Any prudent banker would not normally want to deal with people, having questionable integrity, at any cost.
--BY RAJIB GIRI
Background
How are the lending practices of banks in Nepal today different from traditional moneylenders? i.e. taking pledge of assets and extending loans, irrespective of the borrower’s capacity to pay. In fact, the money lenders wish the borrowers to default, so that they can take possession of pledged assets, at negligible cost. Banking is said to be a specialised business or process, run under certain norms. Do the banks in Nepal follow the same prudential norms that are followed universally? While it may be difficult to validate, there are strong suspicions that not all banks in Nepal adhere to prudential practices.
Barring retail-type loans where the business is simple, straight forward and relatively transparent whereas the condition may be different with lumpy business loans, also known as corporate or project loans. Data reveals that almost half the number of commercial banks, have a very high concentration of big loans over their total loan portfolio, indicating the level of risk they are exposed to. This article attempts to dwell on anomalies present in the lending practices by banks in Nepal.
Basics of Lending Decisions
The basic philosophy of lending is primarily to assess the borrower’s “ability or capacity to pay” and “willingness to pay” aspects. The entire credit process revolves around these two fundamental questions. There are numerous credit tools available to determine the ‘capacity to pay’ aspect viz assessing the historical financials of the borrowing company, business risk, industry risk, management risk, past track record of the borrower and the bank’s judgment on their future prospects/projections, which establishes their ability to repay the debt.
However, there are limited tools to test the willingness to pay aspect. Many cases of default may be caused by the inability to manage the underlying risks as originally envisaged, which is though a normal scenario since banks are in the risk business. As opposed to this, if a borrower utilizes the loan proceeds for purposes other than the approved one, with the intention of willful default it may trigger the ‘willingness to pay’. Hence, the willingness to pay aspect characterises the credibility of the borrower. Any prudent banker would not normally want to deal with people, having questionable integrity, at any cost.
The credit officer should be able to assess all the risks inherent to subject credit, weigh the borrower’s strengths and weaknesses and find reasonable mitigants before arriving at a decision to lend. There should be a control mechanism to ensure that the borrower utilizes the funds for the intended purpose and a proper mechanism should be in place, to monitor the performance of the borrower. The loan should be self liquidating in nature. For instance, if the loan is extended against any specific receivable or sales proceeds the same should repay the loan and not through the sale of property or other sources, where the repayment becomes uncertain.
Various loan products and structures are available to suit the borrower’s needs and to ring fence the risks by the bank. Banks may have their own strategy to hold, grow or exit from a particular industry or business. These are the basic outlines of prudential lending practices. Against the above backdrop, we are going to analyse some of the key practices prevailed in the banking industry in Nepal.
Practice of ‘Name lending’
A fundamental lesson,taught to any banker involved in credit, is to avoid taking decisions, merely based on the “name” of the borrower, which is also popularly known as “name lending”. It is understood that many banks in Nepal indulge in name lending i.e. taking decisions based on the perceived wealth/net-worth of the borrower or perceived support from the owners, should the situation arise.
This notion might have worked in Nepal to a large extent because many businesses are run by privately held companies, which are run with relatively low transparency. The asset of the company and the owner is considered inter-changeable. Real estate collateral securities are often required by banks than assessing the viability of the project, track record of the company, etc. Banks invariably demand personal guarantees of the directors of the company to put pressure on the borrower. Now that the size of lending has grown substantially, it would not be practical to expect collateral securities adequately covering the debt and personal guarantee is less meaningful. But the banks are still understood to be widely practicing ‘name lending’, which could turn into a risky strategy as the assumed fallback may not be an adequate rescue.
Overtrading
The term “overtrading” refers to the practice where the borrowers avail higher borrowing than they deserve under the prudential banking norms. This is a formidable malpractice, widely prevalent in the country. Owing to the pressure of maintaining the historical return on capital (to keep pace with the four-fold rise in capital as required by the central bank) banks often ignore if the borrowers are biting off more than they can chew. There may be cases of duplicate or double financing. Multiple banking practice is largely to be blamed, as borrowers, if they wish to report different current assets and borrowing status to different banks (even fictitious), which often likely go undetected. Financials submitted at the end of the period could be either manipulated or cooked up. Banks do not trust each other to verify information on the borrower through exchanging information.
