Non-performing loans (NPLs): A different perspective

The Banking sector of Bangladesh is trapped in a gridlock of non-performing loans (NPL) so much so that NPL accounts for 11.60 percent of the total volume of classified loans. Bangladesh Bank reports that the volume of classified loans that stood at Tk.481.72 billions in the 1st quarter (Jan- March) of 2014, rose to Tk.572.91 billions in the third quarter (July-September) of 2014. The volume of classified loans in the 1st quarter (Jan- March) of 2014 was worth Tk.481.72 billions, which means that the share of NPL in the total outstanding loan volume rose from 10.75 per cent to 11.60 per cent during the period.  
As financial intermediary, banks normally accept various short-term deposits and grant medium and long term loans. These loans are given by the banks on condition that the borrower will repay the loan in time and manner specified in the contract. In this way, banks also earn profit which is recycled into the economy. But things do not always work as they are supposed to. Many borrowers fail to repay the loans in time and in some cases they do not repay at all. These loans are known as non-performing-loans (NPL's) which are classified by banks or financial intuitions as per instruction of Bangladesh Bank.   
A high volume of non-performing loans can not be a boon for the economy. If the invested funds in an economy are not recovered, it limits the recycling of the funds is reduced by the amount of classified loans which may lead to economic stagnation.  NPL affects banks' profitability adversely because of the provision of classified loans and consequent write-off as bad debts, reduces return on investment (ROI), and disturbs the capital adequacy ratio (CAR). It also increases the cost of capital, widens assets and liability imbalance and upsets the economic value additions (EVA) by banks. EVA is equal to the net operating profit minus cost of capital.
The NPL has always raised concerns among policy makers and the central bank took various measures to reduce the increasing volume of classified loans.  Recently, the central bank has asked the commercial banks to take all-out measures to reduce the increasing volume of classified loans by the end of 2014 through a rigorous recovery drive across the country. Bangladesh Bank also adopted various policies, such as, loan re-scheduling facility, introduction of CIB report, waiver of interest etc. to get rid of this excessive volume of NPL. But things have so far failed to produce the desired outcome. Although rescheduling reduces the amount of NPL, it cannot be an end in itself. Loans are rescheduled after the damage is already done. Besides, statistics indicate that only a handful of lucky borrowers get this opportunity.  Besides, rescheduling is done on political grounds in some cases to enable the defaulters to contest elections.  
The real solution to this problem can be worked out once the causes of NPL are known and if policies are put in place to prevent a loan from becoming a NPL. If we analyze the NPLs in the banking sector of the country, we shall find the following facts:
* A significant portion of classified loans in the country lies with the state-owned banks and specialized banks. According to Bangladesh Bank, out of 10 such banks, 4 are state-owned commercial banks, 3 are local private banks, and 3 are specialized development banks. The classified loans in the state-owned commercial banks are higher due to the nature of their operations such as inefficient in fund management, obligatory financing towards priority sectors etc. and the size of their loan portfolio. Corruption and personal influence are also equally responsible. The Hallmark Group- Sonali Bank scam, the merger of Bangladesh Shilpoa Bank (BSB) and Bangladesh Shilpa Rin Sangstha( BSRS) due to bulging amounts of NPL's, the Basic Bank scandal all occurred  not  only because of nature of their operations, but also because of corruption, political influence and ill- motives of the borrowers.
* Out of the classified loans, the share of bad loans is far higher than other categories of loans. Once a loan is classified, the chance of recovery of the loan becomes slim and it slowly turns into bad loans.
* The sector-wise NPL asset distribution reveals that some sectors have higher share than others. In 2013, the share of agricultural sector was the largest (22.80 per cent) followed by Import credit (19.10 per cent). The share of housing construction (4.10 per cent) was the lowest in the same year. It is clear that some sectors are riskier than others in terms of investment. It is also linked with other external factors which makes specific sector riskier than others.
The above facts indicate a few interesting points. Firstly, a big chunk of NPL is attributable to corruption, political and personal influences by some unscrupulous borrowers. Secondly, the sluggish growth of the economy has made many businesses unprofitable rendering borrowers unable to repay the loans. Thirdly, once a loan is classified, it keeps on being so for a long period of time.
