Adversely Classified Asset

An adversely classified asset is a type of loan classification in which the loan or other asset is considered, to some degree, to be impaired. It is an asset that is considered by bank examiners to be of substandard credit quality and whose full repayment of principal and accrued interest is questionable. In other words, an adversely classified asset is a loan that a bank doubts will be repaid.

According to the Risk Management Manual of Examination Policies used by the FDIC, adversely classified loans fall into three categories: substandard, which are unduly risky and, if unimproved, may be a future hazard; doubtful, whose collection is highly questionable and improbable; and loss, which is considered non-collectable.

A loan that is classified as substandard is one that not adequately protected by the borrower’s current worth, capacity to pay or collateral. The liquidation of this debt is therefore in jeopardy. Such a loan must have a weakness or payment concern that puts the bank’s ability to collect on this debt in question. In credit cards, for example, an open- or closed-end credit card debt that is 90 or more cumulative days past due will be classified as substandard.

A loan that is classified as doubtful has all the weaknesses inherent to the substandard classification, with the added characteristic that these weaknesses make the collection in full of the loan highly unlikely. A loan that is classified as a loss is one that cannot be collected at all, and its value has become so low as to no longer justify its continuation as a bankable asset. This may not necessarily mean that the loan has no potential for salvage or recovery, but it does mean that it’s no longer desirable, or practical, to refrain from writing it off. A loan that is classified as a loss is pretty much worthless, even if it may be partially recovered at some future point. An example of an asset classified as a loss would be a closed-end credit card loan that is 120 cumulative days past due, or an open-end credit card loan that is 180 cumulative days past due.

The current method of calculating the Allowance for Loan and Lease Losses means that the most common adverse classifications are substandard and loss.

An asset may be classified special mention if it has potential weaknesses that need to be examined by a loan manager. These weaknesses could contribute to the asset’s becoming adversely classified at some point in the future, if they are not corrected. However, special mention assets are not considered adversely classified, nor do they expose the granting institution to enough risk to warrant such a classification.

An asset must be adversely classified before an examiner can calculate the impairment amount. This will illuminate the book value of the asset and its collateral. Besides stating the amounts of adversely classified assets in each category, bank examiners also typically compute the ratio of adversely classified assets to total assets and the ratio of adversely classified loans to total loans.