Business

28th October 2001

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Loan defaults hit banking industry

By Dr. S. Colombage

Much publicity has been given in recent weeks to defaults in the repayment of loans obtained by certain individuals and companies from the two state banks, Bank of Ceylon and People's Bank. The solvency of banks depends to a large extent on their ability to recover credit. Non-recovery of loans has wide implications for the banking industry as well as for the entire financial system. In a way, the magnitude of such bad loans is an indicator of the health of the banking industry.

Non-performing loans are a major problem of state banks in Sri Lanka as in the case of several other developing countries. About 19 percent of the total sum of loans of the two state banks was non-performing last year, compared with 17 percent in 1996 (according to the IMF country report). This is much higher than the internationally accepted norms. It is widely known that a major reason for the distress of state banks has been the political pressures applied from time to time not only to lend to discreditable borrowers but also to allow them to evade debt repayments. Some big borrowers are reported to have defaulted willfully under political patronage.

Apart from such willful defaults, social obligations of the state banks, which had a tendency to have a bias towards granting loans to small and medium scale entrepreneurs, also had a bearing on the quality of their loan portfolios. Their greater involvement in retail banking, especially in rural areas, made it difficult to recover the credit efficiently. Very often, successive governments have called upon state banks to grant loans to selected production sectors, and in such instances the two banks had to deviate from the accepted lending norms. Also, the government on many occasions directed the state banks to write-off certain bad loans and this tended to create a undesirable credit culture. A recent example is the directive given by the government under the relief package to write-off farmer loans. So, debt recovery has been a recurring problem in state banks.

It is alarming to observe that the debt recovery problem has proliferated in domestic private banks and foreign banks too. Non-performing loans held by private domestic banks now account for 16 percent of their total loans and this was only 10 percent in 1996. Foreign banks now have a bad debt portfolio of 13 percent, up from 9 percent in 1996. Overall, the bad debt portfolio of the commercial banking system is 17 percent, up from 14 percent in 1996. Thus, the problem has aggravated during the last several years at a rapid pace.

The rise in loan defaults is partly due to the economic setback. In the present economic environment with a near-zero GDP growth, the profitability of the corporate sector tends to decline and as a result, entrepreneurs find it difficult to service their bank loans. Escalating interest rates have worsened the situation. Thus, not all defaulters are dishonest people. The gravity of the problem can be judged by the large number of advertisements of commercial banks appearing in newspapers and weekly government gazette for auctions of mortgaged property of loan defaulters under the parate execution laws.

In the context of the rising trend of loan defaults, remedial measures need to be taken to protect the solvency of the banking industry. As regards state banks, steps are being taken under the ongoing restructuring programmes to reduce political interference and to make them autonomous bodies, but the progress is rather slow. The regulatory framework should also be streamlined. In order to safeguard banks from excessive risk-based assets, banking legislation specifies minimum capital adequacy standards for banks. It is the responsibility of the Central Bank to keep a tab on these standards through its Bank Supervision Department. This has become rather difficult, as bank supervision has not kept pace with the development of the commercial banking system in recent years. It is important to identify in advance the risks faced by the banking industry. For this purpose, forward-looking surveillance should be adopted, instead of the post-mortem type bank supervision that is being conducted at present.


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