Bad credits: their origin and causes of occurrence

As the banks carry out credit operations, dealing with bad credits becomes extremely important for securing credit recovery.

By saying ‘bad credit’ we mean loans that the borrower has difficulties paying back in full concordance with bank agreements and contracts which brings about a potential threat of partial or total loss of money to be repaid to the bank by a borrower in accordance with a lending commitment (Sorokin, 2006).

The term is translated into Russian as a “problem loan” which means a doubtful loan causing distrust, suspicion, or anxiety (Dal, 1980). In banking practices it is quite often associated with overdue loan, which is not the same and the two notions should not be confused. An overdue loan cannot be treated as a bad loan, since short-term payment delay does not affirm a threat of a loan default. On the other hand, absence of overdue payments does not guarantee loan reliability.

American specialist in the field of bank management P.S. Rose thinks that the loan is to be treated as a bad credit if a borrower failed to settle one or more payment obligations or if a credit collateral value decreased (Rose, 2004).

British specialists of the Civil Council believe that a bad credit appears when a borrower cannot clear a bill or settle an obligation without cutting other expenses.

According to S. Collard and E. Campson inability to clear the bills over a three-month period indicates a bad credit. The longer it takes to admit that the loan has turned to be a bad one and start working with it, the smaller is a chance to have the credit repaid.

Rating agency Standard & Poor’s defines bad credits as follows:

- all overdue loans;

- all loans to people associated with troubled borrowers;

- renegotiated loans;

However, this list defines a risk zone rather than describes bad credits (Karimova, 1012).

In the research works of some economists the notion “bad debt on a loan” is often substituted with the notion “bad credit”. A loan differs from a credit in the fact that the loan can be non-repayable while the credit must be repaid (Kazakov, 2008). Here the notions “loan” and “debt” are considered with the financial and economic point of view and within the given context there is no dramatic difference between these notions.

Sometimes the English term “bad credit” is translated into Russian quite literary. This translation, in our opinion, is not very accurate. At the same time these phrase occur in most of the works devoted to the problem of lending borrowers as maintenance of credit portfolio. However, only few authors explain the notion. In her works, K.R. Tagirbekova defines a credit as "a loan on which the borrower doesn’t commit obligations on time and to the fullest extent or the value of collateral significantly decreased" (Tagirbekova, 2001).

Having considered the definitions of a “bad credit” we can conclude that this is a credit that is characterized by a set of features that raise reasonable fears among loan inspectors concerning repayment of a principal debt an interests on debt (bank fee).

To illustrate the object, subjects and the subject matter of the overdue loan we need to draw parallels with the notion of the credit, as well as its object, the subject and the subject matter.

A loan is the provision of money or goods on credit, usually with interest payments (Bukato, Golovin, Lvov, 2001).

The Brockhaus and Efron Encyclopedic Dictionary defines credit or loan as a relationship originating from a lending transaction according to which one party passes certain valuables (usually money) over to another party that is obliged to return them in a certain period of time with a bonus (interests) (Brockhaus, Efron, 2002).

The essence of the loan is defined by the nature of the economic processes that occur only in the event of credit relations.

By analogy, it can be assumed that the essence of an overdue loan is determined by the content of the economic processes that occur only in the event of default or failure to repay the debt in a timely manner.

The most widely spread subject of an overdue debt or a loan is money, but it may also be certain valuables; its main difference from a subject of a loan is that these are valuables or money that were in part or in the whole unpaid to date.

The object of the loan is cash or goods provided as a loan (debt), expressed in value. Hence, the object of a credit is credit and economic relations connected with the movement of the cost subject to the starting point on terms of collectability (the lender).

The object of an overdue loan in general is a partial or complete failure to return the money or goods that have been borrowed (debt).

The subjects of an overdue loan are the lender and the borrower, same as the subjects of a loan.

Special credit institutions, primarily banks, non-banking credit organizations, grants and the state may act as creditors. Individuals and legal entities like, businesses, organizations, including banks and the state can act as borrowers.

V.D. Zharikov classifies bad debts into irrecoverable debts and “gray” debts.

A group of irrecoverable borrowers impedes conducting business because they do not meet the conditions of the loan agreements and, as a rule, they themselves need financial recovery.

A group borrowers referred to as "gray" is considered as the most problematic for the following reasons. This is an understudied category of clients which requires special attention during a period of financial recovery (Zharikov, 2009).

Operations of any bank occur within the system of life-sustaining activity in the country and the world, i.e. within the variety of relations with the community, with other banks, businesses, public authorities of the country, and also abroad. In other words, operations of banks are affected by a wide variety of external factors, such as macro-, meso - and micro-economics of the country, the level of development of legislation, foreign and domestic policy of the country, the standard of living and the level of education of the population, social and demographic situation in the country, climatic conditions, and many others. Consequences of the influence of these factors on the bank operations can be both positive and negative.

M.Y. Sorokin writes about four factors that aggravate the problem as shown in Figure 1.

Figure 1. Factors, aggravating bad debts

If we consider each group of factors separately then we shall find the following:

- Inflation factor: a high inflation level is characteristic for developing countries and countries with transition economies. Inflation rate has a direct correlation with the level of interest rates in the economy. If the average level of profitability is lower than the inflation, the demand for bank loans implies negative interest rates. Under the influence of external or internal factors negative changes in the industry may lead to a serious deterioration in the financial condition of borrowers which will place in jeopardy the fulfillment of credit obligations;

- Fiscal deficit policy: existence of a large fiscal deficit means that the government was forced to apply for external and internal borrowings, thus increasing the amount of public debt. It is characterized by accelerated pace of lending to the public sector and vice versa inconsiderable lending to a private sector. This results in the increased interest rates and, therefore, in the increased risk of a bad debt crisis;

- Currency exchange rate: fixing and overvaluation of the currency exchange rate make a negative effect on the pricing mechanisms. This situation is characterized by the increased risks of banks and their customers. When an exchange rate changes suddenly some of the borrowers appear to be unable to meet their credit obligations;

- Slowdown in GDP growth rate: the biggest danger is the situation where there is a significant decline in GDP growth or general economy growth rates become negative. This results in a reduction in income and leads to development of problems in debt payments (Sorokin, 2006).

