Bad Loans and their write off
Microfinance institutions often fail to write off bad loans for a number of reasons. It could be that they are afraid of regulatory rigidities about capital impairment and other legal issues. This could also be a result of their desire to show exaggerated profits and look good to their clients and the general public. Failure to write off bad loans will distort the statistics on loan recovery, which are important indicators of effective management of a lending programme
When wise people hear that a stitch in time saves nine, they don’t just pass in a hurry without a thought given to the adage. They normally pause, often unconsciously, and run their thoughts through events around them,contemplating the tear they may have and the possible ways to stitch it. But those who are not that contemplative do not really pay any mind to such an adage. They inevitably face the consequences of their disregard for wisdom as they come. Bad loans have always been a source of concern for both regulators and operators in the finance industry. Both parties are aware of the pervasive implications of loans made out to client or customers that fail to get repaid at the times they ought to be paid. They know the damage such loans could do to the health of their institutions.
There are many things that happen at the lending office before a loan finally goes into the thrash can of bad debts. The Central Bank has issued Prudential Guidelines, for various aspects of banks’ operations. These include the thorny issue of effective risk management, the lingering issues of proper corporate governance, know your customer (KYC), money laundering, financing of terrorism, loan loss provisioning, different peculiarities associated with an industry as wide as finance and banking, and other sectoral needs of the economy. The guidelines normally require deposit money banks to develop, and have their board of directors approve comprehensive credit policy, which must address among other issues, loan administration, disbursement and appropriate monitoring mechanisms, and action plan against any eventuality of non-performance of loans. Such a credit policy should be reviewed from time to time; at least every few years.
Prudential guidelines are so critical to the health of any financial sector in the world that they are monitored and updated regularly as the industry evolves, and the global economy revolves in its dynamism. They go as far as stipulating the tenure of external auditors in banks for the obvious reason of the consequences of familiarity and capture. In some countries they set a maximum period of about 10 years from date of appointment after which the audit firm shall not be reappointed in the bank until after a period of about another 10 years. This shows the importance, which central banks rightly attach to credible audit reports as instruments of good corporate governance.
There is a natural tendency of human beings to show off their performance, especially when such performance is good. It has both announcement and ego values. This tendency is part of the dress code of deposit money banks. It is also growing among the other categories of banks to be dressed up prim and proper at all times. However, things may not always be as rosy as we want them to be or as presented. Besides, the core duty of image and reputation managers is to maintain a consistently good and rising profile for the institution. This is why many financial institutions will go a long distance to keep a good image, and that sometimes, implies understating the record of non-performing loans.
In the revised prudential guidelines for Nigerian banks, issued by the Central Bank, loans are classified based on performance, into specialised and non-specialised loans with differing loan loss recognition and measurement criteria. These requirements are such that non-performing, non-specialised loans are classified into Substandard (overdue by greater than 90days); Doubtful (overdue by 180-360days); and Lost (overdue by greater than360days). For non-performing specialised loans, the classification is into Watchlist, Substandard, Doubtful, Very doubtful and finally, Lost.There is no doubting the difficulty lenders have with recognition and acceptance that a loan is bad. Worse still, they find it hard to accept that a loan is lost. So, the tendency is rife to carry a bad loan in the books for a long timeas though it were good. Some financial institutions tend to delay or completely avoid writing off bad loans from their books. But keeping the books clean by weeding off lost loans is not only a measure of sound banking practice but the hallmark of good corporate governance.
There is however, a certain danger that haunts a financial institution, especially microfinance institution that understates its non-performing loans. Microfinance institutions often fail to write off bad loans for a number of reasons. It could be that they are afraid of regulatory rigidities about capital impairment and other legal issues. This could also be a result of their desire to show exaggerated profits and look good to their clients and the general public. Failure to write off bad loans will distort the statistics on loan recovery, which are important indicators of effective management of a lending programme. Recovery rates are important story-tellers on the health of both a lending institution and the industry as a whole. Delinquency ratio is known to be low in microfinance because the poor have proved that they can be trusted even more than the rich.
In 2005, when I presented my book on microfinancing, as part of the United Nations’ International Year of Microcredit, I went a considerable length to drive home this point, indicating that the ownership and control of the instruments of coercion by the rich, has advanced their tendency to dishonesty. Impunity fuels corruption at all levels. Meanwhile, the fear of the law, especially in societies where justice could be bought and sold in a criminal justice market place, has made the poor even more worthy of trust. They are probably the only people who obey the law in such societies. It was the activities of the rich, and not the poor, that forced Nigeria, and many other countries, to establish Bad Banks like AMCON, to clean up the mess crated in the banking industry by the rich.
There are yet no bad banks for microfinance banking, hence the need for proper reflection of the loan loss situation in the sector. Delay or outright refusal to write off a bad loan has the effect of reducing the recovery rate. This is like shooting oneself in the foot. Not only does it affect donor confidence, it also impairs capital inflow to the industry.
If we assume for example, that a microfinance bank made loans of 100 units of money annually and 10 per cent of it is never paid back and not written off, the implication will be a false deteriorating picture of the recovery ratio. This ratio is measured by dividing the value of collections by the amount falling due during the year (less accumulated old bad debts that occurred in the past). The practice in some institutions is to measure the ratio by dividing the collection amount by the amount disbursed plus the total accumulated bad loans from previous years. This is wrong or fraudulent. Failure to write off a bad loan enlarges the denominator, which has the effect of reducing the ratio that measures loan collection performance. This low ratio is a bad testament for everyone in the industry. Regulators must have their eyes wide open to see when this financial engineering is taking place. Next week we show how the eagle-eyed regulator should fish out this misconduct or error, where it exists.