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Banks provide short and long term finances to various organs of the economy. Banks are also supposed to get back the money with interest as profit as per the repayment schedule. Due to many reasons, however, banks are unable to get back some of their money in time from many clients. Banks, as a normal precaution to recover the money, keep some provision (1.0 per cent) against all such advances, considering that due to many reasons there might be some non-performing loans. If the non-performing loan (NPL) exceeds the norm, it creates a significant problem in running banking operation. The amounts of loans which fall under the category of classified loans are called NPL. Loans which are at the stages of either sub-standard, doubtful or bad/loss loan are classified loans. In these categories of loan, the bank fails to collect interest payment or principal amount or both from the borrower.
The NPL ratio in Bangladesh is higher compared to the international level which is about 2.0 per cent or below. The NPL ratios in Bangladesh were 9.32 per cent and 10.30 per cent in 2019 and 2018 respectively.
The average NPL of Asian countries (27 countries) stood at 4.39 per cent in 2018. The highest ratio was in Lebanon (10.26 per cent) and the lowest in Hong Kong (0.55 per cent). The global average NPL (121 countries) stood at 6.88 per cent in 2018. The highest value was in San Marino (53.02 per cent) and the lowest was in Monaco (0.22 per cent). Bangladesh in terms of NPL stood second in Asia and 24 in the world.
The many reasons for higher NPL in Bangladesh are: (1) weak governance in the banking sector; (2) wrong client selection at the time of loan sanction; (3) weak business and industry analysis, mismatched cash flow forecast overlooking historical payment behaviour of the clients etc; (4) political pressure to sanction the loan; (5) lack of proper documentation; (6) lack of security coverage of the loan amount; and (7) weak regulatory framework to recover loan.
IMPACT ON PROFITABILITY: Profitability of the banks is strongly influenced by the increase of NPLs. As per Bangladesh Bank Guideline, banks are required to provide 1.0 per cent of the loans as expenses under the head 'provision'. But if any loan falls under `sub-standard' category due to non-servicing of the loan, then banks are required to keep 20.0 per cent provision. In case the loans are 'Doubtful', then provision is 50.0 per cent and for 'bad and loss' category, 100.0 per cent provision is required. Thus, the huge amount of provisioning against income reduces the profitability of the banks. This reduction of net profit ultimately hampers the shareholder's equity, reduces the dividend-paying ability of the bank.
The considerable amount of NPL ultimately accelerates the operating costs and reduces employment opportunity. The effects of NPLs get reflected in dividend payments, high interest rates and low levels of investments resulting in the lower economic development of the country. Table-2 NPL ratios in Bangladesh
Table-1 shows that NPL position of SCBs and SBs has been alarming which ultimately raises the overall NPL. Overall NPL in 2019 declined to 9.32 per cent from 10.30 per cent in 2018 mainly due to recent changes in loan classification and provisioning policy as well as rescheduling policy.
Under loan classification policy (as per BRPD circular No:3 dated on April 21, 2019) a continuous loan, demand loan, fixed term loan or any installment(s)/part of installment(s) of a fixed term loan which will remain past due/overdue for a period of three months or beyond but less than nine months will be put into the 'sub-standard' category. Under rescheduling policy (as per BRPD circular No:5 dated May 16, 2019), loan defaulters can make 2.0 per cent down payment to avail 9.0 per cent interest rate and a 10-year payback period, including one year's grace period. The aforementioned policies seem to discourage good borrowers to repay their loans in time while bad borrowers are being rewarded.
IMPACT ON LIQUIDITY: When a loan becomes non-performing, it creates a significant impact on the liquidity. Due to non-receipt of instalment, the planned cash buckets are directly affected. Banks are dependent on these loan instalments for their further investment, meeting expenditure and also to repay the liabilities in time. In view of poor recovery, banks are required to go for short term borrowing from the money market or any other alternative cash sources which again, increases the expenditure having a negative impact on profitability.
Under Basel-III, a minimum Tier-1 leverage ratio of a bank is prescribed at 3.0 per cent. If NPL amplifies, Tier-1 capital decreases. If Tier-1 capital shrinks, then leverage ratio will be reduced which is ultimately a great challenge for banks to maintain the regulatory requirement.
Large NPLs could lead to falling confidence of both depositors and foreign investors.
IMPACT ON CAPITAL ADEQUACY: Capital adequacy is the amount of capital a bank or any financial institution has to hold as required by its financial regulator in order to absorb the potential losses and protect the financial institution's debt holder. Under Basel-III, Banks operating in Bangladesh are instructed to maintain minimum capital requirement at 10.0 per cent of Risk-Weighted Assets or Tk 5.0 billion as capital whichever is higher. Under this policy, a minimum Tier-1 capital ratio will be 6.0 per cent and Capital to Risk-Weighted Assets Ratio (CRAR) will be 12.50 per cent (including capital conservation buffer) in the year 2019.
Since capital is a cushion against which to charge losses, the riskier the asset composition, the more capital is required to maintain a given level of soundness. That said, capital adequacy ratio mirrors that the bank has risky loans and as these risk assets grow, the bank should adjust its capital to keep pace with the loans.
If the income of a bank is not covered by the provisional requirement then it has to be set off from the bank's capital, which might result in capital erosion and a short fall in regulatory capital. 12 scheduled banks of Bangladesh suffered Tk 108 billion in provision shortfall at the end of the year 2019. At the same time, 12 banks also failed to maintain capital requirement and faced a capital shortfall of over Tk 236.12billion.
Increase in NPL may reduce the retained earnings. The item of retained earnings is a component of Common Equity Tier-1 (CETI) capital. If CET1 capital is reduced through fall in retained earnings then it will also shrink CRAR. On the other hand, a shortfall in provision against NPL will be deducted from CET1 Capital (as per regulatory guideline) which will also trim down the CRAR.
HOW TO CONTROL NPL: To contain NPL, banks need to strengthen their corporate governance. Banks should follow objective oriented governance practice. Members of the board need to understand the risk management activities. They also need to avoid undue influence and strictly follow banking rules and regulation.
Banks also need to deeply analyse the borrower in terms of the viability of the business/project, considering expected EBITDA (Earnings Before Interest and Taxes) from the business to repay the installment, marketing strategy of the business to take the competitive advantages, working capital requirement and subsequently debt financing need, industry risk and prospect analysis. The bank should also review the repayment behaviour of the borrower, experience of the owner on a particular business arena, succession plan, and attitude of the management.
Security coverage of the loan is one of the influential indicators to minimise the risk of the loan. The value of the collateral which is rightly priced and title of the collateral which is proper are key tools to reduce NPL. Banks should also identify the loan at the early stages which may have the probability of becoming NPL.
A nationalised Asset Management Company (AMC) should be formed which carries separate legal entity for the purpose of purchasing, managing, and disposing of NPL from one or more banks. All banks should sell their NPLs to AMC at a certain level to minimise the country's NPL position. The process of selling and buying NPL are covered by approved law.
Tanzirul Islam is Vice President at Credit Rating Information and Services Ltd (CRISL). The view expressed in the article is the author's own.