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The dilemma of handling NPLs

Update : 05 Dec 2021, 08:24 PM

The problem of a high-level of non-performing loans has plagued the Bangladesh financial system for decades.

As noted in the previous columns, NPLs reduce the growth of the economy by wasting resources that could go to a better purpose.

This is a somewhat theoretical view and a deeper understanding of the impact of NPLs is needed.

All loans carry the risk that circumstance or character will prevent repayment.

In Bangladesh we can see two different themes of the impact of this risk on non-performing loans.

One is through the operations of the state commercial banks, the other through the private banks. 

The state commercial banks carry very high levels of non-performing loans as a result of making loans for purposes and projects that would never meet proper banking standards and default is almost guaranteed. 

Much of this reflects government policy. 

Many state enterprises borrow from the SCBs to cover their operating costs as revenues are controlled by regulation at levels that guarantee the borrower will lose money.Ultimately the government will cover such loans. 

Allowing the enterprise to run up loans to cover expenses or even to make investments separates the losses of the enterprise from the budget. 

Good accounting management would close the enterprise loss by a budget transfer. 

Government often prefers to maintain a lower deficit and so “hides” part of the deficit in loans from the state commercial banks to state enterprises. 

Of course, there are plenty of scams and corrupt loans issued by the SCBs. 

Together these two types of loans lead to a very high level of non-performing loans. 

Private banks have a different structure for NPLs:  When the governance system is working correctly, then the natural behavior of the profit maximizing commercial bank is to limit loans to those that have less than a minimum level of risk. 

The bank does not want to take chances. 

However, entrepreneurs may be prepared to take on much more risk particularly if they believe there is a good chance they can avoid adverse consequences. 

If an economy has the opportunity for rapid growth, then the conservative view of the private banker slows the economy!

Riskier behavior by the private banks would result in more borrowing and more rapid economic growth. 

More rapid growth will make many enterprises profitable that would not be in a slower growth environment. 

This has certainly been the case in Bangladesh over the past 20 years when growth was typically faster than private bankers expected.

The NPL levels at private banks have reached levels that require a high lending rate to cover the losses. 

Further, there is some evidence that competition among private banks has declined arising from covert relationships among Directors or ownership by a group of several banks.

Such relationships, by reducing competition among enterprises, leads to a greater willingness to default and defer repayment.

 Reform programs to reduce NPLs

When the government and Bangladesh Bank set out in 1990 to reform the financial sector, a major focus was to reduce loan losses. 

There were seven actions taken to tackle this problem. 

1.      Shift of the banking sector to a much greater role for the private banks. This automatically would reduce the average level of NPLs.

2.      The governance system established for the financial system would punish banks with poor recovery records and encourage owners and staff to improve lending efforts. The introduction of a strict provisioning system forced banks to recognize the costs of a NPL. Previously, bad debt costs were deferred indefinitely into the future and had limited impact on the current management of the bank. The reforms required the bank to recognize bad debt quite promptly. Higher costs reduced profits, leading to lower dividends and additional capital requirements. Private owners would work to prevent this.

3.      The introduction of the Credit Information Bureau (CIB) that would maintain records of defaulting companies and individuals and such information would normally cut off credit to borrowers who already had loans in default. Previously cross checking of credit quality among banks went on in theory, but this was not done in a systematic manner.  The CIB made this process much simpler. 

4.      The money loan courts were established. The courts were to hear disputes over non-repayment of loans or other commercial contracts. There was a requirement for judgment to be reached in six months. Most bank loan cases are straightforward and the defaulter is required to pay within a short period or the bank can take control of the collateral. The bank normally would auction off the assets provided as collateral. Most loan contracts also allowed the bank to seize possession of the personal assets of the sponsors of the defaulting borrowing organization. 

5.      A Bankruptcy Law was passed and courts set up to implement the law. The Bankruptcy Law was structured to allow a systematic process of restructuring the defaulting company including writing off of some liabilities so as to get the company in shape to continue to function profitably. 

6.      Rules were introduced to limit the size of the ownership of the individual private bank and also to prevent one individual or household from owning more than one bank.  This was meant to increase competition and limit covert relationships between directors.

7.      Government banks with the worst record were limited in their rate of expansion of credit. This, plus issuance of many private bank licenses, would result in a greater proportion of lending to private enterprises passing through the private banks.

Fate of the reform program efforts to reduce NPLs:

1.      The banking sector shifted to increased private banking directly improving loan quality and reducing NPLs. 

2.      The Bangladesh Bank did an amazing job of introducing the provisioning rules and auditing their implementation. Costs of NPL began to appear in the financial condition of the banks and banks responded rapidly to prevent lending to poor quality borrowers. The impact on profitability was immediate. As time passed the quality of the central bank supervision declined, resulting in insufficient recognition of the bad debt costs. The central bank allowed banks to avoid recognition of their bad loan costs, i.e. not taking full provisions into account. The two effects were thus (1) not classifying bad loans and (2) allowing banks to avoid taking the provision as costs. This resulted in banks' capital adequacy ratios being exaggerated. It is necessary to reverse these trends by increased effort at monitoring and auditing the identification of classified loans and taking the appropriate provisions. The central bank should never allow the bank to avoid recognition of the provisions. This will reduce profits and dividends. It will also lead to a reduction of the bank’s capital. Banks without adequate capital must be required to correct this condition promptly. Failure to maintain capital adequacy must be dealt with by takeover by or merger with another bank. If this is not achieved then Bangladesh Bank must take over the bank, restructure it, ultimately selling it back to the public or closing the bank.

3.      The CIB works very well. However, some large defaulters are reported to have obtained stay orders to prevent the CIB from reporting the person as a defaulter. Obviously, this is a gross misuse of the law. The key is to get these cases disposed of in one month. The judicial system can easily do this as the facts are simple to present.

4.      The money loan courts were never able to reach the 6 months target for judgment. It is closer to five years. The Ministry of Law can create many more money loan courts, increase training of judges, and maintain records of the status of cases at each court. Improving the effectiveness of the money loan courts is a major signal that the Government is serious about improving loan recovery.  Without a major effort improving these courts the only conclusion is that the society is not serious about stopping the loan defaulters.

5.      The Bankruptcy Courts were a failure and have had limited impact. The legal and financial system in Bangladesh is not mature enough to use bankruptcy courts effectively and it is best to abandon the whole system. Efforts should concentrate on improving the Money Loan Courts.  Programs to support restructuring should be left to the commercial banks to work with the defaulting borrower.  But no loan should be rescheduled with a restructuring program.

6.      Efforts to limit ownership to prevent one person or one family from excess control of one bank have been only partly successful. Efforts to prevent one person from controlling more than one bank have failed. Nothing can be done about this. The power of the wealthy families and groups is too strong for Bangladesh Bank to control.

7.      The SCBs have been able to increase their lending too rapidly. Bangladesh Bank should limit increases in lending to the private sector by the SCBs to some fixed percent of net lending [outstanding balance of loan reduced by provisions]. A reasonable growth rate is 2-3%.

The poor loan recovery of the banks is a long-standing Bangladesh problem. 

The situation is deteriorating and requires immediate attention.

The items listed above would have a powerful impact and gradually reduce the volume of NPLs.


Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.

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