
Dynamics of loan classification and provisioning: How it affects financial health of a commercial bank
Sunday, 30 October 2011
Lending is a principal business activity for banks. Loan portfolio is therefore typically the largest asset and the source of revenue for banks. In view of the significant contribution of loans to the financial health of banks through interest income earnings, these assets are considered the most valuable assets of banks. Unfortunately, some of these loans fail to perform and eventually result in bad debts which affect banks earnings. These bad loans become liabilities for banks in terms of their implications on the quality of their assets portfolio and profitability. This is because in accordance with banking regulations, banks make provisions for non performing loans and charge for bad loans which adversely impact on the bank's financial performance through reduction in loan interest income, profits and lending funds.
Loan Classification: Loan classification refers to the process banks use to review their loan portfolios and assign loans to categories or grades based on the perceived risk and other relevant characteristics of the loans. The process of continual review and classification of loans enable banks to monitor the quality of their loan portfolios and, when necessary, to take remedial action to counter deterioration in the credit quality of their portfolios. Loan portfolios are classified into various categories to determine the level of provisions to be made for it. Poor Grading scheme undermines the provisioning process and leads to distortions in a bank's balance sheet and an overstatement of capital and capital ratios. Therefore, loan classification system is crucial for bank management, depositors, owners, auditors and of course the regulators.
Loan loss Provisioning: Loan loss provisioning is a method that banks use to recognize a reduction in the realizable value of their loans. This guarantees a bank's solvency and capitalisation if and when defaults occur. Safeguarding the depositors' money, protecting owners' equity, ensuring proper recycling of fund, ensuring proper credibility of the financial system, and restoring trust and confidence in the mind of the depositors are major objectives of provisioning.
Effects of Loan Classification and provisioning: (a) On lending fund:
Non performing loans can lead to inefficiency in the banking sector. The phenomena that banks are reluctant to take new risks and commit new loans are described as the "credit crunch" problem. A "credit crunch" is a disequilibrium phenomenon. It exists when banks are unwilling to lend, especially when a firm with profitable projects cannot obtain credit in spite of low interest rates. Credit crunch results in excess demand for credit and hence credit rationing, where loans are allocated via non price mechanism. Eventually, it imposes additional pressure on the performance of the monetary policy.
Specially, the reluctance of banks to lend can be caused for several reasons, such as the increased capital adequacy requirement imposed by Basel Accords; impaired debt servicing capacity, especially small to medium enterprises (SMEs); risks of a further fall in collateral value, etc., which make the interest rate not to serve as the main determinant by banks in credit approval. Non performing loans have been viewed to constitute one of the most important factors causing reluctance for banks to provide credit. In a high NPL (non performing loan) condition, banks increasingly tend to carry out internal consolidation to improve the asset quality rather than distributing credit. Also, the high level of NPLs requires banks to raise provision for loan loss that decreases the banks' revenue and reduces the funds for new lending. The cutback of loans impairs the corporate sector as companies face difficulty in expanding their working capital, limiting their options for resuming normal operation or growing. Unavailability of credit to finance firms' working capitals and investments might trigger a second round of business failure which in turn exacerbates the quality of bank loans, resulting in a re emerging of banking or financial failure. In a worse case scenario, it triggers an endless vicious liquidity spiral: As a result of poor economic condition and the depressed economic growth, the level of NPLs increases the weaker corporate sector makes banks more reluctant to provide additional credits with insufficient capital, the production sector is further weakened, resulting in decreases in aggregate demand again, even worse, borrowers' condition creates more NPLs.
One implication from the Credit Crunch view is that increased non performing loans can cause the decline in commercial bank credits, as banks with high level of non performing loans in their portfolio may become increasingly reluctant to take up new risks and commit new loans.
Normally, the supply of loans is determined by banks' lending capacity and factors that influence banks' willingness to provide credits. . Based on Credit Crunch view, the NPLs should have a negative effect on loans, implying that the higher NPLs in a bank's portfolio, the less credit that the bank can and is willing to supply.
For a simple commercial bank balance sheet, assets are mainly composed of commercial loans and other earning assets; while on the liability side, deposits and capital are the main components. Thus, we can conjecture that the loan growth is affected by deposit growth, capital growth and other earning assets growth. In addition, we take the non performing loan growth into consideration. The basic model is as follows:
LGR 1.1= ao + a1 DGR 1.1 + a2CGR 1.1+ a3OAGR 1.1 + a4NPLGR 1.1-1
where ,the index i is the index for individual banks and i is the index for time period. LGR1.1 is the loan growth rate, DGR1.1 is the deposit growth rate in each time period t, CGR1.1 is the capital growth rate, OEAGR1.1 is the other assets growth rate, and NPLGR1.1-1 is non performing loan growth rate of the previous year.
As financial intermediaries, commercial banks' main function is to receive deposits and disburse loans to facilitate the flow of capital. For most commercial banks, deposits are the main funding sources for commercial banks' assets. And loans take up the biggest proportion in the asset portfolio.
With the expansion of the asset size, banks will expand the volume of loans to re balance the asset portfolio. Under normal conditions, loan growth rate is expected to move in the same direction as the growth of deposits. The sign in front of DGR1.1, thus, is expected to be positive. But when banks are in poor condition ridden by high level of NPLs, the willingness for the banks to expand loans is decreased, which implies that loan growth will not be consistent with the expansion of deposits.
(b) On Capital Adequacy: The Risk Based Capital Regulation by the Basel Accord II has been playing an increasing critical role in commercial bank decisions. It mandates that banks hold capital in proportion to their perceived credit risks. The Risk Based Capital (RBC) is viewed as a regulatory tax that is higher on assets in categories that are assigned higher risk weights. As capital is usually more expensive to raise than other assets, such as insured deposits, therefore, the implementation of RBC is expected to further magnify the substitution effect, which encourages banks to switch from the 100 percent risk credit category, such as commercial loans, to assets in low risk category, such as government bonds and treasury bills.
Under Basel Accord framework, banks are supposed to perform differently according to their capital conditions. The reluctance in the supply of credit is expected to be more significant where the proportion of non performing loans held by the capital deficient banks is greater. Banks faced with the requirement to raise their capital ratio to improve their risk position will make efforts to meet the RBC standards either by raising expensive capital or by reducing risk weighted assets through substituting out commercial loans, where the latter enhances the negative effect on loans. As a result, the capital ratio will affect the lending decision. In addition, it will further influence the lending by interplaying with non performing loans.
(c) On Financial Statements
l Non performing loan generates no income which reduces the interest income in Profit & Loss accounts.
l Provisioning is a regulatory requirement of having NPLs which reducethe total earning in profit & Loss accounts.
l In calculating RBC Adequacy, high risk weights are given to non performing loan which increases the total risk weighted asset.
l Because of NPLs, the amount of risk weighted assets is increased and the capital required also increases which reduces the distributable profit of a commercial bank.
l As the Capital Adequacy Ratio (CAR) is 10% of total risk weighted asset, NPL increases the capital requirement in absolute amount.
l High capital requirement imposes a negative image in the market.
The writer is General Manager, Karmasangsthan Bank, and can be reached at mail: dilwar_gm@yahoo.com