Betting on self-regulation?

The loan rescheduling policy recently announced by the Bangladesh Bank has evoked a mixed reaction from industry leaders and economists.

The bankers have embraced the delegation of the decision to reschedule from BB to the banks. The delegation will facilitate efficient rescheduling. Increased default forbearance should do no harm because bankers have the option to not reschedule. Given wide heterogeneity in the quality of corporate governance, economists worry about the macroeconomic, if not the systemic, risks due to selection of aberrant borrowers and repayment moral hazards created by the increased generosity in the terms for rescheduling without a compelling rationale.

The new policy

The general policy guidelines in the Master Circular are prudent. Rescheduling is intended to preserve economic value of units, not evergreening of accounts. It provides borrowers breathing room for managing unanticipated shocks, allowing them to resume loan repayments as their distress ease.

Before rescheduling a loan, the banks must identify why the loan has become non-performing. If the borrower has diverted funds elsewhere, indulged in fraud or malfeasance, or is a habitual defaulter, the bank must deny rescheduling. Subject to passing these tests, banks must assess the borrower's overall repayment capacity considering their liability position with other banks, cash flow statement, audited balance sheet, income statement, and other financial statements.

Bank officials should ensure by spot inspection, if necessary, that the borrower's business will be able to generate a surplus to repay the rescheduled liability. The banks must factor in the impact of rescheduling on their own profitability, liquidity, capital adequacy, the ability to lend to and the repayment behaviour of other borrowers.

The loan may be rescheduled after all the above due diligence signals going ahead. Otherwise, the bank shall take legal steps to realise the loan, make necessary provisions and follow the due process towards write-off. No account should be rescheduled without establishing its financial viability and a reasonable certainty of repayment under the terms of the rescheduled package.

Banks on their own

Prior approval of loan rescheduling from BB is no longer mandatory. Even within banks, the first two rescheduling do not require Board approval. The bank management is responsible for assessing the rescheduling worthiness of the borrowers not able to pay the instalments and principal with interest under the original terms of the loan. The onus of distinguishing between habitual and non-habitual defaulters is on the banks.

In fact, each bank must frame its own rescheduling policy within the parameters set under the BB's new rescheduling framework. Bank management is best placed to make all the strategic and granular judgement calls based on the history of their customer relationships. BB deserves plaudits for incorporating this reality in its policy.

Since the regulator has abdicated imposing rescheduling decisions on the banks, the borrowers have no obvious incentive to lobby with them. It arguably is one way the regulator is escaping capture by vested interests. The banks are required to report the rescheduled loans to the Credit Information Bureau along with the rationale. The regulator can therefore hold the bank accountable ex-post for rescheduling decisions. Any rescheduling done without assessing the viability of the projects financed by rescheduling would be treated as an attempt at evergreening a weak credit, thus provoking regulatory response.

Prudential regulations such as above enable and incentivise bank management to act in the best interest of all the stakeholders.

Plaudits again!

Delinquency incentivised as well

The ambiguity in the definition of habitual defaulters leaves the bank management and boards with discretion that can cut both ways when the quality of corporate governance is not uniformly judicious and farsighted. The banks must identify behavioural attributes distinguishing the habitual from the non-habitual. However, if a current borrower has already rescheduled the loan once or twice, they cannot be automatically categorised as habitual. The BB policy allows rescheduling a third and, on special considerations, even a fourth time.

Knowing Your Customer may not be enough to ringfence the banks' loan portfolio against delinquent borrowers when the policy is so generous. If you borrow over Tk500 crores, you can potentially get a maximum of 29 years of loan rescheduling. If the original maturity is five years, you are effectively getting a loan with a largely backloaded 34 years' repayment schedule. The net present value of such a loan is most likely very small or even negative at any reasonable rate of discount from the bank's point of view and highly positive from the borrower's point of view. What then prevents opportunistic borrowers from seeking loans to profit from the rescheduling generosity?

Imagine there are two types of borrowers: those who willfully default and those who do not. Each type is looking for bank loans. The bank, without insider information, cannot differentiate the two. It routinely seeks information on their credit history. The wilful defaulter knows answering truthfully will not get the loan. Knowing that the veracity of the information is uncertain in an environment where auditing and financial reporting standards can be compromised, the bank offers lending to all on harder terms, building in a risk premium. This makes the honest borrower dropout leaving the bank only with felonious borrowers.

