A loan is considered to be in default when the borrower fails to repay money on the due date of payment, as agreed in the loan contract. It normally occurs after a couple of months from the agreement when the debtor is unable to pay his debt on time.
These default loans have posed a major risk to the financial and banking systems of an economy. It is often termed the “cancer of the financial system.” This has been haunting Bangladesh. About 11% of its total loan disbursements are classified as defaulted.
The question is why NPLs are such a huge threat to the financial sector. A one-sentence answer will hardly help in finding an accurate response to this question. Let’s see from the point of view of economics how this whole phenomenon looks.
NPLs have threatened the modern banking system on several occasions and for several reasons. That is, they impact the financial sector from different angles. For instance, higher NPLs predict lower GDP growth, higher unemployment, and a decline in loan growth.
When a loan defaults, the banks have to make provisions for classified and non-performing loans out of their profits, which are largely derived from interest on performing loans. Default loans decrease bank profits while increasing the interest rate for the borrowers.
A hike in interest rates discourages investors from undertaking loans with high interest rates. Since this is an increment of the cost of risk, the investment activities decrease. At the end of it all, reduced investment at the economy level creates fewer job opportunities and negative implications towards the GDP.
On the other hand, to provide for NPLs, banks can reduce the interest payments to depositors. Such actions discourage depositors from saving their money in the banks since lower returns present deposits as less attractive, and it decreases the availability of credit in the whole economy.
Making provisions for NPLs out of profits also reduces the rate of return for individual shareholders of the bank. This reduction affects the market price per share of the bank and eventually erodes shareholder confidence and market value.
In a worse case, the inability of a bank to provide for NPLs from its profit may result in compelling it to sell its capital in order to meet the depositor’s claims. It is an acute situation that can be substantially detrimental to the proper running of the bank.
High levels of defaulted loans deplete confidence in depositors, borrowers, and shareholders, which may endanger the bank’s operation. It may further lead to an overall financial failure within the economy.
Why do loans become defaulted? The simple answer is poor corporate governance. An autocratic government, for example, may exploit the banking sector through the exercise of unbridled power. Corruption then becomes the main culprit in such situations, weakening the very foundation of the financial system.
Besides, the inept regulatory oversight increases the magnitude of the problem. When banks are never taken to task for their loans, they may start intensive or politically motivated lending sprees, increasing the possibility of defaults. This, again might create a vicious cycle of rising NPLs and generally deteriorating financial health across the sector.
Another contributing factor is economic instability. Inflation, depreciation of currency, and reduced consumer spending power all work to squeeze the borrower in a manner that makes paying loans back difficult. Even well-intentioned borrowers may fall into default during times of high uncertainty, thus further straining the financial system.
The defaults on loans are the silent yet potent force of destruction in the banking arena. In short, what is required for stability in financial markets to usher in sustainable economic growth is strong corporate governance, transparency, and systemic reform.
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Writer
Fazlul Karim,
Intern, Content Writing Department
YSSE