E.P. Shustova provides a matrix of indicators of bad debts: the signs of emerging problems are be found among the indicators characterizing the primary and secondary guarantees of the credit recovery. In order to systematize these signs Table 1 provides a matrix of bad debt indicators.

Table 1. Signs of emerging bad debts

Losses caused by bad loans are not limited only to direct losses from non-repayment of loans and non-payment of loan interest. The loss may be more noticeable if you consider that bad loans:

- "freeze" the bank funds in unproductive assets;

- undermine the reputation of the credit institution, the confidence of depositors and investors;

- increase bank administrative costs;

- increases the risk of outflow of qualified personnel from the bank due to the reduction in their material incentives caused by decrease in credit transactions profitability (Shustova, 2011).

We can refer to a debt as a bad one only in respect of loans already issued. The reasons for their existence can be varied. Some may be related to the client, others to the bank operations; some of them are of an objective nature, others dependent on the subject.

Borrower-related bad loans are most often connected with the borrower’s job.

Reasons out of the borrower’s control that cause bad debts most often include unforeseen political and economic events and changes in the legislation. The debt reason is external to the borrower.

Reasons that are not related to the bank operations are diverse. They include a sharp deterioration in the economic situation, when the non-payment of bank loans has become a common phenomenon. Also, they may include natural disasters that affect bank operations.

Bank-related reasons are connected with different violations of the loan process.

This may include:

- provision of a loan based not on economic rationale but on friendship relations with the borrower;

- poor or unprofessional analysis of a loan application;

- poor loan structuring from the risk perspective;

- insufficient loan collateral;

- improper loan registration;

- poor control over the borrower’s work during the loan disbursement period.

Table 2 provides information about the main causes of deterioration of banks' loan portfolio and their classification according to the origin.

Table 2. Classification of bad debt causes according to their origin

All of these reasons, one way or another, lead to a breach of the lending process, undermining the stability of both the borrower and the creditor bank.

Of course, the consequences do not occur immediately. "Getting mature", they gradually affect the lend money, and, one way or another, demonstrate signs of their negative impact. These may be indications reflecting the financial condition of the borrower, testifying to:

- The existence of overdue payments to the budget;

- The violation of terms of providing financial and source documents to the bank;

- Poor quality of loan collateral;

- Short-time delay in loan repayments and loan charges;

- Frequent requests for loan rollover (Lavrushin, 2009).

One of the most significant factors leading to the increase in the number of bad debts is loan tightening. Obviously, the difference between the floatation and attraction of financial resources is a fee to the bank for providing financial intermediation services, and banks are interested in selling their resources at higher prices. However, tight loans lead to the inability and even unwillingness of the borrowers to service excessively tight loans, as a result, increase the risk of delay or non-repayment of loans. It is obvious that the brunt of expensive loans ultimately lies with the borrower.

A tight loan is a kind of trap for borrowers, which turns a prompt payer into a non-payer due to a paradoxical situation when the borrower agrees to any terms of the loan agreement to get the money, knowing that he could not meet them. Then, a bank turns to be in a critical situation (Smulov, Nurzat, 2009).

Thus, there is no generally accepted notion of a bad debt; each author treats it in a different way. The same can be said about the factors and causes of emergence of bad debts, which can be varied but, anyway, each of them has a direct impact on the emergence of problems in the repayment of the debt.

REFERENCES

1. Sorokin M.Y. (2006). Predictors of Bad Debt Crisis. Lending Market, № 05, pp.46-56.

2. Dal V.I. (1980). Explanatory Dictionary of the Russian Language. Moscow: Russian Language.

3. Rose P.S. (2004). Bashnish I.V., Novikova I.y. (Eds). Bank Management. Moscow: Delo Ltd.

4. Karimova Sh.D. (2012). Bad Credit, definition and causes. Banks of Kazakhstan, №5, pp.19-25.

5. Kazakov O.N. (2008). Discussion Questions on Loan and Inter-bank Loan. Banking Services, №9, pp. 5-7.

6 Tagirbekova K.R. (Ed) (2001). Study Guide: Fundamentals of Banking. Moscow: Ves Mir.

7. Bukato V.I., Golovin Y.V., Lvov Y.I. (2001). Banks and Banking Operations. Moscow: Finances and Statistics.

8. Brockhaus F.A., Efron I.A. (Eds) (2002). Encyclopedic Dictionary. Modern Version. Moscow: Unity.

9. Zharikov V.V. (2009). Study Guide: Managing Loan Risks. Tambov: Tambov State Technical University Press.

10. Shustova Y.P. (2011) Bad credit: Criteria for Definition and Causes of Emergence. Altai Academy of Economics and Law Bulletin, pp. 11-13.

11. Lavrushin O.I. (Ed.) (2009). Bank Management. Moscow: Knorus.

12. Smulov A.M., Nurzat O.A. (2009) Bad Debt: Concept, Main Characteristics and Measures to Increase the Repayment Efficiency. Finances and Loans, №35, pp. 7-9.