momentum investors for its aggressive expansion strategy in Year 2. However, the value investor, focusing on the NPL ratio, would have been alarmed. Growth First Bank's rapid expansion came at the cost of quality. To grow its loan book by 20%, it had to lend to much riskier clients. When a mild economic downturn hit, its NPLs exploded from 2% to a dangerous 5%. This forced it to take massive loan loss provisions, wiping out its profits and hammering its stock price. Meanwhile, Steady Savings Bank stuck to its conservative lending standards. Its loan growth was “boring,” but its NPLs remained stable and low. It sailed through the downturn with its profitability and book_value intact, proving itself to be the superior long-term investment.

• Objective Indicator: The 90-day rule provides a relatively clear, standardized trigger for classifying a loan as non-performing.
• Early Warning System: A rising NPL trend can signal deteriorating economic conditions or poor internal risk controls long before a bank reports a major loss.
• Strong Comparative Tool: It's one of the most effective metrics for comparing the fundamental asset quality of different banks.

• Lagging by Nature: A loan is only classified as an NPL after the borrower has already been in trouble for three months. The underlying problem existed long before it showed up in the ratio.
• Vulnerable to “Evergreening”: Banks can sometimes hide a problem loan by “restructuring” it—for example, by extending the repayment term. This can keep the loan technically “performing” on paper, delaying the recognition of a loss. This practice is often called “extend and pretend.”
• Doesn't Show Recovery Value: The NPL ratio tells you how many loans have gone bad, but it doesn't tell you how much the bank might recover from selling the collateral (e.g., foreclosing on a house or seizing business assets). A bank with high NPLs but strong collateral may be in better shape than one with moderate NPLs secured by worthless assets.

• loan_loss_provision
• book_value
• return_on_equity_roe
• net_interest_margin_nim
• margin_of_safety
• risk_management
• circle_of_competence