View Point (Spotlight Weekly)

Managing Non-Performing Assets

By Dr. Tilak Rawal

After the crisis of 1997, many countries initiated reform measures. On the question of reducing huge Non-Performing Assets (NPA) in the financial system, South Korea made remarkable progress followed by Malaysia. We had sent a team to Malaysia to learn from their experience and to establish an AMC (Asset Management Company) in Nepal.

Nepalese Case

Nepal is passing through a critical period of time. For the first time in about two decades the economy contracted by 0.5 percent in 2001/02, the balance of payment position also turned negative once in the recent past. However, the economy rebounded in 2002/03 with a growth of 2.4 percent and the growth of 4.7 percent is expected in 2003/04. Exports and imports have shown positive signs in the initial months of the current fiscal year. Level of foreign currency reserve at Nepal Rastra Bank (NRB) is at a very satisfactory level.

Financial sector of Nepal started opening up in 1986/87 as a result of which the number of financial institutions in the country increased rapidly thereafter. Measures were initiated then to correct anomalies in the system mainly in Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL) viz; CBPASS followed by re-capitalization of RBB and NBL. Corrective measures initiated then, however, were on piece-meal basis. Re-capitalization of the institutions was not followed by other measures. Consequently, therefore, the intended targets were not achieved. This time the approach to reform has been a comprehensive one encompassing, among others, legislative measures to support the reform strategy.

Astounding level of NPA of the banking system, which stands at 30 percent, has caused anxiety and has become a matter of concern. The situation is even worse in case of the two banks RBB (52% NPA) and NBL (62% NPA) which together account for 37 percent of the total deposits of some Rs. 200 billion and 40 percent of the total loan outstanding of Rs. 125 billion of the banking system in the country. Besides, some of the private banks also do not seem to be doing well. This deplorable situation along with the need to make our financial players competent enough to take on the financial players of international repute in the gradually evolving competitive environment, prompted us to go ahead with the reform measures.

Crisis And Reforms

Reform measures are initiated and executed during crisis. For example, the US has experienced serious banking crises over time. The first one was during the Great Depression of the late 1920s and early 1930s. Deposits in different banks were depleted by the poor performance of the banks, bad loans and troubled economy. The real GNP took a nosedive from $ 203.6 billion in 1929 to $ 144.2 billion in 1932. So was the decline in investment and the level of inflation stood at negative 10.1 percent in 1931. Hundreds of banks were closed and thousands of real estate properties were foreclosed. Unemployment recorded an all time high of 25.2 percent in 1933. In response to the call to do something to avoid economic misfortune of this kind, the US Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933 and Federal Savings and Loan Insurance Corporation (FSLIC) in 1934. Among other things, these two agencies were also responsible for making sure that the financial institutions were following bank laws, policies and procedures. The system worked well and the economy at large benefited from the trust established.

Again in 1970s and 1980s another debacle hit the financial industry which is blamed on the very poor lending practices and non-transparent bank supervision by the regulators. By the end of 1988, both the FDIC and FSLIC were bankrupt. Thousands of loans were in default. The US Congress established the Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA). This comprehensive bank legislation created Resolution Trust Corporation (RTC), among other things, to liquidate the failed Savings and Loans Associations. In addition to investigating and prosecuting corrupt bankers, the RTC had sold by 1995, 95 percent of the assets of 747 organizations of the book value of $ 451 billion - at 87 percent of the book value. It is clear that the reform measures had the full backing of legal system in the US and the RTC completed the task assigned to it and in December 1995, 3000 RTC staffs lost their job for the job well done.

After a decade of robust economic growth, the so-called tiger economies (of South East Asia) began to experience set back in 1997. The crisis started in the financial sector and took the shape of full-blown economic crisis as time passed by. Indonesia, Korea, Malaysia and Thailand had remarkable real GDP growth rates in 1996 ranging from 5.9 percent in Thailand to 10 percent in Malaysia. In 1998, however, all these economies contracted, Indonesia registering the largest decline (-13.1%) and Korea suffered relatively lesser (-6.7%). BoP position also deteriorated in these countries. The crisis in some of these countries was blamed on unhedged short-term borrowing from outside to fund unproductive projects with long gestation periods, laxed enforcement of prudential norms and directed lending programs and unjustified exchange rates. Korea turned out to be a net exporter of capital. These countries, however, did not wait for the crisis to be over for reform actions to start. Korea for example went ahead with a coordinated approach with the support of IMF, restoring confidence with government guarantee to prevent a run on the bank, closing insolvent institutions, redoing viable ones, enforcing adoption of standard accounting, supervision and regulation practices. A powerful Financial Supervisory Commission was established in 1998 and at the same time deposit repayment through the Korean Deposit Insurance Corporation was restored. The establishment of KAMCO did wonders as far as reducing the level of NPA is concerned, from above 16 percent to less than 4 percent now. We intend to learn more from the experts on this front. With the job will done, KAMCO is learnt to have been diversifying into areas it was initially supposed not to take into.

