Let us start with some numbers that give shape to the issue of non-performing loans (NPLs):
As per data from the Bangladesh Bank (BB), the volume of non-performing loans (NPLs) jumped by more than 21 per cent to Tk 621.72 billion as on December 31 last year from Tk 513.71 billion (year-on-year).
As a result, the BB issued warning at a meeting with 20 banks on their loan recovery positions. The BB's move came against the backdrop of poor recovery of both classified and written-off loans during the October-December quarter of last year. During the period under review, all 57 scheduled banks recovered Tk 33.86 billion, which was only 5.15 per cent of NPLs amounting to Tk 658.08 billion as on September 30, 2016. This is clearly a critical issue.
In developing a response, let us start by addressing some myths. NPL, as an issue, is neither unique nor new. What is somewhat 'new' is how wide-spread it is becoming and it is impacting us (considering the economy's reliance on banks). Also, 'NPLs' is generally used as a shorthand term. Technically, NPL encompasses non-performing exposures, as well as foreclosed assets, and also touches on performing exposures with an elevated risk of turning non-performing, such as 'watch-list' exposures and performing forborne exposures.
Furthermore, this is not an 'emerging markets' issue. A cursory glance into the performance of the European banks highlights the challenges those banks are facing with regard to getting to grips with broadening and deepening NPL exposures. What is also apparent is that some banks are better at dealing with this issue than others. As such, there are sensible approaches that can be deployed. As this can be an expansive topic rather than summarising beyond usefulness, we address NPL strategy in this piece.
The NPL strategy establishes strategic objectives for high NPL banks for the time-bound reduction of non-performing loans over realistic but sufficiently ambitious time-bound horizons (NPL reduction targets). It should lay out banks' approach and objectives regarding effective management (i.e. maximisation of recoveries) and ultimate reduction of NPL stocks in a clear, credible and feasible manner for each relevant portfolio.
NPL strategy tends to include:
As you might naturally expect, the first step is to assess internal capabilities to effectively manage NPLs. A thorough and realistic self-assessment should be performed to determine the severity of the situation and the steps that need to be taken internally to address it. The banks should fully understand and examine scale and drivers of the NPL issue, outcomes of NPL actions taken in the past and operational capacities (processes, tools, data quality, IT/automation, staff/expertise, decision making, internal policies, and any other relevant area for implementation of the strategy) for different process steps involved.
In terms of operational capacity, banks should consider early warning and detection/recognition of NPLs, forbearance, provisioning, collateral valuations, recovery/ legal process/ foreclosure, management of foreclosed assets and monitoring/ reporting (including the effectiveness of NPL work-out solutions).
Next, external condition/operating environment needs to be considered. Understanding the current and possible future external operating conditions/ environment is fundamental to framing of a NPL strategy and its associated reduction targets. A sensible framework for assessing this aspect should include macro-economic conditions, market expectations, any 'NPL investor demand', NPL servicing, regulatory, legal and judicial framework, and tax implications.
Finally, capital implications of the NPL strategy need to be analysed. Capital levels and their projected trends are important inputs in determining the scope of NPL reduction actions available to banks. Banks should be able to dynamically model the capital implications of different elements to their NPL strategy, ideally under various economic scenarios. Those implications should also be considered in conjunction with the Risk Appetite Framework (RAF) as well as the Internal Capital Adequacy Assessment Process (ICAAP).
The NPL strategy should, at a minimum, include time-bound quantitative NPL targets (supported by a corresponding comprehensive operational plan). The strategy, including the operational plan, should be approved by the management body and reviewed at least annually. On the basis of this, banks should review the range of NPL strategy implementation options available and their respective financial impact. Examples of implementation options, not being mutually exclusive, are:
n Hold/forbearance strategy: A hold strategy option is strongly linked to operating model, forbearance and borrower assessment expertise, operational NPL management capabilities, outsourcing of servicing and write-off policies.
n Active portfolio reductions: These can be achieved either through sales and/or writing off provisioned NPL exposures that are deemed unrecoverable. This option is strongly linked to provision adequacy, collateral valuations, quality exposure data and NPL investor demand.
n Change of exposure type: This includes foreclosure, debt to equity swapping, debt to asset swapping, or collateral substitution.
n Legal options: This includes insolvency proceedings or out-of-court solutions.
Banks should ensure that their NPL strategy includes combinations of strategies/options to best achieve their objectives over the short, medium and long-term and explore which options are advantageous for different portfolios or segments and under various conditions.
High NPL banks should include, at the minimum, clearly defined quantitative targets in their NPL strategy (where relevant including foreclosed assets), which should be approved by the management body. Targets should be established at least along the following dimensions:
Finally, the NPL strategy should be supported by an operational plan which is also approved by the management body. The operational plan should clearly define how the bank will operationally implement its NPL strategy over a time horizon of at least 1 to 3 years (depending on the type of operational measures required).Any deviations from the plan should be highlighted and reported to the management body in a timely manner with appropriate remediation actions to be put in place.
As execution and delivery of the NPL strategy involves and depends on many different areas within the bank, it should be embedded in processes at all levels of an organisation, including strategic, tactical and operational. Some key features of effective 'embedding' includes:
n Information: Communicating to all staff the key components of the NPL strategy in line with the approach taken for the institutions' overall strategy and vision.
n Ownership, incentives, management goals and performance monitoring: Clearly define and document the roles, responsibilities and formal reporting lines for the implementation of the NPL strategy, including the operational plan. Staff and management involved in NPL workout activities should be provided with clear individual (or team) goals and incentives geared towards reaching the targets agreed in the NPL strategy.
n Business plan and budget: Components of the NPL strategy should be fully aligned with and integrated into the business plan and budget.
n Risk control framework and culture: The NPL strategy should be fully embedded in the risk control framework. A strong level of monitoring and oversight by risk control functions in respect of the formulation and implementation of the NPL strategy (including operational plan) should also be ensured.
Studies show that successful episodes of NPL reductions are driven largely by a fall in the stock of NPLs as opposed to the growth in fresh credit. As such, reduction of NPL exposures, in a strategic manner, has become long past due for us.
The writer is a Senior Advisor/ Risk Faculty consultant at Bangladesh Institute of Bank Management for Bangladesh Bank.
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