Non Performing Loans:
Elusive Solution

By Santosh Pandey & Thai Phien Nguyen

Non Performing Loans (NPLs) remain an acute headache for every national regulator because the problem is tough to be sorted out. The government’s role looks to be unavoidable to stop the surging NPLs. However, there are two sides of the coin; its intervention could either end up with bad loan reduction or finish up with no achievement at all with persisting flow component (flow component means new lending to state owned enterprises made by banks to reduce its impaired loan ratio). This article is going to assess two main methods normally undertaken by governments (debt cancellation and debt transfer to Asset Management Companies) to deal with NPLs. We also make an attempt to come up with some recommendations for transition economies because the lessons/experience from “first wave reforms” in the developed nations cannot be fully applied in every country due to the particular traits of each country. 

Debt cancellation

Debt cancellation resolution emerges due to specific characteristics of transition economies’ “inherited bad loans” which are results of government decisions and has been proved to be economically wrong. In centralized economies and in the pre-transition period, the government orders each and every SOEs to accomplish particular objectives regardless of the laws of supply and demand or availability of resources and even without consideration of profitability. Obviously, the wrong decisions make enterprises unable to repay their principal or even interest with the government indirectly “making its own goal”. The consequence here is the lending institutions are left out with huge burden of bad debts to deal with. The policy of canceling inherited debt in the transition economies was advocated by a number of prominent economists (Beger and Portes, 1993; Calvo and Frenkel, 1991). They argued that cancellation of the inherited debt would remove a burden of the past from firms’ balance sheets without changing the value of state-owned assets since all firms and banks were state-owned at the beginning of transition. Interestingly, with the exception of Bulgaria , none of the transition economies have canceled any of the inherited debt. The most frequent explanation for the absence of this policy has been its creation of a credibility problem: if the government is willing to cancel debt once, then the state enterprises (SOEs) and banks may believe that the government will be willing to do the same in the future as well (asymmetric information problem). However, it is not the debt cancellation that gives rise to the credibility problem but the bank recapitalization, which is followed subsequently. In case there is no recapitalization after debt relief, the banks would oppose this policy because it would require them to write down their assets. Thus, the credibility argument cannot fully explain why other policies have been undertaken rather than debt cancellation.

Debt cancellation could be one method which authorities are looking for. Since SOEs fumble to find a way to renew themselves with huge amounts of debts blocking their way, a clear balance sheet would become a fulcrum for them to attract outside investor for privatization or joint venture. It does not only help SOEs become more effective but also enhance the performance of the whole economy. On the banks though, debt cancellation means their asset side gets a deficit and thus, they must be provided with some kind of financial assistance by the government.

Asset Management Companies

Setting up Asset Management Companies (AMCs) has been employed to tackle the bad debt problem in the financial system. Two main types of AMCs are found to be responsible for either expediting corporate restructuring or disposing of assets acquired/transferred to the government (rapid asset disposition vehicles).

Two methods are used to balance the asset/liability of parent banks, or to put it in another way, to get the resulting hole on the bank’s balance sheet filled.

• To reduce the liability side, the parent banks transfer some lending from the central bank to the AMCs. This method take both bad assets (NPLs) and liabilities (Central Bank lending) and hence the bank downsizes.

• To increase the asset side, the parent banks buy some bonds issued by AMCs.

The transfer of NPLs from parent banks to AMCs involves an exchange at the face value of the loans; thus, the parent banks get compensated fully for all transferred loans.  The desirability of transferring debt to an AMC has been the subject of considerable policy discussions and also has been cited by many economists as an element of best practice in the response to the surge of NPLs. Many countries, including the US , Japan , Sweden , Czech Republic , Thailand and China have used AMCs to tackle the problem.

However, some researches conducted on the issue of efficiency of AMCs show that it can be effectively used only for narrowly defined purposes of resolving insolvent and highly distressed financial institutions and selling off their assets. Two of the reviewed corporate restructuring AMCs in Finland and Ghana did not achieve their target. Only the Swedish AMC successfully managed its portfolio because of its acting, in some instances, as lead agent in the restructuring process despite it being controlled by the government. Rapid asset disposition vehicles fared somewhat better with two out of four agencies ( Spain and the US ) achieving their objectives.

What are the reasons for bad performance of such AMCs? There are mainly three reasons to be blamed.

First, most of AMCs are still being controlled by government authorities such as Ministry of Finance, Central Bank or special committee who are in charge of dealing with NPLs. With the overlapping directions from government and “behind the curtain” problems (corruption), the AMCs can not take their own and the right decisions. Second, transferring bad debt from parent banks to AMCs does not mean that all information is transferred. Parent banks with long standing records of borrowers can easily find out the potential trouble borrowers and therefore take actions accordingly. This advantage of parent banks cannot be transferred to AMCs. Moreover, the relationship also fosters collusive behavior and inhibits competition. Third, if the size of the capital market is small, there will be very less investors to invest on NPLs.

After going through the literature of the experiences of other countries, some of the recommendation we deem necessary to put up here for Nepal , which is also suffering from the growing trend of NPLs, are as follows:

• To reduce the loss of information problem, not only old bad loans should be transferred to the AMC, as has been the current practice, but all of the SOEs’ banking business should be transferred to the AMC so that AMC could get adequate information. This will evade the problem associated with asymmetric information.

• To encourage the collection of revenues and to punish nonperformance and corruption, a penalty-incentive scheme must be designed. 

• To broaden and deepen the capital market, the government should allow foreign investors enter the market and such policies would enhance the performance among AMCs themselves due to competition.

(The authors are undergoing an MSc. Course in International Banking and Finance at London Metropolitan University )

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