The various actions that were started in the early 1990s with the Financial Sector Reforms Programme (FSRP) to improve loan recovery were successful for some time but their efficacy has declined and the bad loan problem has again weakened the banking sector.
The courts have not been able to provide support to the banks in loan recovery, and, without the threat of real bank action that threatens the assets of the borrowers, the commercial bank's efforts at loan recovery are weakened.
We should keep in mind that a loan to an enterprise is to enable the enterprise to become more profitable in its operations. The increased profitability provides the means to repay the interest on the loan. The principal of the loan is repaid essentially from the depreciation of the plants and equipment that the loan was used to purchase. The borrower may not repay for two reasons: His project failed to produce the returns to capital that had been anticipated or the borrower has decided he is not going to repay.
What is the source of all of this build-up of non-performing loans? Are these enterprises successful and simply refusing to pay the loan? Or, are the enterprises failing to earn an adequate return? In my experience there is a lot of optimism by investors and entrepreneurs; when things do not work well then there are difficulties in repaying the loan and it often becomes difficult to catch up to the loan repayments. This usually leads to great difficulties in the cash flow problems of the enterprise. When the investor has a good project then the bank should work to insure that the borrower has the funding to be successful. This interaction between borrower and bank is rather lax in Bangladesh.
The question is, "How can the commercial banks continue to function when there is such a high rate of non-performing loans?" This is not an accounting question. Banks take in deposits and pay interest on them. The bank has costs for its staff and facilities. The money to cover these costs is supposed to come from the interest earned on its loans. High levels of bad debt lead to low earnings from lending. The banks also make quite a lot of money from fees charged for services. Finally, the bank owners are always anxious for dividends to be generous. With the high levels of bad debt it is difficult to earn enough to cover the costs.
What is a Ponzi scheme? Briefly, one advertises that if anybody invests Tk 10,000 in his forestry development scheme the latter will receive 20 per cent return per annum. Good investment! Many people will make the investment. The first year 500 invest and the promoter has Tk 500,000; he pays 100,000 back to the investors. Next year 1000 persons invest and the promoter has an additional Tk 1,000,000; he pays Tk 300,000 out and also takes some money out for myself. So long as more and more people invest he can pay the 20 per cent and take a lot of money for himself. This cannot go on forever; after a while he has to run away with the money. We have had several schemes like this in Bangladesh in the past decade. It is a favourite device named for an Italian-American who was a master of this trickery.
My claim is that commercial banks, particularly those with high levels of non-performing loans (NPLs), are essentially Ponzi schemes. So long as the inflow of new deposits is large enough the interest on deposits can be paid from the incoming fresh deposits. The new deposits have to cover the withdrawal of deposits and also the interest payments on all deposits. This can be managed whenever the rate of increase of net deposits is greater than the average interest rate paid to depositors. So long as it gets enough earnings from fees and interest from loans to cover its costs - as easy condition - the bank can keep going for a long time. This may go on, so long as the growth of deposits does not slow down too much.
This is the great danger. Deposit growth slows and the banking sector is thrown into crisis. When subscriptions to a Ponzi scheme slow down, it cannot survive. Though the banking sector is not so fragile, the danger arises from the difficulties that banks will face when deposit growth slows down. Raising the deposit rate only works if deposit growth is responsive to higher interest rates. At present the high National Savings Directorate (NSD) rates reduce the responsiveness of deposits to interest rate changes.
Of course, the central bank, as lender of last resort, can lend to the commercial banks. But the amount of lending necessary would prove to be inflationary.
The banking system has continued to operate quite well despite the heavy burden of NPL. In assessing the condition of loan repayment one should understand the imperfections of the loan classification system. There are numerous ways that one can decide on whether the loan should be classified. In a perfect system, a loan identified as non-performing would not be repaid; a loan identified as performing would be repaid. This is impossible. Typically there are many loans that are not classified that never get repaid. Thus the official NPL rate of about 10 per cent is far too low for Bangladesh's banking system. The rapid rate of deposit growth has supported the Ponzi scheme of the bank operations; this disconnects the continuation of banking operations from the quality of the loan portfolio.
Another consequence of the weak loan recovery is that lending resources are tied up and cannot be reallocated to other sectors as loans are repaid. As profitability of the ready-made garment (RMG) sector has declined the loan recovery in the sector has deteriorated; even if loans are not classified they are rolled over or rescheduled. This locks up resources in weak RMG companies and limits the expansion of successful companies and prevents directing resources to new sectors. The failure to operate the Bankruptcy Law to enable distressed borrowers to make real steps to restructure limits the meaningful restructuring and resource reallocation.
The ability of the banks to keep operating in the face of poor loan recovery arises from the Ponzi scheme nature of commercial banking. But Ponzi schemes come to an end - even ones that have continued for a long time. It is extremely important to take actions to improve loan recovery. The first necessary and key action is to strengthen the judicial support for loan recovery. Only then can the banking system begin to rebuild.
Dr Forrest Cookson is an economist. [email protected]
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