A resurgence of zombie lending

Hail, hail, hail! The expected has happened.  The Non-Performing Loan (NPL) ratio has declined from 12 percent in September 2019 to 9.2 percent in December!  A massive reduction reflecting the rescheduling generosity extended by the Bangladesh Bank to 6,632 defaulters, as reported in this newspaper.

A large NPL ratio can be tackled in two ways: reduce the outstanding stock of NPLs or wait until fast growth of new loans makes the NPL problem obsolete. The NPL ratio can fall either when its numerator contracts or when its denominator expands. The former is known as the "active" method while the latter as the "passive" method of NPL reduction.

Bangladesh happened to be in a procrastination mode in which no active action was being taken and credit expansion was slowing even though economic activity was growing at reportedly the fastest rate in the world.

What gives urgency to NPL reduction?

NPL related losses on banks' balance sheets lead to a strong, negative impact on the economy. Studies typically find a negative and significant impact of rising NPL ratios on GDP growth and employment. No such problem in Bangladesh though. Measured GDP has grown in tandem with NPLs despite weak private investments and volatile exports. Domestic demand allegedly was the source of the economy's resilience despite weakening credit growth.  However, a large increase in the NPL ratio has turned out to be a reliable predictor of financial crises. An active method was thus warranted to pre-empt such a crisis.

A higher-than-normal NPL ratio (3 percent or less) dents economic performance by making banks more cautious in their lending. We have seen it happen as private sector credit growth hit a recent all-time low of 9.8 percent in December 2019, serving as a transmission mechanism from greater creditor risk-aversion to weaker demand, which in turn creates risk of business failures, weaker growth and a further increase in NPLs. An overhang of NPLs can also result in a misallocation of resources in an economy like Bangladesh where bank-business interlinkages are very strong.

What have we not done to address the problem? This may sound strange, but it can help understand the implications of what we have actually done to achieve such a significant (nearly 3 percentage point) reduction in the NPL ratio.

Banks did not need to transparently and credibly asses the quality of the assets on their balance sheets to build up necessary provisions to cover the expected losses. One of the by-products of the NPL problem is damaged market confidence, making the provision of credible guidance to market agents an important part of the process. Relying on banks' voluntary efforts to resolve NPLs was not considered sufficient, especially as the NPL burden ballooned. The regulator decided to prod banks into disposing of NPLs, by setting deadlines for loan rescheduling. The regulator did not guide banks as to the optimal use of their capital buffers and determine target loan loss provisions. Banks did not need to develop special capacity to deal with NPLs.

It was also not necessary to create a good legal framework for corporate restructuring and timely disposal of NPLs, even though the judicial capacity to deal with NPLs case by case is lacking. The government took a central role in arranging rescheduling of non-performing debt. Authorities want to encourage a liquid secondary market for NPLs by creating a "bad assets bank" called Asset Management Company to allow commercial banks to transfer the NPLs on their balance sheets.

The practice of continuing to lend to otherwise insolvent firms by banks is called zombie lending. To accommodate regulatory forbearance, the banks can keep credit flowing to the insolvent borrowers by engaging in loan rescheduling. This helps thwart the normal competitive outcome where the zombies would shed workers and lose market share. The congestion created by the zombies reduces the profits for healthy firms, which discourages their entry and investment. Even solvent banks may not find good lending opportunities in such a context. Experience globally shows that zombie-dominated industries exhibit more depressed job creation and lower productivity by depressing investment and employment growth of non-zombies.

Is the rescheduling a real remedy or just a plastic surgery that will eventually make the face uglier? Nearly one fifth of total loans have undergone rescheduling. Net profit of banks will increase due to the fall in provision requirements resulting from rescheduling facilities, but it is bound to decline eventually because of the higher provision requirement following the reappearance of rescheduled loans as NPLs. The signal emitted by the implementation of a rescheduling facility softer than the original loan terms is that you are financially better off by defaulting.

This kind of a superficial NPL resolution effort defers more serious restructuring to the future. When banks channel most new credit into the existing troubled companies, they may help to prevent second-round business failures.  But it diverts funds away from new, more productive parts of the economy, thus compromising the country's long-run growth prospects.

Generally, active policies to resolve NPLs rely on sufficient capitalization of banks allowing for full provisioning of non-performing exposures and their write-off or sale at discounted prices. Centralized solutions involve well capitalized state-backed bad banks, asset management companies or significant tax incentives for NPL resolution.  However, they carry a fiscal cost. Active policies also require strong administrative capacity and legal regimes supportive of NPL resolution.

A number of legal and regulatory obstacles impede swift resolution of NPLs. The flip side of the NPL problem is the need for restructuring and renewal of the corporate sector. There is no formal framework to support enterprise restructuring.  The procedures under the existing insolvency law are highly ineffective and widely abused. There is an urgent need to adopt effective out-of-court and formal court restructuring mechanisms, including a new bankruptcy law that supports accelerated approval of restructuring agreements. The experience in Asia, Turkey and several other crisis-affected countries shows that formal mechanisms can help promote a faster return to normalcy.

Will history repeat itself like we experienced following the rescheduling of eleven large NPLs in 2015?  Is there any reason this time to expect a better or different outcome? Time will tell, but do not bet on any major difference on the positive side!  The reason is the immutable law of economics—people respond to incentives, including businesses the regulator wants to help.  That is why the rescheduling facility may not end up working as intended.  When the regulator says this is only a one time exit opportunity, people do not believe it because they know the regulator responds to incentives too. Unless the incentives that induced them to offer the exit this time changes when the known knowns become known, there is bound to be more of the same.

The author is an economist.