Deleveraging of Debts: How can this improve the Credit Ecosystem

25th Feb 2022, Industry Insights

Bad loan problem is one of the biggest challenges for a nation.  A debt pile impacts the valuations of companies and their overall financial health. This in turn is a reason behind the slowing down of the economic growth of a country. When the bad debts reach a certain level, financial institutions are also unwilling to lend in such circumstances, thereby, increasing the problem of non-availability of credit. Policymakers in different countries understand the importance of getting out of this situation and have taken several steps in the right direction, but success has not yet been forthcoming.

Let us now understand what one means by deleveraging of debts?

The process by which a financial institution reduces their level of indebtedness, by increasing their capital and reducing assets is called deleveraging of debts. In other words, deleveraging is the reduction of debt and the most direct way for an entity to deleverage is to immediately pay off any existing debts and obligations on its balance sheet.

The Asian market for distressed loan is young and fragmented but has huge potential, specially after the Covid-19 pandemic. Distressed assets are assets which are unable to service interest and principal for more than 180 days and subsequently become delinquent. They are inversely proportional to economic growth as these assets only end up consuming additional capital.

A company can use the following techniques to deleverage:

Debt Sale:

When banks and financial institutions (FIs) sell their portfolios to a third party or collection agencies, it is called debt sales. The sale of debt by lenders/ creditors to buyers is generally done at a discounted rate. When a debt buying company purchases an account from a creditor, it purchases the contracts and all rights, benefits and liabilities that were held by the creditor associated with the contract. These purchases can include accounts that are performing (i.e., making payments), as well as those that are nonperforming (in default). However, most of the time debt sales is mostly performed on stressed portfolios which are mostly deemed unrecoverable.

Debt sales is generally resorted by lenders for the following reasons:



Developing strategies for management of NPLs

Financial institutions need to address their NPL problems by developing a detailed strategy for its supervision. This includes the following steps:

Collection strategy of NPL accounts begins with portfolio classification and bucket categorisation sorted as performing loans DPD 0-30, 30-60, 60-90, DPD 90-360 days and DPD>360 days. Once the portfolio has been clearly identified and bucketed, creditors need to decide upon which portfolio to be collected internally, which to be outsourced and which to be sold. The following table can be followed to recognise the same:

Portfolio Selection Criteria

Financial institutions need to identify the portfolio which needs to be sold. Thus, a criteria dependent on following factors can be developed:


Deleveraging of debts helps the company to get rid of toxic debt, a type of debt where the company cannot pay back the interest and principal amount. A reduction in toxic debt will reduce the number of liabilities on the balance sheet and improve financial ratios, which will be looked at favorably by lenders and investors. Thus, policymakers should work towards taking steps to have more inclined methods and processes for deleveraging of debts, thereby helping the credit ecosystem.