What to Know About Substandard Loans

Banks issue loans to businesses and individuals for a variety of purposes. Those loans are then classified a certain way based on a variety of factors often outside the bank’s control. The classification can affect whether or not the loan will be granted or declined. A loan classified as substandard can alert the bank to certain potential problems.

What Is a Substandard Loan?

Loans are classified based on the ability of the signer to repay the debt. A substandard loan doesn’t have adequate protection based on the obligor’s paying capacity or current worth. The bank should be prepared to sustain a loss based on the potential for the obligor to default based on current deficiencies.

Who Determines the Classification?

Since loans are based on their risk of nonpayment above all else, examiners carefully evaluate the loans to determine the classification. Substandard, doubtful and loss classifications all have adverse risks associated with them. In essence, the examiner has doubts on the ability of the obligor to repay the debt or the assets ability to pay it if sold. The examiner looks at a variety of factors including how the loan was previously classified and the other assets and debts of the obligor.

What Happens When the Loan is Substandard?

If the loan has already been awarded, the banking institution may more carefully monitor the loan itself. Banks naturally want to minimize their risk of loan defaults. They may choose to limit the number of impaired loans they are willing to take on as an institution. Each bank should have their own policies in place for how they handle these types of classifications.

The risks associated with a loan classified as substandard depend on the obligor and the deficiencies seen by the examiner. Sometimes deficiencies can be addressed and change the classification of the loan or make the obligor more likely to be awarded the loan. An expert can ascertain the risks associated with each loan and classification.