Malaysia also responded quickly to the crisis, which is manifested by the imposition of capital control measures there. In 1998, Danaharta (Malaysian AMC) was created to obtain NPAs of banks and Danmodal was created to re-capitalize institutions whose capital adequacy ratio fell below 9 percent. These two agencies, respectively, purchased 50 percent of NPLs and injected $ 1.6 billion into the capital weak institutions.

Reform Measures in Nepal

In light of crisis that struck different economies at different periods of time and the measures adopted to overcome the problems there, we in Nepal have decided to make a frontal attack in a comprehensive manner on problems of varied nature and magnitude that the financial sector of Nepal is riddled with. Management of the two ailing banks has been handed over to two teams consisting of experts from within and outside of Nepal.

Financial sector reform measures can be broadly grouped under three heads: (i) restructuring of RBB and NBL (ii) reengineering of NRB and (iii) capacity building in the financial sector. The enactment of new Nepal Rastra Bank Act, 2002 and enforcement of inspection and supervision manual based on the recommendation of the Basel Committee are important achievement. Further, with a view to strengthen the legal framework and consolidate the financial sector an umbrella act - Banks and Financial Institutions Act is in the process of approval. Debt Recovery Act has been approved and the Debt Recovery Tribunal has been constituted. Asset Management Company Act is in the process of being approved. NRB now has decided to concentrate only on core functions and therefore is shedding non-core activities and reducing the number of non-professional staff, which has been effected through voluntary retirement scheme.

Financial institutions in Nepal suffer from unclear role and responsibilities of managerial bodies, boards, shareholders and other stakeholders. Further, in view of the absence of a code of conduct for employees, managerial bodies, board members and other stakeholders, and rampant irregularities financial sector, NRB has initiated different measures to improve corporate governance in the financial sector.

Some of these include: –

(1) raising of paid up capital for national level commercial banks from Rs. 500 million to Rs. 1 billion.

(2) increase in share capital participation in a national bank by a foreign bank to 67 percent from 50 percent.

(3) setting of minimum qualification requirement for promoters interested in opening financial institutions.

(4) issuing of directives in regard to capital adequacy, loan classification and loan loss provision.

(5) establishing code of conduct for governing bodies of banks, defining the duties and responsibilities for the Board of Directors and establishing qualification for the appointment of Chief Executive Officer.

Undoubtedly, as was the case in other countries, this is going to be a painful process here, too. The willful defaulters, it seems, are going to be hit hard. We want the banks and the clients to walk a mid-way. That said, please be informed that NRB will initiate, stringent measures, if required, to stop depletion of common man's deposits and erosion in the common stakeholders capital. The clients have to, at least, start servicing the debt, they can not totally ignore the banks, specifically RBB and NBL. Defaulting on loan payment in the pretext of bad economic conditions cannot be a saleable proposition because we have seen that loan recovery was carried out with full vigor in economies, which went through a more serious phase of turbulence than we are in at the moment. The bankers have also to understand in very clear terms that they have to learn to consolidate their position which can be effected through building a strong capital base and adoption of prudential banking norms relating to provisioning, transparency and accounting standards. I want bankers to think seriously about cost cutting measures and also think about the days ahead, which together with increased level of benefits and opportunities will bring in increased level of competition and risk for you.

Conclusions

Before I conclude let me tell you that Nepal has a lot to learn from Korea, a hilly country, too, whose per capita income approximated $ 80 in 1960 and today stands at $ 10,000. It is interesting to see how Korea transformed itself into a prosperous nation overtime, making use of the abundant labour in light industries in the beginning and succeeding in eradicating extreme poverty by 1970s. After 1970s, Korea started to build heavy industries e.g. steel, petrochemicals, automobiles and shipbuilding. I agree that Nepal should import technology and capital and make use of the abundant labour. It is worth mentioning here that China today, because of the cheap labour, is the low cost producer of almost everything one could conceive of under the sun. I also agree that the government should strive to increase production and investment while the central bank should conduct monetary policy to avoid erosion of the basis for price stability. In view of the limited ability of the government to provide the much-needed fiscal stimulus, we have adopted a little bit accommodative monetary policy because the fundamentals are permitting us to do so. As permitted by the level of inflation which has lowered around 3 to 5 percent in the recent past and favourable BoP position, thanks to worker's remittances, NRB has revised downward the CRR rates as well as refinance rates more than once in the last 3/4 years. We, at NRB, will continue to be dictated by economic and market fundamentals and our resolve to go ahead with the financial sector reform program with the support of national and international collaborators is firm and unshaken.

(The article is an excerpt of the governor of Nepal Rastra Bank Dr. Rawal’s inaugural address at the workshop held recently in Kathmandu)