The central bank’s regulation on consortium financing has served the intended purpose and limited to ‘pari passu’ sharing of assets. Bankers are happy since they continue to get interest income out of borrowed funds or have no choice, to be modest. The debt to equity ratio is usually very high on companies practicing ‘overtrading’. While under normal circumstances, this practice may not pose a serious threat, in the stressed scenarios like in the current pandemic situation, the highly leveraged companies are the ones, which are like to be severely impacted earlier than any other companies, as their interest cost would be unsustainable.
Normally banks with higher cost structure, board of directors with inadequate knowledge of banking business or bad corporate governance, high ambition and risk taking nature, etc. are found compromising on basic norms and resorting to practices of providing excess financing than the competition for the same asset, ignoring lending terms, etc. since they are unable to not compete on pricing due to higher cost structure. These banks are the most vulnerable to fail in the stressed scenario like the current one.
‘Evergreening’of Loans
Another major departure from credit fundamentals we come across is “evergreen loans” and “ever greening of loans”,which are widely perceived to be practiced by banks in order to conceal the deteriorating quality of loans. The Nepali banking industry is crowded with a high number of banks & financial institutions (BFI), having relatively higher capital base, almost all catering to the same market, thus creating an unhealthy competition, compelling them to compromise on basic norms and accepting sub-prime credit proposals. Refinancing of loans extended by other banks, becomes rampant, and whereby the problematic credit of one bank becomes a good client of other banks and it goes on until it really turns ugly.
In accordance with the international banking principles and practices there should not be a hardcore element in good working capital loans. The minimum level of current assets during the year (e.g. stocks, debtors, etc.) should be structured as longer-term loan or funded by borrowers’ own equity whereas banks have no luxury to follow such a practice. Some international banks also require an annual cleanup of working capital loans (i.e. making the loan ‘nil’ at least once a year).
Assessing the true borrowing cause and selection of right product for the right borrower are parts of prudential practices. Overdraft or revolving working capital type of loans (short term loan, demand loan, etc) are liberal banking (evergreen) products, which are widely offered to borrowers in Nepal, thus encouraging ‘evergreening’ of loans. Nepal Rastra Bank report of Mid June 2020 reveals that overdraft (Rs 660 billion),demand and other working capital loan (Rs 402 billion) aggregate represents 37.7 percent of the total loan and advances of commercial banks (Rs 2,815 billion), which is very high.
Import or Trust Receipt (TR) Loan is disbursed to finance imports, which is supposed to be cleared on the due date determined based on the borrower’s operating cycle. However, it is often found that demand loan of the same amount is disbursed on the due date to repay the same; another short-term loan is disbursed to repay the previous demand loan and so on. Also, it is a common practice to disburse short-term loans to pay another bank’s loans on maturity so that it never gets due for final repayment.
Generous credit limit is set up for clients so that even interest can be cleared out of new loans, it is said. These are a few examples of ‘evergreen loans’ and ‘evergreening practices’, which if uncurbed may lead to unpleasant scenarios in the banking fraternity. Large borrowers usually have much higher undrawn lines of credit, available with a number of banks as a fall back of repayment, which is the result of multiple banking practices.
Other Anomalies
Nepal Rastra Bank has issued many directives aimed at curbing or limiting banks’ loan investments in the real estate. One major regulation came out in 2008 restricting banks real estate lending to 25 percent of their total lending, curbing the asset price bubble. Many banks having high exposure in the real estate brought it within the approved limit, by redefining it as a business loan. Still, it is understood that many loan transactions of banks ultimately find ways offinancing the real estate indirectly.
Also, there may be cases of loans granted in speculative business, unethical purposes and extended with mala-fide intentions or bad corporate governance, which can’t be ruled out (e.g. Nepal Share Market, Grand Bank, etc.) as has surfaced in the past. A large public bank of India, ‘Yes Bank Ltd’, which had high concentration of risky large corporate loans and exhibited similar malpractices that we discussed, went through a ‘run on the bank’ last year.
