The issues revolving around accounting for bad debt have again come to the fore. Prior to the Financial Sector Reform Programme the practice in Bangladesh regulatory procedures was to consider a loan performing if it was believed that the collateral offered for the loan was sufficient to cover the amounts outstanding. Although recovering collateral was very difficult and rarely accomplished, the central bank followed this very weak treatment of non-performing loans. With the financial sector reforms the central bank introduced a system for assessing loans that identified non-performing loans (NPLs) early in the history of a loan and required the bank to recognise this potential loss by making provisions to cover such losses. Once the loan was non-performing, according to Bangladesh Bank rules, the commercial bank could no longer claim that the interest owed was income to the bank unless it was actually paid.
The provisions acted as a cost to the bank that is recognised early in the history of a non-performing loan. If the loan was not repaid then it could be written off the books of the bank concerned and the provisions removed with a reduced shock to the bank's financial position. At the same time earnings were reduced as interest earned [but not collected] could not be taken as income. Prior to these reforms banks overestimated income and underestimated costs.
The point of all of this is that the NPLs impact the balance sheet and operating statement of the bank, forcing the owners to recognise the reduced profitability caused by the NPLs. Expectation is that such recognition would result in actions by banks to improve their loan recovery position and select good borrowers. Provisioning requirements do not only cut the profitability of banks but also result in the reduction of capital or net worth of the bank. This immediately affects the central bank's rule relating to the mandatory maintenance of capital by a commercial bank. Should a bank not maintain its required capital the central bank would take various actions to force the bank to rebuild its capital. Actions include, refraining the bank from making new loans or requiring that new capital be sought diluting the value of the shares held by existing owners.
There are two rules that a central bank must always follow: (1) All provisions must be taken by a commercial bank. No exceptions. A bank must recognise the implications of a non-performing loan through the making and booking of provisions. (2) A commercial bank must maintain its required capital and should it fail to do so then it must take appropriate actions to correct the situation. If a commercial bank cannot maintain the required capital then it must go for liquidation or merge with another bank.
In Bangladesh, commercial banks are trying to avoid having to book their loan provisions. They appeal to the central bank to allow them to only recognise part of their provisions required by the rules on non-performing loans. The Bangladesh Bank should never agree to such a step. Allowing commercial banks to avoid recognising the full provisions will undermine the supervision of banks and will lead to the growth of poor banking. By poor banking I mean making loans to companies that will not repay; taking risks that the central bank will have to cover or allow banks to fail.
In Bangladesh, the policy of the central bank has been that no bank can fail so the result is more and more bailing out of banks that have performed badly making bad loans. But bailing out a bank should not be done by allowing them to delay taking provisions. Banks must recognise all of the provisions and also take none of the interest booked to non-performing loans. There can be no deviation from this rule or the banking system will be undermined.
Once these provisions are taken then many banks will find that they do not have adequate capital according to the central bank regulations. The central bank must then require that such banks provide a realistic programme for correcting the situation.
The recognition of provisions and the resulting impact on the capital position of the bank are the fundamental issues the central bank uses to force corrective behaviour on the banks. If this is not done then the quality of loans made will deteriorate, the growth of the economy will slow, and financial system will do a bad job of matching savers and investors. Of course, this is exactly what has happened in the past few years.
What if the capital of a bank is inadequate? The meaning is a belief that if such a bank is unable to pay its depositors, the authorities will either have to step in to help the depositors or allow everyone to lose part of their deposits. Capital adequacy is meant to protect the depositors from losing their money and to protect the government from having to bail out the bank in order to enable the bank to provide funds to the depositors.
When there is inadequate capital what should the central bank do?
First, stop the bank from making any loans. The only exception might be to roll-over continuing credits assuming that these are being repaid. But no new project loans or consumer loans and no new continuing credits.
Second, require the bank to develop a plan to rebuild the capital of the bank. The primary vehicle for doing this is to allow the bank to issue new shares either to existing shareholders or to new ones. The central bank itself may buy shares if it also takes over the bank management; its explicit objective is to improve the bank and then sell the shares. While this often works in well-developed financial markets it is not clear how well it would work in Bangladesh. Probably one can make a success if Bangladesh Bank hires an experienced commercial banker to run the troubled bank. However, it is essential that the bank reach and maintain capital adequacy.
When a bank fails the capital-adequacy test it is at risk of a run on the bank. The central bank must then be prepared to lend money to the troubled bank to meet any depositors' withdrawals.
The government should also forbid government organisations from withdrawing deposits from a troubled bank; it is foolish to make things worse. To prevent loss of confidence in the banking system the central bank must always be prepared to be a lender of last resort.
Finally, a troubled commercial bank may be merged with another bank. The combined bank must meet capital adequacy and the distribution of shares in the merger must be worked out by the boards of the two banks.
There remains one issue requiring discussion. A bank has bad loans which are fully recovered by provisions that it has booked. On the books of the bank the loan is now worth nothing. The bank should be able to write off this loan. However, there is still a liability of the borrower and this should not be forgotten. Many such loans are written off but the liability of the borrower has not gone away. The bank should be able to sell the loan to some other organisation and the right to collection should be attached to the sold loans.
In conclusion, we put forth two principles that are urgent to be enforced in Bangladesh. Failure to do so will undermine the financial sector.
Firstly, all provisions must be booked by commercial banks, with no exceptions, no special treatment.
Secondly, when a bank fails to meet capital adequacy the central bank must forbid more lending with some exceptions and work with the bank to find a way to promptly correct the capital shortfall.
Following these rules, the owners of banks will carry out their affairs better and avoid bad loans. The plethora of scams and bad loans that have adversely impacted the banking system will be reduced.
Dr Forrest Cookson is an economist
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