Sep 27 - Oct 03, 2004





The banking system in Pakistan has been plagued with high non-performing loans (NPLs) for quite sometime. Presently, NPLs are estimated at Rs. 220 billion. Efforts to reduce NPLs seem to work but reduction in NPLs has not been as significant as was envisaged. Quota-free regime under WTO ensuing in a few months might have problems for many export-oriented industries. One would not be surprised that a few bank borrowers, now current in debt servicing, default and approach their creditors for rescheduling. This might increase bank NPLs further. In order to manage this risk, the stakeholders namely, the banks, the borrowers and the government (including the SBP) are urged to take protective measures now to make these industries fully competitive.

Loans and advances, largest asset of banks and DFIs, are the single major source of income to them. Loan income enables them pay some profit to depositors. However, as rewards from loans are high, so are the risks. In case one or more loans go sour, the banks are obliged to forego expected income but also to make up the loss of principal from their reserves. Loans are secured but enforcement of security takes time and proceeds might not fully cover the credit risk. According to the SBP requirements, the banks have to make large provisions for problem loans. More bad loans might endanger the continuity of the banks. Due to privatization of most of the nationalized banks, it is imperative that the depositors are protected even more. The SBP might strengthen its guidelines and ask the banks to give more attention to credit function than in the past.

NPLs can be minimized under close supervision of the Board of Directors, through better credit management by properly motivated, honest and extensively trained bank personnel. Improved credit management throughout credit cycle-credit approval, documentation, procurement, disbursement and recovery is essential. One weak link in the whole chain has the potential to jeopardize the entire process and turn the loan sour. Broad requirements for better management of credit and market risks and for minimizing of NPLs are discussed below.

Small loans to shopkeepers, cottage industry or small farmers being numerous are generally handled by bank branches spread all over the country. For such loans, usually credit approval depends on loan security or guarantee. In view of the changing scenario, apart from security, approval process for such loans might be improved to ascertain the need and use of loan funds, sources from which the loan would be repaid and the capability of the borrower to manage his business, industry or farm. Simple credit scoring system might reduce bank NPLs and also save the farmers/shopkeepers from loan-related legal consequences. Renewals of existing short-term loans might also be processed accordingly.

NPLs fall into many categories. There might be some NPLs with technology that is not obsolete, plant being capable of economically producing readily saleable products and for rehabilitation of which the sponsors are keen and willing to invest more money. Such rehabilitation might be examined and supported in the light of the findings. In case, however, the main plant and machines have become out-dated in the meantime, there might not be big justification for revival even if the sponsors are ready for additional investment. Other projects might require change of ownership and management. The NPLs might be subjected to detailed study to identify projects that have potential for rehabilitation. The rest of the NPLs might be dealt with through other measures.

The project sponsors are often blamed for NPLs. It is alleged that they derived unduly large benefits due to which the companies defaulted in debt servicing. There might be a few such cases. However, it is felt that the sponsors in most cases are also ruined if their projects fail, as most of them lose their stake, raised mostly through loans from relatives and friends. In addition, they stand to lose more due to enforcement of their personal guarantees. All borrowers/sponsors must be treated fairly. The sponsors through letter in the newspapers or complaints to the SBP allege that certain banks have charged markup on markup due to which NPLs against them appear larger. The banks are urged to study all NPLs and allow the benefit to the borrowers.

Many lessons for future can be learnt if existing NPLs, particularly the big ones, are reviewed by special teams of bank officers. Independent experts with background in banking operations could also be used. Such an exercise would also help segregate the sponsors who are willful defaulters.

Portfolio of normal loans deserves extra care. The banks might scrutinize this portfolio and segregate loans that have high probability of going sour in the coming months on effectiveness of quota-free regime under WTO from January 2005. There might be cases that need to add new plants and machines for sustaining their profitability or market position. New equipment might be needed by most of the plants to comply with environment and social welfare/labour safety requirements. In their effort to contain NPLs, the banks might consider extending further loans to efficient borrowers.



In carrying out credit operations which are their bread and butter, the banks might scrutinize the integrity of the entire process including appropriateness of the organization for credit function, delegation of sanctioning powers, internal controls including check and balances for monitoring the performance of the bank teams and credit guidelines covering different phases of the credit cycle. Particular attention might be given to the teams of loan officers, who should be selected on merit, be properly motivated, committed to safeguard bank interest and of high integrity. These officers might be supervised by senior officers who are competent, fair and honest.

Main reasons for NPLs include lack of clear policies, poor control of credit/monitoring teams, ineffective system of detecting loan problems, lack of understanding of borrower needs, project appraisal faulty or inadequate, borrower selection not proper, political interference, ignoring provisions of bank's credit policy, ignorance or mismanagement by borrower, genuine difficulties due to external factors or willful default by the borrower. The loan officers and the senior management might be aware of all such reasons.

