A loan disbursed by a bank can be turned into a bad loan in course of time due to various reasons. A loan may be bad because of the selection of wrong borrowers. It may be bad because of risks faced by borrowers which are beyond their control. The default may occur because of the problems specific to borrowers. The selection of wrong borrowers is the main reason for which a loan goes bad. This article focuses on the process of selection of wrong borrowers by banks which results to a large amount of bad loans in the banking sector of Bangladesh.
Information is at the centre of all financial transactions and contracts because decisions are made on the basis of information. The lender and the borrower are involved in a loan contract. The lender may not have all information about the borrower since information is not symmetrically distributed in the financial system. That is why one party has more information than the other and the party who has more information has potential to exploit the other with less information. The inequality of information between the bank and the borrower is known as asymmetric information. When the borrower gives all information to the bank, it is easier for the latter to assess the creditworthiness of the former. But in many cases, the borrower tends to give partial, wrong or even misleading information to the bank which worsens its decision making process.
The credit market consists of both honest and dishonest borrowers. The challenge faced by a bank in lending is identifying and selecting right borrowers. The selection of a borrower starts with the initial assessment of the same through an application form filled out by the borrower. There are scopes to fill out the form with fictitious information. While an honest borrower always gives true information, a dishonest borrower fills in the form by giving attractive information which may not be true. As a result, the filled out application of the dishonest borrower looks much better than that of the honest borrower. Here lies the trap for the credit officer and she or he may make mistake in the selection of the right borrower. The credit officer may select a dishonest borrower at the cost of an honest borrower which leads to adverse selection. When an honest borrower is termed as a dishonest, it produces an error known as type-one error. There is another kind of error, type-two error, which occurs when a dishonest borrower is termed as an honest borrower.
Both the errors are costly. When an honest borrower is rejected by a bank, it loses the opportunity to make profit because the honest borrower always tries to use the loan properly and makes timely repayment of the same. In contrast, accepting a dishonest borrower makes the loan risky because the borrower who deceives the bank by providing false or misleading information has every possibility not to use the loan in the right manner. Such borrower engages in high-risk activities which turn the loan into a default loan causing trouble for the bank.
EVALUATION OF CREDITWORTHINESS OF POTENTIAL BORROWERS: Now let us see what happens to the banking sector of Bangladesh that is plagued by default loans since the independence of the country. In Bangladesh, human relations among people are deeper than many countries, and they tend to share information with one another. The collection of information about a person in such a structure, where information-sharing is frequent, is not very difficult. If a credit officer is sincere in collecting information about a potential borrower, it is not hard to gather all the required information about him or her. The application form is the primary source of information about the borrower. The officer can also get more information through an interview which gives an opportunity to analyse the information given in the application form. The credit officer can also develop an idea about the borrower by observing his gesture, body languages, and comfort and uneasiness in answering the questions.
The credit officer can also visit the business of the borrower to observe his or her business condition. She or he can also talk to different stakeholders of the business like employees, accountants, legal advisors and raw material suppliers to gather information. If the credit officer can talk to those people properly, she or he will be able to identify the right borrower. However, the credit officer must have the ability to understand the implications of the words and statements given by those people. All those people cannot be purchased by the borrower at a time to furnish false information about him or her to the credit officer. There must be at least some persons who would provide true information about the borrower.
Once the information is collected by the credit officer, there are many qualitative and quantitative techniques to evaluate the creditworthiness of the borrower. The credit officer can apply credit scoring system, credit rating technique and financial statement analysis through accounting and statistical methods to understand the true condition of the borrower. If the information is correct and analyses are proper, there is less possibility that the credit analyst will select the wrong borrower. Accordingly, the performance of loans will be good.
WHY LOANS GET DEFAULTED: Still what makes selection of wrong borrowers that leads to huge amount of defaulted loans in Bangladesh? Is it because the bankers who work as credit analysts do not have enough knowledge to apply the techniques required to assess the creditworthiness of borrowers? The answer is a big "No." As far as the private banks are concerned, there is no lack of quality bankers, because most of the brilliant business graduates are now working in private banks. This sector has a pool of bankers with vast analytical skills. The public sector banks also have quality bankers who can keep default loans at minimum by selecting good borrowers. Such bankers can select the right borrowers in most of the cases by using their knowledge, experience and analytical capacity if they are given freedom to do so.
But there is undue interference from various corners which curb bankers' freedom in the borrower selection process. It is alleged that the board members of many banks whose duty should be confined to policy making for the banks often influence or obstruct lending decisions. Loans sanctioned in such manner may not pass the feasibility test. The managing directors and other bank officials just execute the directives. In such conditions, the credit officer is bound to prepare attractive proposals for the referred borrowers. The proposals are approved in the board and those loans ultimately go defaulted. When the board exercises such undue practices, the top bankers also sanction loans through corrupt practices and take undue benefit from borrowers. It sometimes corrupts the mid-level bankers too. However, when the irregularities of such loans are unearthed, the signing officer becomes the scapegoat.
This is not the end of the game. Politics also plays an important role here. There are allegedly political pressures via board members for some loans to be sanctioned. In many cases, political leaders are also in the board. These leaders are also sometimes lawmakers. Laws that lawmakers make are may have loopholes through which the defaulters can escape easily.
The legal procedures for collecting defaulted loans are very complex and lengthy which also encourage some borrowers to default intentionally. More importantly, the culture of impunity has a clear effect on the potential borrowers becoming defaulters in future.
Some loans are sanctioned without proper analysis of the proposals and they go bad; the responsibility here goes to credit officers. A few loans become non-performing when the borrower faces unavoidable risk factors which have negative impact on loan performance. It may be treated as the natural fate of those loans. But a good number of loans become bad because they are sanctioned as per the directives of many parties, including board members, politicians and various influential people. Here, the credit officers know ex ante that such loans will go bad ex post.
In this scenario, it is quite impossible to reduce the volume of defaulted loans in the banking sector in near future. The Bangladesh Bank has the list of top loan defaulters of the country which was given to the finance minister. But the list was not fully disclosed. If the authorities concerned are not even willing to disclose the names of the financial culprits to the nation, it can hardly be expected that the loan defaulters will be duly punished under the law.
Md. Main Uddin, PhD is a Professor of the Department of Banking and Insurance,
University of Dhaka.
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