Are wilful defaulters handing bankers paper money?

Last year the central bank introduced a loan moratorium in anticipation that many lenders will default due to the economic fallout caused by the Covid-19 pandemic.

Implementation of this program meant that scheduled banks had to stop reclassification of loans (change in classification) unless reclassification led to graduation (improvement) from the classified status.

After two consecutive extensions, the program eventually expired in December 2020, as confirmed by the central bank in February 2021.

Right after this announcement, Moody's, the world's leading credit rating agency, lauded the action saying, "The lifting of the loan moratorium is also credit positive because it restores transparency and payment discipline in the country's banking system, ensuring the comparability of asset quality between banks. It will also allow banks to identify borrowers that are truly affected by the economic slowdown and those that are wilful defaulters."

Unfortunately, a little over a month later, the central bank reversed its decision, on 25 March 2021, by restoring and extending the loan moratorium program until June 2021.

This in many ways has been the final nail in the coffin, submerging the banking sector in more and more uncertainties.

According to the Central Bank, loans are categorised as unclassified or classified based on the length of time for which the repayment of the loan (or instalment) is overdue.

Unclassified loans comprise Standard loans and Special Mention Accounts (SMA). While Classified loans are broken down into Sub Standard (SS), Doubtful (DF), and Bad Loans (BL).

According to BPRD Circular No. 03 (dated April 19, 2019), a Continuous or Demand loan is classified as a Bad Loan 12 months after the expiry date. This means a demand loan is said to have gone bad 12 months past the due date.

On the other hand, a Fixed Term Loan is classified as Sub Standard (SS) Loan 9 months past expiry date, Doubtful (DF) after 15 Months, and as Bad Loan (BL) after 18 Months past expiry date. 

Generally, Sub Standard (SS), Doubtful (DF) and Bad Loans (BL) together form Non-Performing Loans (NPL).

For each type of unclassified and classified loans, banks are required by the central bank to maintain various levels of provisions. The riskier a category of loan the higher the rate of provision mandated by the central bank.

These provisions are treated as expenses by banks as they are created in anticipation of future losses that may arise due to the borrower's non-repayment.

Unfortunately, the moratorium program, which was undoubtedly initiated with good faith, has started to yield undesired outcomes, such as - piles of paper money from defaulters and low-quality assets.

Interest earned on loans disbursed is a bank's primary source of income. Since deterioration in classification was halted, but improvements were allowed, the overall income of the banks was misrepresentative in 2020. 

According to Central Bank guidelines, Interest accrued on Sub-Standard, Doubtful and Bad/Loss loans is transferred to the interest suspense account. This means that interest due from Non-Performing Loans are not treated as interest income. Instead, this portion of interest accrued is recognised as interest income only when it is realised in cash by the bank.

Many loans got exempted from being categorised as classified loans due to the moratorium the last year. As a result, interest from these (potentially classified) loans was instead treated as income, overstating the total income of the banks with paper profits- i.e., artificial profits. 

On the other hand, for business loans, the central bank requires banks to maintain a provision of up to 5% for Unclassified Loans, 20% for Sub Standard (SS) Loans, 50% for Doubtful (DF) Loans, and 100% for Bad Loans (BL).

In 2020, because of classification deferment and lower provision rates for some businesses, such as CSMEs, the base for the provision and the rates of the provision were both understated. Since these provisions adjust the operating profits of banks to account for losses due to non-repayment, profits were overstated.

Asset quality has also been impacted because of this influx of paper money. Since improvements in classification were reflected but the defaulters of 2020 were still kept in the books as per their previous classifications, asset quality became difficult to assess.

Furthermore, any interest accrued and provision on Non-Performing Loans is adjusted in the Balance sheet to lower the total amount of Net Outstanding Loans. This adjustment has also been understated due to classification deferment. 

Over the last few months, leading bankers have expressed concerns saying that a large part of these borrowers who are availing facilities of the moratorium program may be wilful defaulters. 

This implies that a large part of the interest accrued on "classification deferred" loans, which the bank is treating as income, may not be recovered at all. This paired with understated provisions will result in "paper income" and "paper assets" - money that does not exist and may not be realised at all.

Without a doubt, we are already facing the consequences of this accumulation of paper money. The conservative banking sector is now becoming even more conservative, as indicated by the willingness to lend and levels of liquidity.

Total liquid asset to total demand and time liabilities (TDTL) ratio increased to 27.5% FYQ1'21 from 23.5% FYQ3'20. 

Similarly, liquid asset excess of SLR to TDTL rose to 12.6% from 6.9% during the last year. 

At the same time, private sector growth slipped lower, staying below an average of 8.9% throughout 2020. 

However, some economists argue that excess liquidity and low credit growth is due to the low demand for funds from borrowers.

Fortunately, some changes made to the moratorium program upon extension may stop the worsening of the paper-money problem. 

The newer guidelines for the moratorium states that instead of the central bank, now, bankers can defer the classification of lenders till June 2021, based on their outlook and relationship with the lender (client). Therefore, how much paper money we generate and recover in the years ahead hinges on the banks' due diligence. 

Going forward, we must ensure that banks pay special attention to following-up and supervising lenders that have deferred classification under the moratorium program. This is consequential in determining how much of the piled "paper money" banks can and will eventually realise. 

Furthermore, once the demand for credit ramps up, the central bank must consider lifting the lending cap to a higher rate. This will allow banks to accommodate more lenders and compensate for risk accordingly. Given the banking sectors' proclivity to hold excess liquidity as G-Secs and T-Secs, the central bank must consider reducing interest rates on these asset classes. This will greatly encourage lending once the demand for funds is back to pre-pandemic levels.