The best guarantee for averting future flow of NPLs is through improved credit management of industrial and infrastructure projects


Dec 13 - 19, 2004





Non performing loans (NPLs) are the bane of banking sector in many of the developing countries including Pakistan. As per SBP Annual Report-2003-04, NPLs of all banks for FY04, according to current accounting practices, were Rs 188.6 billion as against Rs 187.1 billion for FY03, an increase of Rs 1.5 billion. This is due to high incidence of NPLs in specialized banks, which comprise around 29 percent of the total NPLs. The commercial banks instead witnessed a decrease from Rs 141.5 billion in FY03 to Rs 133.8 billion in FY04. This improvement in NPLs growth by commercial banks is due to low lending rates, higher earnings of corporate sector, improved restructuring policies of banks which increased the coordination between bank and the borrowers, better evaluation of borrowers in terms of available credit history through CIB of SBP, etc.

However, even now NPLs are considered excessively high. As inflation and interest rates have started moving up, instead of becoming complacent, the banks and DFIs might redouble their efforts to minimize NPLs through various measures including better credit management. Moreover, the banks might scrutinize their existing portfolio of normal bank loans to segregate loans that have high probability of going sour on effectiveness of quota-free regime under WTO from January 2005.

The State Bank of Pakistan has issued time-based criteria for loan classification and provisioning of loans in repayment default. For all loans-short, medium or long-term where mark-up/interest or principal is overdue by 90 days, unrealized mark-up/interest is to be put in Suspense Account instead of the usual Income Account. In case such loans are not rescheduled, banks will not be able to book the income. In addition, if short-term loans are over-due for 180 days, provision at 20% of net principal, after adjusting outstanding principal against the forced-sale value of loan securities, shall be made. For medium and long-term loans, the over-due period for 20% provisioning is one year. In case loans are classified as Substandard, Doubtful or Loss due to default for longer period, higher rates of provisioning are applicable. SBP has allowed transition period up to Dec. 31, 2004 to the banks and DFIs to regularize their provisioning position. Higher provisions against earlier shortfalls would reduce banks' profitability.

Credit and advances, largest asset of banking sector, are the single major source of income to them. However, as rewards from credit are high, so are risks of NPLs. More bad loans might endanger the continuity of the banks concerned. The banks are diversifying their portfolio to consumer credits but term industrial loans might remain their mainstay for sometime along with infrastructure loans for which there is great appetite. The best guarantee for averting future flow of NPLs is through improved credit management of industrial and infrastructure projects in all phases of the credit cycle credit appraisal, approval, documentation, procurement, disbursement, follow up and recovery. One weak link in the entire chain has the potential to jeopardize the entire process and turn the loan sour. Credit management can be improved through consistent application of appropriate principles and guidelines, some of which are discussed below.

Credit cycle is relatively long for industrial projects financed through bank loans. It starts with loan enquiries by borrowers and ends with the repayment in full of loan availed for setting up of new capacity or for BM&R of an existing projects. Main stages in between are receipt of loan application; appraisal process; screening of appraisal reports at different levels within the bank leading to loan approval; execution of credit agreement; complying with disbursement pre-conditions, provision of loan security, placing orders for procurement of project machinery; construction of factory and allied infrastructures; arranging utilities; hiring of senior management and labour; bringing machines to site and their installation; arranging raw material and start of trial run for manufacturing products; test marketing of products, start of commercial operations, inflow of revenue from sales; meeting expenses; and the paying of interest and principal to the creditors. However, it might be noted that every stage in the credit cycle has a number of important activities which need to be accomplished well as otherwise physical progress of the project or its viability may be adversely affected. The main activities at each stage of the project- cycle are briefly discussed below.



Appraisal is the most critical stage during which scrutiny is done of matters such as suitability of the project sponsors; adequacy of their financial means and management capability; commercial viability of the project including suitability of location and availability of land; technical feasibility/suitability of technology and plant and equipment; corporate structure and capitalization of the company; and availability of all needed inputs and material etc. Based on details supplied by the borrowers and corroborated through other means, the loan officers would also 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 needed facilities would be available when required at estimated costs. There should be validated estimates of project cost for project completion supported by appropriate financing plan. The loan officers would examine project risks and mitigates thereof, appraise debt servicing capability, compliance with policy guidelines, government laws and regulations and suggest terms & conditions including security subject to which the loan might be considered by the management. Quality and thoroughness of the appraisal process can minimize the occurring of serious problems and delays in implementation.