Wrong selection of borrowers is one of the main reasons for NPLs. The sponsors use loan proceeds, implement the project and repay the loan with profit as per agreed schedule. The loan officers should satisfy that these sponsors have not been in default to the banks, have not availed any write off and are not under litigation with existing creditors. Particulars of each promoting director including qualification and experience, existing businesses and bank accounts, business acumen and managerial capability to appropriately handle men and matters, reputation in the business market, financial means, income tax paid, wealth declared to the tax authorities, etc will help determine their suitability. The banks must carry out KYC check on each one of them and obtain credit reports from other banks and CIB-SBP.

Project appraisal is a critical activity for minimizing NPLs. Project parameters including facilities for implementation are to be evaluated carefully by the team of loan officers. Based on the details supplied by the borrowers, the loan officers might establish that there is ample demand for the products to be manufactured, the project is technically feasible and capable of manufacturing goods at costs lower than the market prices, infrastructure and other facilities needed would be available at the estimated costs and in the target timeframe. There should be reasonable and validated estimates of project cost for completion supplemented by appropriate financing plan and suitable corporate structure. The stake of the borrowers must be high to keep them interested in the welfare and operation of the project. The loan officers would examine project viability and risks, appraise debt servicing capability, loan compliance with policy guidelines and suggest terms & conditions including security subject to which the loan might be considered by the management.

Security, the last resort for loan recovery, is a measure of loan safety and liquidity but it should not be the major reasons for the grant of a loan. Viability of the project and other measures mentioned above are more important. Depending upon the project, the borrowers, and bank policy, loan security is determined from among a number of options such as first charge on project land and buildings, hypothecation or pledge of inventories, floating charge on other assets, lien on receivables / bank deposits, pledge of sponsors' shares, personal guarantee of sponsors. The security should be accepted if it has clear title to the owners (legally complete in all respects).

Loan agreement provides the legal basis of the financial arrangements between the borrower and the lender. The borrowers agree to a number of affirmative and negative covenants. Through negative covenants, the borrowers agree not to do certain things such as no new borrowing, restriction on capital investment, no dividend payments if loan in arrears, no sale of sponsors' interest, no sale of fixed asset and no charge on borrowers' assets without written permission of the bank. Through affirmative covenants, the borrowers accept obligations to submit financial statements regularly, maintain adequate insurance of project assets / loan security, repay principal and pay interest as per agreed scheduled, always maintain minimum current ratio, debt service coverage and debt/equity ratio and to allow inspections of factory and books of account to officers of the bank. These conditions provide a handle to the bank to control the borrowers as well as NPLs and must be carefully negotiated and monitored for compliance.

Reasonable stake of the sponsors is important to keep them interested in the welfare of the project. The banks would not release loan funds before sponsors equity is raised and is being used for purchase of project assets such as project land which is mortgaged in favour of the bank before letters of credit are established for import of plant and machinery or for the acquisition of the locally manufactured machinery. Personal guarantees of directors in favour of the bank are also executed before letters of credit are established or loan is actually released. Machinery financed by bank and borrowers must be installed on this land.

The borrowers are responsible for procurement of all assets for making the project operational. However, as all these assets would ultimately form security of the loans, the banks too have a stake in this process. Therefore, the banks as part of the loan conditions require the borrowers to follow procurement procedures that are more suitable for ensuring value-for-money. Depending upon the loan-size, the banks prescribe an appropriate procurement procedure. The banks review draft machinery contract and monitor procurement process. This process is important for the success of the project and the recovery of the loan.

The bank officers remain in contact with the sponsors to see that the projects are completed within time and cost, without serious problems. By proper sequencing of activities such as construction of factory and other buildings, availability of power and other utilities, hiring of middle management, technicians and labour, etc this objective can be achieved. The borrower would also be submitting to the bank progress reports, which would enable the bank compare actual progress in financial and physical terms with estimates. The banks must keep a check on stock position and other securities provided by the borrower and ensure that valid insurance policies are in place, paid for by the borrower and duly assigned to the ban.

Unexplained deterioration in rapport by the sponsors with the bank officer is one early warning signal. Of many other symptoms, some include drop in usual deposit balances, delay in submitting financial statements, payment delays or irregularities, non renewal of insurance policies, high management turn-over or labour unrest and deteriorating relations with trade suppliers. The loan officers should guess the impending problems and report their observations to the bank management.

When a borrower is found irregular in payment, discussion/negotiation with him is in mutual interest and might pave the way for resolving genuine difficulties by injection of more capital by the sponsors, rescheduling of loan, etc. If matters do not resolve and the borrower appears to be defaulting willfully, the position has to be reported to SBP-CIB. In addition, the bank might initiate credit squeeze leading to recall of loan and enforcement of security. 'Hope for the best but prepare for the worst' is true in lending. The banks might prepare for such a situation from day one when the loan application is received. Legal process being last resort, the banks must handle carefully, with best legal help and diligent follow up.

The banks might adopt a clear policy for future to take up the matter with the government if there is sudden adverse policy change due to which their regular borrowers making timely debt-servicing might turn into defaulters.