Unlikeliness to Pay: a Worked Example

A business in decline usually pays its bank last of all to fall behind. It stretches suppliers, runs down cash, sells assets or borrows from its owners, and the instalments keep arriving. A default test built only on arrears would therefore report the problem months after the lender could see it. Supervisors pair the 90-days-past-due count with a judgement test so that the classification follows the credit, not the payment calendar.

The test asks one question of the whole borrower: will it repay in full without the bank having to realise its security? If the answer is no, the borrower is in default, with every consequence that carries for the bank's provisions, capital and reporting. A loan that would be repaid only from a sale of the security can still be well secured, and the bank may lose nothing, but the borrower has defaulted.

The UK's article 178(3) of the retained Capital Requirements Regulation and Australia's APS 220 give nearly the same list of elements that must be treated as indications. New Zealand's rules for its IRB banks use the same two-part definition.

Most of the list is the bank's own action, which is the point: a lender that provides against a loan, or restructures it because the borrower is in distress, has in effect already formed the view that the borrower is unlikely to pay, and would struggle to report it as sound. Banks add their own indicators in policy, such as a breach that signals distress, a lost major customer, or negative equity, but those are triggers for the judgement, not defaults in themselves. In the UK, banks using internal ratings are expected to follow the European Banking Authority's guidelines, under which a distressed restructuring counts as reducing the obligation once it cuts the loan's present value by more than a threshold the bank sets, at no more than 1%.

A chain of language schools for international students, constructed for this page like every figure in it, owes its bank US$7.5m at 8% and has not missed a payment. Enrolments have fallen by a third after a change to visa rules. At the annual review the bank finds the business paying everyone out of a cash balance that is not being replaced:

On a past-due test alone, nothing happens until around month 13: ten months of payments from cash, then three months of arrears. The review reaches the answer now. Without new money the business cannot repay in full, and the bank's estimate of what a sale would fetch leaves a shortfall it must provide for. Raising that provision is itself one of the listed indications, and with a ten-month runway it settles the judgement: the borrower is in default today, with its account fully current.

Suppose instead the bank were asked to cut the rate from 8% to 5% for two years to help the business through. On the full US$7.5m, leaving aside the principal repaid meanwhile, the saving to the borrower is US$225,000 a year. At the loan's original 8% rate, that is a present-value loss of 225,000 × 1.783 = about US$401,000, or about 5.3% of the loan's present value. Under the UK guidelines' test that is well past 1%, so the concession would itself put the borrower into default. APS 220 asks whether the forgiveness or postponement is material and sets no figure, so an Australian bank makes that call under its own policy.

A watch list is where a bank puts a borrower it is worried about. It changes how closely the file is managed, and it often brings a downgrade to a weaker grade, but the borrower is still performing. Unlikeliness to pay is the line beyond that: the bank no longer expects to be repaid in full without recourse to security. The early warning indicators that move a file onto the watch list are the evidence a credit officer then weighs when deciding whether that line has been crossed.

It also differs from the past-due count in how it ends. Arrears can be paid and the count stops. A default for unlikeliness to pay ends only when the bank can show the reasons have gone, and the rules add conditions before it may say so.

DEFINED IN ONE PARAGRAPH → · 90 DAYS PAST DUE → · EARLY WARNING INDICATORS →

The decision sits with the credit officer who reads the review, and the hard part is timing. A bank that has known for two quarters that a borrower is living on its cash, and has not classified it, has a problem with its supervisor as well as with the loan. The classification also reaches every exposure the bank has to that borrower, because Australia's rules for a business borrower, and the UK and New Zealand IRB rules outside the retail class, apply the test to the borrower, not the facility. The overdraft, the equipment loan and the guarantee line go into default with the term loan.

The second decision is the restructure. Any concession to a struggling borrower is tested twice: as forbearance, which sets how long the label lasts, and for whether it reduces what the bank will collect, which sets whether the borrower is in default. A credit committee that wants to help a viable business without a default label can sometimes do it by deferring rather than forgiving and charging interest on what is deferred: under the UK guidelines' present-value test that can leave the obligation undiminished. The guidelines still ask the bank to weigh the other signs of unlikeliness to pay, and in Australia whether a postponement is material stays a judgement. In a stage 3 file the same review usually produces the provision, the accounting classification and the workout plan at once.

PROBLEM LOANS AND WORKOUT → · THE THIRTEEN-WEEK CASH FLOW →