While the remedy of the first cause is left with personal choice of the borrowers involved, the following measures can be taken to reduce the effects of other causes.
* Risk assessment is a must for dealing with investment. Although many financial institutions have their own guidelines for risk assessment, the employees working in the credit department, particularly at branch levels, do not understand the guidelines properly and depends on their own sense of judgement. A wrong assessment in the proposals from branches may lead to wrong decisions at head office.  Therefore, banks should deploy the best employees who have the necessary risk assessment expertise at the credit department at each branch. Banks should also update their guidelines by analyzing sector-wise risks from time to time.
* Banks should be allowed to use the services of recovery agencies for collecting classified loans. The effectiveness of recovery agencies shall bring desired results if the prevailing law and order system of the country is satisfactory. It has been observed that when a loan becomes classified, defaulters use the loopholes in the law to get undue protection.
* Some motivational measures can be taken by banks to motivate the borrowers to repay the loan. A national level reward can be introduced for the best loan performer. Individual banks can give monetary incentive in the form of rebate or discount for good borrowers. Various incentives such as tax exemption for best performer can be introduced.
* Banks can consider small-sized short term loans instead of large-scale long-term loans for investment. However, it is not always possible to avoid long-term large-scale loans as many businesses or projects require so. In case of large loans, syndicated loans can be provided. In some cases, investment in the large scale loans can be made by splitting the tenure of the venture or project into three or four terms and investment can be made one after another subject to satisfactory settlement of the preceding term.
While a significant amount of the NPL 's in the country  are being held by commercial banks, especially state-owned banks, specialized and private commercial banks, the banks pursuing Islamic banking are relatively better off. According to Bangladesh Bank, in 2013, ratio of classified investments to total investments in Islamic banks was 4.2 percent while it was 8.9 per cent for the overall banking industry and the classified investment to capital ratio was 39.88 percent for Islamic banks compared to 59.8 percent for the overall banking sector in 2013. In 2012, Islamic banks' classified investments to total investments ratio was 3.9 percent while for overall banking Industry it was 10.0 percent. During the same year, the classified investment to capital ratio of Islamic banks was 43.5 percent while for the overall banking industry it was 76.0 percent.  These data indicate that Islamic banks are more efficient in monitoring their investments (loans) and enjoy better position compared to the overall banking industry.
Islamic banks do not operate in an interest rate system and to make a profit, Islamic banks invest the funds by extending various profit-and-loss sharing (PLS) and non- profit -and-loss sharing based financing. The funds for the financing comes from the Islamic bank's own equity and customers' deposits in current, savings and investment accounts. In Islamic banks, current accounts and saving accounts are guaranteed whereas capital is not guaranteed for investment accounts because they are based on the profit and loss sharing system. The investment account holders are entitled to a share in the bank's net profit or loss and this is based on a profit sharing ratio of a certain pre-agreed percentage. In case of loss from the activities of financing, the investment account holders can lose all their investments. Since deposits are guaranteed for all accounts holders other than investment account holders, the loss flows to them first. Only when the loss is major it will flow to the rest of the depositors. Therefore, Islamic banks are able to pass the negative shocks on the asset side (Musharaka a/c) to the investment depositors.
Since Islamic banks are not able to charge interest, they claim various charges like cost plus, Ijara (leasing), Mudaraba, Musharaka etc. which are consistent with Islamic principles. All these contracts have some in-built capacity to prevent a loan being defaulted due to nature of their operation.   For example, in case of cost-plus-mark-up financing, banks purchase goods and services on behalf of the clients and sell these goods and services to them. Therefore, the chance of diversion of funds into unproductive sectors or to a sector other than the agreed one, is minimal. Besides, banks can monitor and control the use of loan by the borrowers which reduces the chance of defaulting to an extent.
Islamic banks operate under the same legal and regulatory framework under which conventional banks operate in the country. However, the relatively better position of Islamic banks in terms of NPL indicates that there are some tools and techniques of the system which have the capacity to minimize the number of defaulting loans. The conventional banks can replicate these tools and techniques by making necessary adjustments to make them compatible with the nature of their operations and thereby reduce the chances of loan being defaulted.  

The author works for a private bank in Bangladesh and has a post-graduate degree in Islamic Banking, Finance and Management from United Kingdom.
akbar.chowdhury@yahoo.com