Even where there are greater risks that the banks recognise, they only cause a loss after giving a warning sign

Causes of non-performing loans in the banking industry

Christopher Boachie Business News Apr - 27 - 2016 , 10:00

Lending is one of the main activities of banks in Ghana. This is evidenced by the volume of loans that constitute bank assets and the annual volume of credit granted to borrowers in the private and public sectors of the economy.

Loans are therefore, typically, the largest and the most important asset and source of revenue for banks through significant interest income earnings. The banking industry in Ghana has seen very strong competition in the last decade. This competition is mainly as a result of the entry of banks from the sub-region who brought very innovative ways of banking never experienced before on our shores.

There has been an intense scramble to attract the large number of the unbanked population. This has seen banks deploying direct sales people to go out to prospect for customers, expansion in bank branch network, the opening of ‘cashless’ bank accounts, mobile phone banking and so on. As bank customers and deposits grow, the need to give loans to firms and individuals also increases. In order to make profit and outdo each other, many banks have given out loans and advances to customers and not all these loans get re-paid. This has introduced the incidence of non-performing loans onto banks' books and this is gradually becoming a major concern to banks and regulators alike.

Performing loan

A performing loan is a debt on which the borrower has historically made payments on time. For example, if a homeowner takes out a mortgage and pays his home loan faithfully each month, his mortgage is considered as performing loan. In some cases, loans in which payments are less than 90 days late may be considered performing.

Non-performing loan

A non-performing loan is a debt on which the borrower is late on making payments or is in danger of missing payments. At what point the loan is classified as non-performing by the bank, and when it becomes bad debt, depends on local regulations. According to the International Monetary Fund (IMF), a loan is non-performing if it is 90 days (3 months) overdue. A loan can also be classified as non-performing if it is less than 90 days overdue but repayments are no longer anticipated. Repayment of principal and interest on loans create a stream of cash flows for the bank.

It is from these interest repayments that banks make profits. Therefore, a high non-performance loan portfolio reduces banks’ profits and their ability to further lend to borrowers. This ultimately has a negative effect on the economy.

Shifting focus from the traditional banking sector, the non-banking institution such as Micro-finance and Small Loans Center (MASLOC) has dragged many of its defaulting customers in different parts of the country to court. This means that the issue of non-performing loans is widespread across the general financial industry. Across the border in Nigeria, the country's Central Bank, in a bid to save the Nigerian banking sector from collapse created the Asset Management Corporation of Nigeria to buy all non-performing loans on the books of the banks that were at risk. Similarly, at the height of the credit crunch in America, the Obama Administration set up the Toxic Assets Recovery Program to buy all non-performing loans or ‘toxic assets’ as it was called so that the banks could resume lending.

Ghana's situation has not reached such crisis levels as experienced in Nigeria and America but an NPL ratio of 11.2 per cent in the Ghanaian banking industry is still a cause for concern. The high rate of NPLs in the books of commercial banks is sparking worries among bankers and industry watchers. So what factors account for this high default rates on loans in the Ghanaian banking industry? This article considers the various possible causes of non performing loans.

The harsh economic environment affecting some small and medium scale enterprises and individuals is a factor. High cost of operation, especially the increasing prices of input materials and energy can have a considerable impact on banks non-performing loans, as these reduce the earnings of businesses. At a news conference, Ghana's Central Bank Governor, Kwesi Amissah-Arthur, observed that the share of NPLs were higher in commerce, finance, manufacturing, services and construction sectors.

Some bank managers’ reactions to competition from other banks encourage a weaker lending standard that leads to loan defaults. Due to the competition and the pressure to deliver increasing returns, banks increase the granting of credit facilities to marginal borrowers. These facilities are aggressively priced to compensate for the increase in risk.

Although this strategy delivers short-term results, credit losses follow and in many cases cause banks to fail. The failure of banks can, therefore, not only be linked to unfavourable economic environments, but also to the nature of the credit policies they employ.

Lack of proper skills among loan officials, speedy process of evaluating loans mainly due to external pressure, are among the factors that lead to huge concentration of non-performing loans.

Regular monitoring of loan quality, possibly with an early warning system capable of alerting regulatory authorities of potential bank stress, is essential to ensure a sound financial system and prevent systemic crises. The need to give due attention to borrower, thus, need not be overemphasised in order to ensure loan performance. There is a tendency by borrowers to give better attention to their loans when they perceive they get better attention. Some of the loans defaults ascribe to lower level of attention given to borrowers. It is advised that banks keep up with their loans timely.

