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MOODY’S Investors Service’s report on the banking system’s outlook, issued on Feb 28, 2018, delineates the large holdings of low-rated government bonds, modest capital levels and high asset risks as major challenges faced by Pakistan’s banking industry.

According to the report, 9.2 per cent of gross advances of the country’s banking industry are non-performing loans (NPLs).

Asset risk in the context of banking refers to a high level of non-remunerative loans in total asset portfolio. High levels of NPLs negatively impact banks’ supply of money to the economy and increase the cost of lending.

In a press report a large public sector bank has disclosed that a high level of such loans is a hurdle to opening branches in China, pointing out challenges that asset quality poses to capitalisation of the banking sector at large.

Due to the legal impediments to writing-off loans, banks are reluctant to shed off bad loans from their books. A prudent write-off policy and recovery laws can improve the situation

Toxic loans are an international phenomenon. Bad lending, weak foreclosure law and dismal economic conditions can increase NPLs. Keeping such loans on banks’ balance sheet not only affect their capital but also affect economic growth.

When an NPL is written off by the bank, the lender gets a tax benefit of an equal amount by reporting low taxable profit since the amount is a non-cash expense. Due to the increase in net receivable, the balance sheet and capitalisation of the bank increases.

Is it worth bearing the cost of write-offs, which the government does in the shape of fiscal loss? Constant active NPL reduction pays off in growth dividends and short-term costs are worth incurring. Write-off in general is connoted via a clean chit to the borrower or abrogation of bank’s right to recover the lent money.

Contrary to general perception, declassification of toxic loans as assets from the balance sheet is considered a write-off where the bank provides for the asset. It does not mean that the bank loses the right to recover or that the borrower is not obligated to pay the loan.

The write-off process in Financial Accounting Standards is perhaps quicker and more straightforward than what the regulator process mandates in Pakistan. For instance, there are no specific prudential guidelines on write-offs in Sri Lanka and Nepal.

Banks in Bangladesh can write off the loans that were categorised as bad loans for the last five years and are 100 per cent provided by debiting their current year’s income where loans are not fully provided.

Similarly in India banks either make full provision as per the guidelines or write off by debiting their income. Compared to neighbouring countries the write-off regulatory framework in Pakistan is very stringent and needs the Board of Director’s and State Bank of Pakistan’s (SBP) review and supervision.

Writing off bad loans is just one tool banks have in keeping their NPL ratios low. They also have the choice of restructuring and liquidating these troubled assets. Little effort is undertaken by regulators and legislators to work out insolvency and bankruptcy legislation.

According to Bloomberg, the Reserve Bank of India has revised its framework to ensure speedy resolution of bad loans under its landmark insolvency and bankruptcy code 2016. Under the legislation, a special regulator is formed to oversee insolvency professionals, insolvency agencies and information utilities.

Contrary to the neighbouring country, in September 2017 the Senate of Pakistan passed the Corporate Rehabilitation Bill based on the principle of joint mediation. However, a more comprehensive legal framework is required to rehabilitate the distressed companies.

Asymmetric information across lenders can be bridged by the central bank. On commercial banks’ part capacity building is imperative but policymakers should also provide an adequate legal framework for insolvency and bankruptcy.

NPLs relative to gross advances have declined from 15pc to 9pc during 2010-16, however this is still greater than the international standard of 5pc. The more worrisome part is fewer write offs: 3pc of bad loans were written off in 2016 compared to 14pc in 2010.

If banks do not offload toxic assets quickly the scuffle would hinder both economic development and implementation of the Basel III international banking accord that requires well-capitalised banks.

Banks have to admit that certain assets have lost value and keeping them on their balance-sheets benefits no one. Piercing the veil and tracing the assets for recovery as required by the SBP write-off guidelines needs to commence.

—The writer is an investment banker and a visiting faculty at PAF Kiet
adilf39@gmail.com

Published in Dawn, The Business and Finance Weekly, March 12th, 2018