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, which provide a handle to the banks to keep a check on the borrowers and must be carefully negotiated and monitored for compliance. 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 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 loan security, the banks too have a stake in this process. Depending upon the loan-size and for ensuring best-value for money, the banks prescribe an appropriate procurement procedure, normally review draft machinery contract and monitor procurement process.

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, with the aim to see that the project is completed within time and cost. Project implementation is delayed due to reasons such as delays in the purchase of land or subscription of equity, delay in availability of loans from co-financiers, disputes regarding purchase of land or among the sponsors, late delivery of machinery or late arriving at site or delays in installation, legal formalities taking extra time, genuine difficulties due to external factors, etc. The difficulties or delays if not tackled properly in good time might jeopardize the project viability and the money invested.

The borrowers submit periodic operation reports and financial statements to the creditor banks. Such reports might be properly analyzed. The analysis might be supplemented through market intelligence of the project and the borrowers. The projects experience problems due to factors such as: project products are readily marketable due to high price or poor quality or both, raw material becoming costlier, adverse changes in government policies, pilferage in company resources, political unrest, poor law and order, increase in financial cost and operational costs, inefficiency of the bankers to monitor project operations, etc. The projects sometimes face problems that are beyond the reasonable control of the project sponsors and/or the creditor institutions. International developments and change in policies by the government are some of the examples. A united effort by both these counterparties might be more helpful. The creditor institutions some times leave resolution of such problems to the sponsors but in doing so they also damage the chances of recovery of the loan funds already invested in the project.

The bank personnel must periodically monitor the raw material and stocks offered to it as security and also monitor the physical condition of assets offered as loan security. The banks must ensure that all project assets have valid insurance polices in place with payment of premium. The banks to exhort the borrower to comply with GOP requirements including paying taxes on timely basis as any trouble with the GOP will jeopardize the loan servicing capability of the borrower.

The project sponsors are often blamed for NPLs. There might be a few such cases. However, it is felt that the sponsors in many 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. Distinction might be made in dealing with the willful defaulters and the sponsors who have been unlucky.

In tackling NPLs and for better credit management operations in future, the banks might scrutinize the integrity and soundness of entire credit 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.

Unexplained deterioration in rapport by the sponsors with bank officers 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 visualize the impending problems and report their observations to the bank management.

When a borrower is found irregular in payment, discussion 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.

Project delays generally result into cost over-runs, which are financed by the existing creditors and/or main sponsors. If this is not possible, the over-runs might be met by withholding payments to contractors and suppliers, delay in payment of interest to the creditors, deferring payment of insurance premium, late payment of wages, salaries and utility bills, etc. More often such steps aggravate the situation and turn the project into a problem project. In case the borrowers approach the creditor banks for rescheduling the loans, their request might be considered favourably if it is determined that the delay is due to reasons beyond borrowers' control. Rescheduling of loans is basically deferring receipt of cash to a new date or dates in future. The creditors, however, have to be more careful if delay is due to mismanagement or sponsors' lack of finance. On rescheduling, viability and cash flow generation capacity of the project might be assessed afresh.

The project might be unable to pay creditors' liabilities when due to genuine or concocted difficulties. Such projects need serious review and restructuring including that of the loans. The project restructuring would vary from project to project. Some projects might have technology/plant 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 through restructuring even if the sponsors show readiness for revival through additional investment. Other projects might require change of ownership and management. To identify projects with potential for rehabilitation, all projects in default might be subjected to detailed study.



The creditors might consider restructuring of projects always under legal advice. If there is more than one creditor, joint action by them will be more useful. The experts/creditors should examine the project details to identify different weak areas and agree on best option, which might be presenting to the sponsors/borrowers. The sponsors might be asked to inject more cash or changes in the Board of Directors or Senior Management, sale of surplus assets, etc. As part of restructuring, the capitalization of the borrower company might be adjusted through measures such as converting part the loan to equity of creditors, reduce the loan to a sustainable level on the basis of projected cash flow of the project, the rest of the loan to be frozen and might be written off if the restructured loan is fully repaid according to the agreed conditions. There shall be no interest on frozen loan amount. The restructuring exercise shall have a better chance of success if all creditors work as one united team and agree on pari passu arrangements.