Managing nonperforming loans

Banking professionals, economists and money market specialists are fully aware that the most common and complicated problem in the banking business is non-performing loan (NPL). This is because bank deals in money and its most important function includes lending to the people, so it is obvious that a certain percentage of money lent out may not be recovered for many reasons beyond borrower's control. Therefore, bad loan or NPL is considered as an unavoidable consequence of bank's credit risk management. However, there is fundamental difference between NPL and defalcation of bank's money as the former is the result of bank's poor credit risk management, while the latter is the result of doling out money by fraudulent means. So, money defalcated from bank through fraudulent activity, should not be treated as NPL. However, from  accounting perspective, there is no way to distinguish these two types of bad loans under separate accounting heads and therefore all loans which are not repaid on time are consolidated under one accounting head as NPL. This is not an exclusive problem in our country's banking industry but is also found elsewhere. 

NPL AND FUND DEFALCATION: Wherever banking business operates, there will be NPL, which can neither be avoided nor eliminated. Even the component of NPL resulting from fraudulent activity cannot be completely prevented. However, it can be minimised to very insignificant level or near zero level by modernising bank's credit risk management system developed with technological applications. Banking industry in the developed world and even many developing countries have been successful in minimising the risk of fraudulent loans by adopting technology based lending system. On the other hand, banks operating in the emerging markets have been scrambling hard to overcome this situation as their credit risk management is still manual and dominated by human judgement leaving the scope of massive manipulation which is commonly found in our country and in our neighbouring countries as well. Loan scandal of Hallmark, Bismillah Group and the recent P.K. Halder's case are blatant examples of fund defalcation from banking system.

NPL IS UNAVOIDABLE BUT MANAGEABLE: Since NPL is the unavoidable consequence of bank's lending operations, its proper treatment is the only acceptable solution as it keeps the bank's NPL at the very minimum. Unfortunately, banking industry in the developing world does not apply proper treatment to NPL, instead resorts to some manoeuvring measures with an intent to conceal the actual NPL and our country is no exception to such manoeuvring strategy to keep the NPL low in banks' books.

NPL is like cancer in the banking industry which cannot be kept hidden, it must be treated properly to avoid dire consequences for the whole industry. No country in the world could derive benefit by hiding their NPLs. Latest example is our neighbouring country, India which is believed to have sound banking system with strong oversight of the central bank. Indian banking system has been severely shaken with piling NPL which at certain point has exceeded 10 per cent of banks' loan portfolio.

RISING NPL PROBLEM IN INDIA: NPL in Indian banking industry has been accumulating over a period of time and banks were able to manage keeping it low in their books through some manoeuvring and window-dressing measures. However, outstanding NPL started soaring with rapid deterioration of overall loan portfolio since global financial meltdown occurred in 2008 when some business sectors, especially steel, power, textiles and construction,  started defaulting on bank loans. After that crisis, banking industry followed contractionary lending policy as banks reduced their direct lending to many borrowers. However, they followed indirect means of lending through shadow banks which are non-depository financial institutions similar to non-banking financial institutions like leasing companies in our country. These institutions further aggravated the NPL situation as these shadow banks indiscriminately lend money to companies which do not even satisfy minimum borrowing criteria. Even many shadow banks underwent massive lending in many dummy accounts. Indian deteriorating NPL exploded in 2018 when massive irregularities were unearthed. One shadow bank, Infrastructure leasing & financial services ltd, was about to collapse in late 2018 while others were getting harder time in managing fund. Even, the Punjab & Maharashtra Co-operative Bank Ltd., which had a very tiny loan portfolio in Indian banking industry, heralded ominous signal to the market in September 2019 that it had lent money to troubled developers. This bank had used dummy accounts and other methods to hide loans from regulators.

INDIAN GOVT.'S DRASTIC MEASURE TO ADDRESS NPL: Rapidly deteriorating NPL with fresh loan scandal in Indian banking sector has stirred the country's economic and financial sector prompting policymakers to undertake some drastic actions. The measures, among others, included (I) injecting about USD 37 billion into ailing banks during the period from 2016 to 2019, (II) removing more than dozen companies from the control of tycoons who defaulted on their debts, (IV) forced merger of lenders, (V) enforcement ofiInsolvency codes, and (V) creation of Asset Reconstruction Companies (ARC) with the objective of cleaning banks' bad loans.

DRASTIC ACTION IN INDIAN BANKING SECTOR BACKFIRES: These reform measures were abruptly taken, and they backfired in many cases giving wrong signals to the people, particularly depositors, who resorted to panic withdrawal. As a result, RBI along with the commercial banks had to carry out massive campaign reassuring that depositors' money in banks was safe and secured. Failure of the govt's action in improving the banking industry burdened with huge NPL is an instance which reveals that instead of sudden drastic measure, a comprehensive action plan works better.

  ESTABLISHING  NATIONAL BAD BANK: Indian government did not, however, sit idle and have come up with an alternative measure by establishing National Bad Bank with the exclusive responsibility to clean NPL problem from country's banking industry. Previously Italy and Ireland had adopted this measure of using a third entity in managing their NPL problem and now India is going to apply the same measures. However, National Bad Bank will not be funded by Indian government, the funding will be provided by the consortium of public sectors banks in India which will fund Rs 150 billion equivalent to USD 2 billion. Bad Bank will take over NPL over Rs 5 billion at par but excluding provision from all private and public sector banks which in exchange will receive either cash or security papers. Bad Bank will subsequently distribute these acquired assets among the ARCs through open bidding process. It may, however, be mentioned here that in India, many private ARCs, are very active and managing about more than Rs 1 trillion worth bad assets. The only advantage of National Bad bank is that security papers to be issued by this it  to the commercial banks in exchange of acquiring its NPL will be guaranteed by the government, so these securities will have strong rating and good acceptability among the investors.

By applying measures of using a third entity, Ireland and Italy have been successful in managing their NPL while Greece have completely failed to reap the benefit from similar measures as they did not strictly comply with the underlying principles of Bad Bank concept.

We have to keep in mind that there is no short-cut to properly manage NPL. When there is massive piling of NPL, it becomes a national problem that the banking industry cannot handle by itself, so the role of third-party either in the form of Bad Bank or ARC or any other vehicle entity becomes necesary to resolve the problem. However,  the features of our country's banking sector -- its structure, regulator's role and authority -- are unique and different from others, so replication of other country's bad bank concept will not likely produce any desired result. Our vehicle entity or bad bank should be developed taking our country situation into consideration.

Nironjan Roy is a banker based in  Toronto, Canada.

nironjankumar_roy@yahoo.com