Bad credits: their origin and causes of occurrence
Table of contents: The Kazakh-American Free University Academic Journal №6 - 2014
Author: Trofimova Yuliya, Kazakh American Free University, Kazakhstan
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
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
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"
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
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
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
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.
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
- 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
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;
the reputation of the credit institution, the confidence of depositors and
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
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
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
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
- improper loan
- 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:
existence of overdue payments to the budget;
violation of terms of providing financial and source documents to the bank;
- Poor quality
of loan collateral;
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.
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
8. Brockhaus F.A., Efron
I.A. (Eds) (2002). Encyclopedic Dictionary. Modern Version. Moscow: Unity.
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.
Lavrushin O.I. (Ed.) (2009). Bank Management. Moscow: Knorus.
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.
Table of contents: The Kazakh-American Free University Academic Journal №6 - 2014