At the end of September 2018, non-performing loans (NPLs) of the banking sector stood at Rs636.7 billion. One year on, the amount swelled to Rs758.1bn. An increase of Rs121.4bn or 19 per cent in bad loans over a year is alarmingly high — and worth probing.

The State Bank of Pakistan (SBP) probed the causes. Banks, too, looked into the issue on their own. Growing financial hardships of private-sector borrowers emerged as the common finding. The government, the central bank, banks and private-sector leaders reached the conclusion that the restructuring of bad loans was a viable solution under present circumstances.

In January, 10 banks jointly formed Pakistan Corporate Restructuring Company (PCRC) for this purpose. These banks are Habib Bank, National Bank of Pakistan, United Bank, MCB Bank, Allied Bank, Meezan Bank, Bank Alfalah, Bank Al Habib, Habib Metropolitan Bank and Faysal Bank.

In addition to slower economic growth (3.3pc in 2018-19 against 5.5pc in 2017-18) and a surge in annualised consumer inflation (7.3pc in 2018-19 versus 3.9pc in 2017-18), and the interest rate tightening to contain it, a couple of other factors have led to the expansion in the NPL stock. Since economic growth is likely to slow down further as inflation in the first seven months of 2019-20 has reached 11.92pc, financial hardships of the private sector are far from over. That increases the risk of further growth in bad loans.

The most contentious issue that PCRC will have to address is to determine whether a loan default was circumstantial or wilful

In addition to high inflation amidst slower economic growth, some other factors have also contributed directly to the expansion in bad loans. These include the withdrawal of energy and agricultural input subsidies, ill-conceived documentation drive and its poor implementation, overall level of private-sector credit inflows, rapid depreciation and continuation of tight monetary policy. A 2015 study on the determinants of NPLs in Pakistan, carried out by the Department of Business Administration at Jinnah University for Women concluded that “exchange rate and loan disbursement to the private sector significantly impact the level of NPLs in Pakistan’s banking industry”.

A larger private-sector credit off-take and depreciation during two or more quarters often lead to an increase in NPLs after a time lag, more so if the economy also begins to slow down. We saw rapid growth in private-sector credit in 2017-18 when it reached the historic high of Rs775.5bn and the unabated rupee depreciation in January-March 2018 that continued throughout 2018 and into the first half of 2019. That explains why net NPLs that had started expanding as early as April 2018 gradually reached the high level of Rs758.1bn in September 2019.

To begin with, PCRC will help restructure stuck-up loans of state-run enterprises, thus helping the government avoid the privatisation of a number of entities that are not functioning well because their lines of financing remain chocked.

But going forward, PCRC will bring banks and even private-sector borrowers to the negotiating table. It will find ways to enable banks to recover overdue loans after making some sacrifices. And, it will convince borrowers that repaying old loans on easier conditions is the only way forward.

There are some categories of NPLs and not all of them are treated as default. Banks deal with each category of NPLs according to the relevant prudential regulations of the central bank. The problem is whenever a loan falls in the first category of NPLs, banks become cautious in further lending to the party concerned.

They treat big and regular customers a bit differently though. They renegotiate terms before the outstanding loan against them falls into the final category of NPLs — a clear default. This special treatment is meted out to them because (1) banks cannot afford to lose them and (2) they are considered “too big to fail” i.e. if banks stop lending to them, they can slow down their activities and hurt an entire sector or the economy at large. Besides, front companies of the most powerful people in the country or industries and businesses enjoying their blessings don’t bother to service their loans regularly. That too is sometimes ‘managed’ in violation of the rules as long as possible.

The restructuring of NPLs through PCRC means the total sum of such loans outstanding against a borrower at a number of banks will be aggregated. Then the borrower in question will be given a chance to resettle the entire stock of these loans under a resettlement package. The job of PCRC will be to develop such a package in consultation with the banks whose loans remain outstanding against the borrower.

If PCRC can work independently and free from any pressure, the idea is not bad. But if it shows “undue haste” in the restructuring of loans of some parties or designs their loan restructuring packages on “unreasonably easier terms,” then the whole exercise will become ineffective.

The most contentious issue that PCRC will have to address is to rule on whether a loan default was “circumstantial” or “wilful”. And that is where the peril of intervention from the most powerful and most influential quarters will be lurking. Banks have a set mechanism of ruling on whether a default is “circumstantial” or “wilful” and they treat each of the two separately.

In the first case, loan structuring is possible. In the other, it is not. Since this applies to both private- and public-

sector lending, the fact that PCRC’s most immediate job is to help financially distressed state-run organisations should not ideally influence its decision to treat “wilful” defaults accordingly. That is why PCRC has been empowered under the law to liquidate an entire defaulting entity and take it over if that is feasible.

Published in Dawn, The Business and Finance Weekly, February 10th, 2020