Banks rarely lose money solely because the initial decision to lend was wrong. Even where there are greater risks that the banks recognise, they only cause a loss after giving a warning sign. More banks lose money because they do not monitor their borrower’s property, and fail to recognise warning signs early enough. When banks fail to give due attention to the borrowers and what they are doing with the money, then they fail to see the risk of loss.

The objective of supervising a loan is to verify whether the basis on which the lending decision was taken continues to hold good and to ascertain that the loan funds are being properly utilised for the purpose they were granted.

In order to meet these objectives banks need to see whether the character of the borrower, its capacity to repay the loan, capital contribution, prevailing market conditions and the value of the collateral that was taken during loan approval time continues to remain the same.

Risk, and the ways in which it can be identified, quantified and minimised, is key concerns for a bank’s management and its auditors when they are considering the need to provide for bad and doubtful loans. No loan is entirely without risk.

Every loan, no matter how well it is secured, and no matter who the borrower is, has the potential to generate loss for the lender. It is the degree of risk to which a loan is susceptible and the probability of loss that vary; these should normally be reflected in the interest margin and other terms set at the inception of the loan.

A bank in considering whether to lend or not takes into account the quality of a borrower which is reflected in, inter alia, its past and projected profit performance, the strength of its statement of financial position (for example, capital and liquidity) the nature of and market for its product, economic and political conditions in the country in which it is based, the quality and stability of its management and its general reputation and standing.

It is important for the bank to know the purpose of the loan to assess its validity and to determine how the funds required for the payment of interest and the repayment of capital will be regenerated. The borrower’s ability to repay a loan is of paramount importance. Ideally, the loan will be self-financing in that it will be repaid from the cash flow that the borrower is able to generate from employing the proceeds of the loan.

The decision to grant loan, however, should be based on the prospects and solvency of the borrower and a careful analysis of how the funds to repay the loan will be generated.

In general, banks lack effective measures to identify, quantify and control the regional and industrial risk, is constrained by obtaining historical data, decentralised information systems and immature portfolio management skills. So they have to make judgment mainly based on personal experience and consequently have weak management measures on concentrated and systemic risk.

Basically, the non-performing loans are a result of the compromise of the objectivity of credit appraisal and assessment. The problem is aggravated by the weakness in the accounting, disclosure and grant of additional loans.

In the assessment of the status of current loans, the borrower’s credit worthiness and the market value of collateral are not taken into account thereby rendering it difficult to spot a bad loan. Compromise in quality of risk assessment, thus, leads to occurrence of non performing loans.

The lack of a central database system from which credit profiles of potential borrowers can be easily obtained to know their credit worthiness does not help banks. In Europe and North America, it is difficult to obtain a loan or credit card from the banking system if one does not have a good credit history. Every borrower credit profile is easily searchable in a centralised system and this is strictly adhered to and cannot be manipulated.

This acts as a check and balance against loan defaults. In Ghana, the lack of a good address and house numbering system also compounds the problem as it is difficult to trace people to their residences.

Wrong attitudes on the part of SMEs and small entrepreneurs in particular contribute to non-performing loans. Many SMEs after securing loans use the funds in extravagant ways not stipulated in their loan agreements. Many expend their funds on funerals and other social activities that do not enhance their businesses. This problem is worsened by SMEs lack of basic business skills such as book-keeping, working capital management, marketing skills and good customer service, which are ingredients for business growth and profitability.

Government's indebtedness

Government's indebtedness to the construction sector and others is linked to loan default rates. Dan Mensah, the Executive Director of the Association of Ghanaian Bankers has blamed the government for 20 per cent of bad loans at the country's banks because of arrears to contractors, suppliers and municipal assemblies. According to Mr Mensah, ''the government's failure to repay its loans has led to road projects being halted and has left schools and clinics struggling to pay for supplies''. Dr Joe Abbey of the Centre for Policy Analysis agreed when he revealed, ''it is a big factor in the stock of non-performing loans in the banking sector''. Mr Amissah-Arthur does agree that government must take a chunk of the blame when he revealed that '' ...after long discussions with the banks, we realised that the government has a role in this (NPLs) because a lot of borrowers are those who have done work for the government''.

Government indebtedness has also been blamed for high interest rates on loans as a result. Credit sanctioning that has not duly considered the credit terms would potentially lead to occurrence of poor loan performance. Causes for the leniency are attributed to disaster myopia, herd behaviour, moral hazard and agency problems that may entice bank managers to take risk and lend excessively during economic boom periods.

Managers’ reputations suffer if they fail to expand credit when the economy is expanding and bank earnings are improving. This herd behaviour results in some loans going to customers with higher default risk than would occur otherwise. Bank managers, therefore, need to adjust lending standards as market conditions change, seeking to smooth overall lending risk.

The writer is a lecturer at Central University, Central Business School, Department of Banking and Finance.