Even if such adverse section problem is somehow solved by investing in financial intelligence, the borrowers have incentive to change behaviour after the loan is granted. Let's say a borrower located in a flood zone has a fire security system and prepares adequately against floods. Doing these is obviously costly. So, he borrows on the expectation that a fire or flood will make his enterprise eligible for loan rescheduling. The incentive to maintain the fire security system and do enough to prepare for potential flooding is weaker because of the insurance implicit in the multiple opportunities to reschedule loans obtained. This insures against both covariate and idiosyncratic risks for 29 years max. Such behaviour subjects the bank to greater risk of having rescheduling applications.

The banks have no foolproof safeguard against these adverse selection and moral hazards. Loan gatekeeping, monitoring and supervision will face added challenges, implying increased cost of lending to large borrowers. The Cost Income Ratio in this market segment tends to be low because of the large volume per borrower. Bank management have a temptation to look the other way on adverse selection and moral hazard exploiting the information asymmetry between them and their principals, particularly the minority owners and depositors. There is no bar on recognition of interest income and no requirement of additional provisioning against loans rescheduled the first two times. Nearsighted boards can collude with management to camouflage the balance sheet long enough for them to make their big bucks and move on.

Are these apprehensions unfounded?

Experience prior to the moratorium in 2020 is instructive on the likely consequences of the new arrangement. BB's financial stability reports in 2016 and 2017 expressed concern about the growing tendency of loan rescheduling in the banking sector. Yet a new policy in 2018 allowed regularising defaulted loans for 10 years by making 2% down payment with one year's grace period and 9% interest rate.

Loan rescheduling peaked in 2019. While banks rescheduled Tk 89,515 crore between 2012-17, Tk 52,770 crore were regularised in 2019 alone—the highest ever in a single year. BB stopped publishing data on stressed advances since 2018. Poor due diligence, negligence in compliance with risk management practices, influenced lending, opportunistic borrowing, fraud, and malfeasance are cited as reasons for the rise. Regulatory forbearance enabled cleaning the books of the banks sidestepping the prudential norms.

There are already allegations of booking unrealized interest on loans not classified because of the moratorium. The net profit of the banking sector soared in 2021 as the moratorium kept getting extended. Most banks registered profit using BB's relaxed loan classification policy. Default loans hit a near record high in the first quarter of 2022 when the moratorium was paused. Both NPLs and loan rescheduling will accelerate when the reincarnated moratorium is lifted.

BB is probably betting that self-regulation under the oversight of the Boards will suffice to prevent the abuse of rescheduling generosity. The surge in rescheduling in 2019 happened under a regulatory regime requiring banks to take prior approval of proposed rescheduling from BB. This at best proves that prior approval is no defence against abuse. It does not mean the problem will disappear by doing away with this requirement because, after all, the rescheduling proposals came from the banks.

Contagion, reputation, and macroeconomic risks

Bangladesh's experience does not provide assurance that some banks will not reschedule loans to habitual defaulters without strictly adhering to the prudential guidelines. If a bank wants to reschedule, it can do so by tailoring eligibility to make a case. The Master Circular has given expanded leverage to the wilful defaulters while encouraging good borrowers to imitate strategies for accessing rescheduling. Even banks with good corporate governance may struggle to withstand pressure from influential borrowers while those with bad governance may embrace them with open arms. Well governed banks would have been in a better position to resist pressures if the rescheduling parameters were tightened instead of slackened. 

BB has reportedly developed the new parameters based on the actual rescheduling experience of the last five years. In other words, since there were deviations from regulatory norms in the past, why not tune them to reality? The opposite argument to tune the reality with regulatory norms by delegating the rescheduling decisions to the banks, keeping the pre-existing regulatory norms unchanged, has as much, if not more, merit.

The rescheduling policy has broadened room for the free riders, extractors, and predators on both the lending and borrowing sides to indulge in malpractices (such as insider rescheduling) in an environment where corporate governance is vulnerable to patronisation, cronyism, and oligarchic pressures. This can become contagious when the stock markets start rewarding such banks with premium prices. Herd behaviour on rescheduling can potentially turn some banks into weapons destroying the reputation of the banking system.

Bangladesh's experience assures that failure of even relatively small banks is considered too risky. There is the time-tested expectation that once in trouble, BB or the government would bail them out. The cost eventually is on the public in the form of higher taxes, lower expenditures and higher inflation depending on the scale and mode of financing of the bailouts.