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Non-performing Loan
Discover how non-performing loans impact lenders and how alternative credit scoring can reduce risk and improve loan portfolio health.
Discover how non-performing loans impact lenders and how alternative credit scoring can reduce risk and improve loan portfolio health.
When issuing loans to borrowers, a financial institution expects to recover the full amount of money and earn income through interest and fees. This is obvious.
However, these plans do not always turn into reality. Sooner or later, some consumers violate their obligations under credit agreements, either delaying payments or failing to repay the debt altogether.
In such cases, we refer to non-performing loans (NPLs).
NPLs refer to loans for which the borrower fails to make scheduled payments over a certain period — typically 90 days or more.
Such transactions are considered risky assets. Regardless of the reason, the absence of payments negatively affects the financial position of the lending institution.
To assess the condition of a financial institution's loan portfolio, the NPL ratio is used. This indicator makes it possible to evaluate the share of loans that are in default or close to it.
This metric is calculated using the following formula:
A high indicator points to serious problems within the financial institution, namely:
To avoid such difficulties, lenders need to balance the number of performing and non-performing loans, minimizing the share of the latter as much as possible.
In many countries, the share of non-performing loans has remained critically high over a long period. In some regions — mainly concerning emerging markets — the NPL ratio reaches 55%:
One of the reasons for this situation is the imperfection of traditional credit scoring mechanisms.
As a rule, it relies on borrowers’ historical financial data. This includes credit history, information about official income, and credit rating.
Such information is often outdated at the time the applicant contacts the credit institution. Moreover, the limitations of this data do not allow lending to so-called thin files — borrowers with insufficient or no credit history.
For this reason, the creditor faces difficulties in the process of credit decisioning, namely, they may:
This issue can be solved by alternative credit scoring.
Alternative data refers to information beyond the traditional data that lending organizations can obtain from credit bureaus.
This may include data on utility and rental payments, insurance contributions, social behavior, and other similar information.
The most informative source of alternative data for credit scoring is recognized as a person’s digital footprint — all the information left about a user on the web as a result of their online activity.
For example:
Such data makes it possible to create a detailed profile of the applicant and make a truly informed decision about the advisability of lending.
Digital credit scoring helps creditors effectively combat non-performing loans thanks to the following advantages:
1. More accurate default prediction. With the help of alternative data, it is possible to identify red flags in the behavior of a potential borrower that traditional scoring models may miss.
This improves the accuracy of forecasting future loan performance.
2. Making informed lending decisions. Creditors can identify high-risk applicants already at the application review stage.
As a result, they can take timely, appropriate actions — for example, refuse to issue a loan, apply stricter terms, or conduct additional checks.
3. Expanding coverage. Turning to alternative credit data providers makes it possible to lend to population categories with limited or no credit history.
A lending organization can improve the quality of its loan portfolio by attracting reliable borrowers excluded from traditional credit markets.
4. Improved risk management efficiency. With the help of alternative data, creditors can build accurate credit scoring models.
This reduces the likelihood of lending to high-risk borrowers, minimizing the occurrence of NPL.
Fighting non-performing loans is crucial for creditors who strive to maintain profitability and stability. For this purpose, it is advisable to use alternative data, as it increases the efficiency of credit scoring and reduces the NPL ratio.
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