Regulatory Landscape
The compliance based audit, which was the supervisory norm of the central bank earlier, didn’t preclude the culture of ‘name lending’ and ‘security based’ lending. It somehow ignored the requirement to assess the borrower’s cash flow, rather largely relied upon the borrower’s assets/perceived net worth and severity of default scenario. One would be deemed to be a ‘good’ borrower if the default tenor is less than 180 days, which allowed ample time for banks to put pressure on the borrower by serving notices, threatening to blacklist them, which not only tarnishes the borrower’s reputation but also bars them from resorting to loans from any financial institution, and it worked in large instances.
Although it is considered a prudent practice to seek for additional collateral as a secondary way out should the primary source of repayment fail to fructify, in the case of large corporate borrowing, it may not be feasible for borrowers to provide tangible security,covering the entire exposure. The augmented lending capacity of banks post the whopping rise in their paid-up capital exacerbated the lending situation dramatically and each bank is now in a position to finance large projects,where it is not feasible to look for tangible securities. Hence, banks would be exposed to higher risks if they do not act prudently.
Now that the ‘Risk Based Supervision’ model has been introduced by the NRB, it is helping reduce the gap. However, the hangover of compliance-based audit is not completely gone away and the repute of the borrower and security as a fall back largely influence our perception. Irregularities and non-compliances, if detected, simply get away with comments requiring rectification within a specific time frame. Provision of penalty is trifle vis-à-vis the level of wrong doings, encouraging those who dare to take such risks. Elsewhere, penalties for such malpractices are understood to be considerable, which puts anyone to think seriously before committing or repeating such irregularities.
Nepal Rastra Bank has issued a Risk Management Guideline, which broadly provides guidelines for banks to have policies addressing various risks viz., credit risk, market risk, liquidity risk, operational risk, etc. However, banks have gaps in formulating and following meaningful policies. Credit fundamentals are compromised in the pretext of demonstrating flexibility. Factory inspection is generally a form filling exercise. Thorough understanding of credit risk and mitigants thereof in the credit proposal, evidence of contacts with the borrower, monitoring of business documented in the file are major tools used by international banks in measuring the credit quality of banks.
Way Forward
There is a relatively stable government regime now; the size of our economy has grown substantially and there is enormous growth potential. Therefore, the role of the banking industry as a major investment partner to business projects plays a very crucial and vital role in the economy. The banking business is run under unique and universally accepted norms. In order to ensure that the banking fraternity keeps up with its respectable image it would be imperative that they should eschew from unhealthy practices in the pretext of growing business.
Owing to a high number of financial players in the market with increased capital size and no consistent policies there are loose banking practices, which are considered unacceptable under prudent international banking norms. IMF has repeatedly raised their doubt over the issue of ‘evergreening’ of loans practiced by banks since the level of non-performing assets (NPAS) is much lower in Nepal than other South Asian nations and even compared to stronger economies like India. This coupled with the absence of Nepal’s own country credit rating by any international rating agency undermines the credibility of the financial institutions of Nepal. Many international banks do not recognise or accept a letter of credit (LC) issued by Nepali banks and require confirmation from recognised banks. International Banks operating in Nepal when doing corresponding banking, still largely demand cash cover to confirm their LCs. Likewise, credible banking practices and country ratingisan important base for increased FDIs and international borrowing at relatively lower risk premium.
Therefore, it calls for a serious revisiting of the way of doing business prudentially. The changes may not happen overnight, but we need to wake up timely before it is too late. Staff in lending areas not only need proper training but should also be encouraged to practice what they have learnt. There should be independence of the risk management unit, free from intervention from the top.
The central bank should further review its resources and the area of coverage and should not hesitate in introducing severe penalties for the deliberate wrong doings. Limiting the number of banks through mergers and acquisitions (M&As), which NRB has already begun, is also likely to lower the competition and help improve the ecosystem. Of course, M&As should be encouraged by offering more incentives and privileges but without having any soft corners for those indulging in unhealthy practices, as discussed above. In the meanwhile, the banking industry and its clients deserve due support from concerned authorities to survive through the pandemic.
The views expressed by the author represent a general perception of the banking industry in Nepal. Giri was with Standard Chartered Bank Nepal for nearly 25 years as Head of Corporates at the time of exit and also worked as Deputy CEO at Kumari Bank Limited. He can be reached at rajibgiri789@gmail.com
