How to deal with problem loans

On August 28 the Internet carried a letter written by Salman F Rahman, vice-chairman of the Beximco Group, to the governor, Bangladesh Bank (BB) asking the latter's assistance in rescheduling and adjusting loans of the group from a number of commercial banks.  In the letter the Beximco vice-chairman noted that the group had struggled for many years to handle the problems that had arisen from the political interference in their relationships with the banks during the period from 2001-2008.  The distortion of the credit operations caused great difficulty in the day-to-day operations of the group's manufacturing operations.  Since 2008 the group has worked hard to manage the pressures in their financial positions arising from this earlier treatment. In particular, the group had repaid Tk 8.0 billion, its all loans are currently performing ones, and the proposal does not ask for additional funding.  

The attempt to deal with the financial condition of the group on a piecemeal basis has not been successful and the letter to the governor proposes that adjusting the loans required three actions: (1) conversion of all loans into term loans, fixing the period for repayment at 12.5 years; (2) this 12.5 years would include a 2.5 years moratorium when no payments would be made to the banks; (3) fixation of interest rate of loans at 10 per cent per annum.  These steps would allow the group to properly balance its production lines, adjust its labour force, and organise their operations in a more efficient manner. The result would be a sharp increase in output with the group's available capacity.
The BB governor has forwarded the letter to the banks concerned asking for their views on the proposal.  This action by the governor is a major breakthrough in the way that the central bank thinks about the credit process. When enterprises come under financial pressure from the debt burden three solutions could be applied to help them. As part of the first solution, the bank goes to court and tries to recover the loan by cashing in the collateral. In most cases this destroys the borrowing company and it ceases to function; the disposition of the collateral often leaves the bank far from full recovery.
Further, this is a long, time-consuming process and is rarely successful for large enterprises. Another path is to declare bankruptcy and try to restructure the debt under the guidance of a judge. This is rarely used in Bangladesh. The third solution is that the banks work with the troubled enterprise to restructure the loans so that the payments can be scaled down to amounts consistent with the capacity of the company to repay. This is the so-called "workout". The banks will usually examine which method will help them get the most.  In Bangladesh, recovering the loan through disposal of the collateral is fraught with difficulty of counter claims and falling land prices. The 'workout' promises better results for everyone involved.
Doing nothing would probably result in the classification of the loans cutting off the Beximco groups from credit and leading to closure of factories and the loss of about 40,000 jobs and $300 million of exports.  Long legal disputes would lead to loss of capital by the banks, as the loans remain in limbo, most of which would need to be covered by the government through bank recapitalisation.
The Beximco letter proposes a 'workout', not asking for additional funding but going straight to the heart of the problem of mobilising resources to correct the unresolved issues of production.  The letter proposes an adjustment of the loans to enable the enterprises to continue to exist.  Deny this workout proposal and the country loses jobs, exports, as well as loss of various other enterprises.  In addition the banks would be stuck with more than Tk 50 billion of loans most of which they would not recover leading to the need to recapitalise the banks to almost that amount.  While collateral would cover some of this outstanding the banks end up with a lot of property that they would have difficulty selling at a good price in the weak property market at anywhere near the collateralised valuation.
To the great credit of the central bank and, in particular, the governor the action of referring this to the banks makes it possible now for the commercial banks to act favourably on Beximco's request. The lesson here is that the commercial banks need to be much more responsive to the prospect of a 'workout' arrangements for 'problem' loans. The Bangladesh Bank has to stop making all kinds of detailed regulations covering management of problem loans and instead allow the commercial bank to figure out what to do.  
The second important point that emerges in this case is the matter of the interest rates in Bangladesh. Lending rates hover between 14 per cent and 16 per cent.  For domestic production this means a real rate of about 8.0 per cent, which is feasible to manage.
But for exports where product prices are not rising the real rates are about 15 per cent and this is impossibly high for manufacturing exports.  [See box where the difference in interest rates changes the return on equity from an unrealistic 10 per cent to an acceptable 20 per cent].  The Beximco request for lowering the lending rate to 10 per cent should be honoured and extended to all borrowing.
Deposit rates should be forced down by the central bank imposing a ceiling on deposit rates at 6.0 per cent.  These draconian actions would assist the central bank in reducing the inflation rates.  Tight money to stop inflation and allowing interest rates to fall through market adjustment will be slow and painful.
Tight money and capping interest rates will enable the central bank to reduce the rate of inflation more rapidly.  In other words, the order is reversed -- rather than reduce inflation and then interest rates fall, one reduces interest rates to make monetary policy more effective at reducing inflation!  
Equally important is the shift in interest rates and consequent fall in inflation. This will bring the real borrowing rates for domestic and export production closer. The spread is now very large between investments in export industries and that in the domestic market, resulting in a strong anti-export bias in monetary policy.  Downward adjustment in the interest rates may be an important side effect of the Beximco proposal.
To lower lending rates it is necessary to lower deposit rates.  The high interest rates offered for national saving instruments may lead to shifts from bank deposits to national saving instruments. What had actually happened was that new purchases of such instruments in the fiscal 2013/14 changed little from the previous financial year. But the amount of early en-cashing of instruments has declined leading to sharp increase in the sales of the instruments. This is partly due to the fall in bank interest rates. The sale of savings tools in 2010-2011 dropped sharply and this would be reflected in reduced repayments during the last year.  There are two points here:
1. One should not be afraid of lower deposit rates leading to shift to national saving instruments. The evidence is not clear to support such a shift.
2. The interest rates on national saving instruments need to be sharply reduced. Why should the nation pay a higher price for debt than is actually necessary? A significant part of the deficit is financed through these instruments; in 2013-14 this amounted to 90 per cent of the domestic financing of the government deficit.  It is odd to finance 90 per cent at high interest rates and 10 per cent at low interest rates when over the previous three years only 12 per cent was financed in high interest rate instruments.  This was expensive; the deficit was financed at 12.5 per cent interest in the last financial year compared to 7.5 per cent interest in the previous three financial years.  How could this have happened?
Implementing the Beximco proposal would achieve three important points:
It would encourage bankers to try to use 'workouts' to manage problem loans with an aggressive attempt to restructure loans to permit the company to overcome difficulties -- a procedure rarely employed today.
Second, it would provide an opportunity to push down both deposit and lending interest rates.  There is no reason not to cap deposit rates.  This worked well in the United States for decades.  When this cap was removed it started off a series of changes that have caused great harm.  
Finally, interest rate reduction for deposits should give impetus to reducing rates paid for national saving instruments and significantly reduce the cost of financing the government deficit.  
The Beximco proposal will serve not only the purpose of getting this important Group back into a strong position to boost exports and employment, but will also indicate the changes that are need to be made in interest rates - in lowering interest rates of saving instruments. Finally, it will open the eyes of commercial bankers to the merits of 'workouts' of problem loans.